Disruption in the Audit Market

The Future of the Big Four

Krish Bhaskar, John Flower

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781000007862
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Focussing on the dominance of the Big Four auditing firms – PwC, EY, Deloitte and KPMG – this concise volume provides an authoritative critical assessment of the state and future of the audit market, currently the subject of much debate and the focus of significant government enquiries. Drawing on extensive research and a vast collection of evidence from interviews with insiders, experts and users, it explores the key issues of audit quality, independence, choice and the growing expectation gap.

Just as disruptive technologies are overturning other established sectors, this book explores their impact on accounting, financial reporting and auditing. It questions whether the Big Four-dominated audit market is prepared not only for the inevitable disruption of new technologies, but also the challenges of negative public perceptions, cynicism about regulation and demands for greater transparency.

In the context of increasing high-profile corporate failures, this book provides a compelling scrutiny of the industry's failings and present difficulties, and the impact of future disruption. At this crucial time, it will be of great interest to students, researchers and professionals in accounting and auditing, as well as policy makers and regulators.

1 About this book

What is this book about?

This book is a concise and accessible guide to the current state of the audit market, exploring not only its failings and how it needs to change to address numerous existing challenges, but also the disruptive challenges of the future.

The Competition and Markets Authority (CMA) and Kingman report were published post-publication. Reactions to the CMA on the audit market and the Kingman report on the replacement of the Financial Reporting Council (FRC) can be found in the online companion volume www.fin-rep.org.

Just as disruptive technologies have played their part in changing the world, through such sites as Amazon, Uber and Airbnb, disruption is starting to appear in accounting, financial reporting, corporate reporting and auditing. This book deals with one branch of auditing disruption. That is the dominance of the Big Four accounting/auditing firms PwC, EY, Deloitte and KPMG who have now branched out into consultancy but still have a stranglehold over the FTSE 350,¹ the UK’s largest 350 companies by market capitalization.

The Big Four was previously the Big Five and included Arthur Anderson. All three of us had some connection with Arthur Andersen in the past as did many of our students. Their consulting arm, Andersen Consulting, ultimately became the world’s leading consulting firm, Accenture, with fees of close to $40 billion. The scandals that caused the break-up of Arthur Andersen (and there is no doubt that in this case the auditors were to blame) not only led to the collapse of the company, but more importantly provoked increased regulation intended to protect auditors’ objectivity. In an environment where competition is limited, auditor objectivity remains a key issue. Moreover, auditors are paid by the firms they are scrutinizing, rather than the investors who in theory they serve. The tighter rules introduced post-Arthur Andersen have had some success: measures of audit quality are improving. But the audit market is under threat more than ever before.

Disruption can develop in a number of ways, none of which, we think, the sector and profession is adequately prepared for. This is not just technology driven, but also the combined effect of a number of factors. For example, changing attitudes in openness and transparency, public perceptions, continued failures or what appears to be a misstatement of financial results despite the continuing actions of regulatory authorities – and the auditors giving what is in effect a clean bill of health.

Definitions

External auditing is an examination and verification of accounts and records, especially of financial accounts, by an appropriate body and is usually determined by legislation of a controlling body. External auditing acts as an important external check and balance. In simple terms, it provides a stamp of approval, usually signalled by a pass or fail audit opinion. In the UK this is mainly overseen by the FRC and to a lesser extent the FCA (Financial Conduct Authority).

In the US, the SEC, and its offshoot the PCAOB (the Public Company Accounting Oversight Board), and the Financial Accounting Standards Board (FASB) provide the same functions. In Europe it is determined by each national government in conjunction with EU directives and regulations. In this book, internal auditing is part of management and the internal controls, so when we refer to auditors, we are referring to external auditors or the process of external auditing.

The current auditing market

In this concise text, we deal solely with the audit market and the future of the Big Four. All three authors come from an auditing background and have consulted widely with the Big Four, the FRC and many others. We recognize that it is often too easy to criticize the auditing profession rather than the origin of the problem, which is the management and the preparers of the report or message. Nevertheless, we believe the Big Four have to change to address the expectations gap, and we recognize that their dominance, and the perception of too little competition has to change. Moreover, the nature of audit must change. The status quo is no longer viable.

However, any criticism of the Big Four needs to be seen in context of thousands of successful audits every year. The British accountancy profession is arguably akin to a national treasure and we should be proud of the sector. Whilst reducing the number of scandals to zero is probably never achievable, we are sure they can be minimized. This will only be achieved if all of those involved in the publication of reports and financial statements – preparers and auditors alike – are faced with a fair and proper disciplinary regime.

So the approach of this book is that it is better to criticize the auditing market and suggest realistic solutions. We strongly believe that the Big Four can adapt and survive in this current disruptive world. But without change they will not avoid the sort of disruptive takeovers that shops, taxis and hotels have faced. It is their choice: evolve or become extinct. The combination of failures in practice and the potential of disruptive technology poses an existential threat. Artificial intelligence (AI) systems mean that the audit functions of the Big Four will only need a fraction of their size, ceteris paribus, quite quickly. Standardized auditing AIs will mean that much smaller firms can undertake the auditing work of a FTSE 100, possibly threatening the Big Four’s monopoly.

This may sounds dramatic but as members of the accountancy profession, we want the profession to perform a vital, useful and transparent function, and to catch problems like Carillion. In our opinion, it was possible for both internal and external auditors to have warned the public as early as early 2016. That might not have saved the company but it would have allowed more people more time to adjust and it would have been fairer and more honest. Like the medical profession, we believe accountants and auditors should have a duty to the truth that circumvents any client relationship. The auditor’s independence is being questioned. If the government is not satisfied, the function of the external auditor could be legislated away to other bodies.

Carillion – a pivotal event

Although there had been previous company failures, the one single most challenging and pivotal occurrence to face the audit market was the failure of Carillion at the beginning of 2018. The failure left a mountain of debt, job losses in the thousands, a giant pension deficit and hundreds of millions of pounds of unfinished public contracts with vast ongoing costs to the UK taxpayer. How could a company that was signed off by KPMG as a going concern in Spring 2017 crash into liquidation with a reported £5+ billion of liabilities and just £29m left in cash a few months later? (See online Appendix 1.01.1.)

The decline in audit quality

Before discussing the FRC verified decline in audit quality, there is the counterargument that the scope, depth and extent of the audit has been increasing year by year. Therefore, it may not be possible to measure quality exactly over time. Yet there is no hiding the fact of the current set of company failures not commented on or found by the auditors.

Stephen Haddrill, ex-chief executive of the FRC, said the UK’s CMA (Competition and Markets Authority) should investigate the case for ‘audit-only’ firms in an effort to bolster competition and stamp out conflicts of interest in the sector. The radical idea would force the Big Four firms – Deloitte, EY, KPMG and PwC – to spin off their UK audit arms into separate businesses. Mr Haddrill’s intervention follows a string of corporate accounting scandals, ranging from Carillion to Steinhoff in South Africa and Petrobras in Brazil. “There is a loss of confidence in audit and I think that the industry needs to address that urgently”, he said. “In some circles, there is a crisis of confidence.”²

Audits on Carillion were criticized in the Select Committee early in 2018 as “a colossal waste of time”³ and suggested the auditors had a role to play in the collapse of the company. The chair of the business energy and industrial strategy said: “We heard from auditors who don’t attend audit meetings, fail to visit projects which they themselves say are at risk, and who provide clarity only about what is not included in an audit rather than what is.”⁴

Carillion and the other audit failures will be analyzed in detail in a separate volume. However, even this brief overview shows that much is left to be desired from current audit practice, despite attempts to improve quality. It appears the way that the current audit sector is configured makes it unable to cope with current economic and disruptive conditions. This is what the FRC said in June 2018:⁵

The Big Four audit practices must act swiftly to reverse the decline in this year’s audit inspection results if they are to achieve the targets for audit quality set by the Financial Reporting Council (FRC)… . Across the Big 4, the fall in quality is due to a number of factors, including a failure to challenge management and show appropriate scepticism across their audits, poorer results for audits of banks. There has been an unacceptable deterioration in quality at one firm, KPMG. 50% of KPMG’s FTSE 350 audits required more than just limited improvements, compared to 35% in the previous year. As a result, KPMG will be subject to increased scrutiny by the FRC.

Stephen Haddrill, the FRC’s ex-CEO said,

At a time when public trust in business and in audit is in the spotlight, the Big 4 must improve the quality of their audits and do so quickly. They must address urgently several factors that are vital to audit, including the level of challenge and scepticism by auditors, in particular in their bank audits. We also expect improvements in group audits and in the audit of pension balances. Firms must strenuously renew their efforts to improve audit quality to meet the legitimate expectation of investors and other stakeholders.⁶

The FRC is not without its own critics, but in essence it has noticed a fall in audit quality. We maintain that fall is due to the convergence of a number of factors:

• Continuing austerity policies eroding government expenditure (and those firms depending on public spending);
• Brexit changing the focus for firms, rapid fluctuations in sterling;
• Low interest rates (which traps highly geared firms or causes higher leverage) into a false sense of security;
• The disruptive effect of new technology, internet and IT in general.

Michael Izza, Chief Executive at ICAEW (the Institute of Chartered Accountants in England and Wales, the premier English institute for chartered accountants who dominate the professional audit market) said in June, 2018:⁷

[This report coupled with the publication of the FRC’s enquiries into the audits of Quindell and BHS] has reinforced my view that the profession is at a watershed moment. The trust that investors and others place in us to get things right has been brought into question. We not only need to regain that trust but, in my view, we also have to ask ourselves whether or not the services we provide are still fit for purpose. If we have a situation whereby politicians, regulators and society expect something more from us, and the product and service that we delivered is no longer regarded as sufficient, we need to engage to see whether or not that can be changed.

The joint Select Committee’s (Business, Energy and Industrial Strategy and Work and Pensions Committees) report on Carillion⁸ was more measured. Two paragraphs are notable:

124. KPMG audited Carillion for 19 years, pocketing £29 million in the process. Not once during that time did they qualify their audit opinion on the financial statements, instead signing off the figures put in front of them by the company’s directors. Yet, had KPMG been prepared to challenge management, the warning signs were there in highly questionable assumptions about construction contract revenue and the intangible asset of goodwill accumulated in historic acquisitions. These assumptions were fundamental to the picture of corporate health presented in audited annual accounts. In failing to exercise – and voice – professional scepticism towards Carillion’s aggressive accounting judgements, KPMG was complicit in them. It should take its own share of responsibility for the consequences.

146. The FRC was far too passive in relation to Carillion’s financial reporting. It should have followed up its identification of several failings in Carillion’s 2015 accounts with subsequent monitoring. Its limited intervention in July 2017 clearly failed to deter the company in persisting with its over-optimistic presentation of financial information. The FRC was instead happy to walk away after securing box-ticking disclosures of information. It was timid in challenging Carillion on the inadequate and questionable nature of the financial information it provided and wholly ineffective in taking to task the auditors who had responsibility for ensuring their veracity.

In paragraph 208 of their report, the Select Committee put the range of options succinctly:

• 208. A range of potential policy options could generate more competition in audit. These include:
  • 1) more regular rotation of auditors and competitive tendering for audit contracts;
  • 2) breaking up the audit arms of the Big Four to create more firms and increase the chances of others being able to enter the market;
  • 3) splitting audit functions from non-audit services, reducing both the likelihood of associated conflicts of interest and the potential for cross-subsidization.

Item 1) has already been undertaken and there is no evidence that more rot...