COVER STORY - Audit: an on-going concern.

Rodger Hughes, head of audit at PricewaterhouseCoopers, tells a favourite old joke: if you ask an auditor what colour that cow is, he’ll say “Well, it’s brown on this side.” It’s meant to reflect the old characteristics of a tick-and-bash auditor, said these days to be a million miles away from the highly-trained, We spoke to the heads of audit at the Big Five firms (some of whom style themselves as heads of ‘business assurance’) to find out the current wisdom about the value of the audit and the audit process. This isn’t to say that firms outside the Big Five have no role, but the larger firms ought to – by definition – be the ones that are at the leading edge of thinking. We also published a survey questionnaire in last month’s issue to find out what readers think of the service they are currently getting, the problems they experience and the value they perceive in the sign-off and the process itself. This month, we publish the results. There’s an obvious conflict. While FDs want to keep audit fees down, audit firms want to raise them. But while the firms’ current thinking is that they should be demonstrating the added value that an audit can provide, there is some scepticism among their clients about whether that value is real or illusory. “Audit firms seem intent on trying to act as consultants rather than just signing off their audit report,” said one client of a Big Five firm. “They feel that they have to continually justify their fee but, in doing so, draw more attention to the poor value for money.” So what’s the value of the audit? “The essential value of the audit always has been a preventative one in that the question is not what an audit can do but what not having an audit would do,” says PwC’s Hughes. “Would banks be ready to lend at the same rate of interest to an organisation whose financial statements weren’t audited? Effectively, it’s a capital markets issue.” At KPMG, Ted Awty argues: “You could say that the value of audit in the UK is the entire value of the stocks listed on the stock exchange.” Awty, who only ascended to his position as head of audit last year, is taking advantage of his ‘new boy’ status by analysing the audit process in terms of value chains to try to establish exactly where the value is. “What the hell does value mean? What it means to us at the moment is that an audit adds value to a member of the management team if it provides a solution to a non-trivial problem,” he says. “So if we start at the top of the chain, you have the chief executive, the finance director, the financial controller, the chairman of the audit committee – loads of individuals – what non-trivial problems or non-trivial issues do they have? How do I as an auditor or we as an audit team address those issues? If they have a non-trivial problem, what is our solution? If we have a solution to their problem we create a benefit – that is the value: how do we measure it? “One of the most fundamental issues that we as a firm and indeed we as an industry are facing is in articulating clearly, ‘What are these benefits?'” In the early 1990s, Ernst & Young commissioned research to find out what clients thought of the service offering and its value. Audit head Geoff Norman says that the feedback demonstrated that clients “perceived very little value in the audit as such – a name on an audit report carries some weight, but other than that they were getting no value whatsoever.” Norman adds that clients told the firm that they were underselling their expertise: “We’re in a very privileged position going into so many companies, seeing so many practices, having been able to build up a knowledge of industry and best practice,” he says. “And the clients said, ‘But you don’t do anything with it. Surely we can benefit from all the knowledge that you accumulate.’ As a result of that challenge, we set about re-engineering the audit completely.” All the Five talk in similar vein about their ability to leverage their wide-ranging experience to clients’ advantage in this way. KPMG’s Awty talks a lot about the firm’s BMP system – Business Measurement Process – essentially, a knowledge management system used to train staff, help auditors understand the industry and risk issues, and which provides the backbone for the rest of the firm’s services as well. “It’s a business analysis process which directs you to areas of risk, whether they be audit risk, accounting risk, business risk, tax risk,” he says. Norman explains Ernst & Young’s new approach: “In the past we would focus primarily on the figures that appeared in the financial statements and audit those figures. We still do that, but the way we approach it is to now break a business down into its key processes and looking to see how effective those processes are in both identifying, interpreting and managing the various risks which affect those processes – because ultimately they will all end up affecting the financial statements.” Andersen’s Whitmore, who also emphasises the business risk issues, adds: “I can guarantee that each of my people has access to all the knowledge that we’re getting around the world from all the other 25,000 people that we have working in our assurance practice – and knowledge that is being used by the other 30,000 that we have working in Arthur Andersen around the world – that’s available to them today. We have efficient knowledge-gathering and knowledge-sharing software which allows us to access that information.” He believes that his firm has, perhaps, a six-month lead over the rest of the Five (though they, of course, disagree). But one FD at a FTSE-100 subsidiary complained to us: “What the hell can the auditors tell me about my business? They send along an audit manager and two trainees. What can they tell me?” It’s a lament that matches our survey finding that the quality of junior staff is the biggest single complaint that clients have with their Big Five auditors. Norman says that E&Y was aware of this criticism in the early 1990s: “People sometimes did tell us that they felt like a training ground.” Hughes thinks this particular FD has missed the point: “Who’s guiding their work? Like any organisation there’s a pyramid of people involved. Those people haven’t just turned up out of the blue. They’ve turned up after a very careful and thorough planning process, all there on electronic working papers, the partner is back in the office with on-line access to them. The greater part of the value will tend to be added by the more experienced people – by definition – but you wouldn’t expect them to go out and do all the detailed collection of the information that enables them to make that judgement.” Hughes recalls one audit where he pointed out that a client was continuing to offer a generous discount to customers for prompt payment even though interest rates had halved over the last three years. “That was worth more than the audit fee in terms of the money that client saved. That’s added value. You might think, ‘That’s very simple and basic’. Yeah, but they hadn’t spotted it, I did.” Others give examples about being able to benchmark clients’ payment systems, inventory management or areas of potential risk. Deloitte & Touche’s Martin Eadon makes the obvious point that it is important not to tell the client things he already knows. He says that a lot of audit propositions “promise something valuable across the business (so) they never go far enough down on any one thing: they come back and tell the client a hundred things which the client already knows – which has no value. But if you’re smart and know the client, you will find the half-dozen areas which are absolutely aligned with the business priorities.” The problem is that, according to our survey, clients are still a little dubious about whether auditors really are adding value. One Big Five client FD said that the auditors’ prime objective “seems to be adherence to SSAPs, etc, to the minutest detail”. Another from a small business that uses a local audit practice, said that auditors are “generally concerned with minutiae rather than commerciality. Very few firms bring a commonsense, practical added-value approach to their audit.” The FD of a subsidiary of a £300m company said that he would prefer to be allowed by his head office “to pay less for the same standard of audit – ie, not Big Five.” We asked readers what sort of problems they had experienced with their auditors, and details of their replies are at the bottom of this page. We also asked the auditors. Their replies were a little less forthcoming. KPMG’s Awty said that “failure to deal with emerging accounting issues on a timely basis” is one complaint. “If the whole team at the client and the auditor were alert, they would have known on time that an issue was emerging, but all of a sudden it becomes an issue two days before the audit committee.” Hughes says that sensitivity to internal politics is vital to avoiding bust-ups with clients. “The FD of a subsidiary will complain that he’s just got a kick from upstairs because something you reported up has come down and kicked him. You can get that the other way round when head office says, ‘Why didn’t you tell me about this?’ even though it’s been dealt with. One of the biggest issues we have is managing the inter-personal relationships. The reality is, the better you can manage that, the more open people are, the more access you get and the better audit you are able to do.” Deloitte’s Eadon offered complaints that he’d been given during tenders about the previous incumbents: “It’s about not feeling they were important to the firm; not feeling they had the best people serving them; not getting responsive service.” His firm recently won the Abbey National audit from PwC, a firm which the other Four insist has lost a considerable number of clients, post-merger – though not all have been made public yet. Hughes professes to be puzzled by the Abbey National’s decision: “Before the merger, Abbey National thought they had the top team at Coopers. So we merged, and they’ve got the same team, so all of a sudden (they claim) they’ve got the B Team? I don’t understand it. It’s big fish, small pool, isn’t it? There is no quality argument that is sustainable.” It’s difficult to see how the firms can differentiate themselves. All the Big Five say that people are the keys to success – but it’s not as if any one of their competitors is populated by useless morons. Whitmore talks about how each firm has its own culture, claiming that Andersen’s is perhaps more innovative than other firms. Hughes talks about the need to have bright, enthusiastic people and the need to feed them with interesting work – not just ticking and bashing. KPMG’s Awty says, “Why is it that we consistently put forward the people who can get on with others? (When you find that out) that’s when you establish what is it that we are doing that is delivering value. And to be honest, I don’t have the answer. I’m going to get the answer, because I know precisely what we’re looking for, but we’re not there yet.” E&Y’s Norman makes the point that it’s a case of getting the right people in front of the right client: “It’s very rare that a company will appoint an auditor if they didn’t gel with the audit team.” Of course, auditors really have two clients when they conduct an audit: the senior management team and the owners, the shareholders, who vote on the appointment of the auditors and to whom the audit certificate is addressed. Awty says: “I’m sure that really understanding what investors, institutions require – what their real requirements are from an audit – might totally change the way in which audit companies operate.” The problem is that, while all the Five recognise that investors are the ultimate clients, there appears to be no conversations taking place at present with the likes of PDFM or Mercury Asset Management about what they want an audit to be. “Perhaps we’re not doing as much as we would like,” admits David Whitmore at Arthur Andersen. “They are involved formally in approving accounts but they don’t have the discussions with us directly unless they do it through appointed directors. Maybe there’s an argument they should be doing that more.” The lack of such discussions – either about auditing in general or with regard to specific companies – may lead to an expectations gap as to what the audit is supposed to do. “When a problem arises there doesn’t always seem to be a deep understanding of the role that the auditor has played and the scope of his work and the limit of his work,” Whitmore says. Institutions have “a negative assessment of the value (of an audit),” says KPMG’s Awty. “There is only an assessment of the negative value when it proves not to have been there. When it proves not to have been there it appears to be huge. When it’s there it appears to be very small.” Awty volunteers an example in which his firm made an audit pitch to a client known to be keen on a shareholder value approach to management. Unfortunately, the board didn’t regard the audit as part of that value creation strategy: they just wanted a basic audit. KPMG’s elaborate sales pitch fell flat and they didn’t win the contract. It’s an interesting example because value-driven shareholders may have taken a different view from that of the board. Fees, of course, are an issue, for both clients and auditors. They’ve been falling in real terms for years, though Hughes says that the squeeze drove out inefficiencies within audit firms, forcing the pace on modernising audit methodologies. Everyone insists that pricing is still “competitive” – though almost half of our survey respondents said fees are still too high, and likely to go higher. Awty argues that more communication is the key to ratcheting up the rates: “There continues to be pressure on audit fees, which is why we as an industry – not as a firm – need to be able to demonstrate the real value that audit delivers,” he says. Whitmore agrees: “What we haven’t done very well as a profession is to persuade the market that, given the way we’ve evolved our external audit offering, we are now providing greater value to companies than perhaps we used to.” E&Y’s Norman isn’t alone in saying that his firm won’t go in for “ridiculous low-balling” to get an audit because the risk-reward equation just doesn’t balance. Hughes also says that his firm “is not in the business of selling cheap signatures on accounts. It devalues our brand, what we stand for. We will only do what we regard as a proper job.” He argues that, even where some firms have pitched in with a “silly quote” to win a tender, it was simply not necessary to do that to win the business. Hughes takes some encouragement from a few instances where audit committee chairmen have queried whether their FDs have screwed down the audit fee too much. If fees are very low (and only two FDs in our survey thought they were) then, says Hughes, “it must ultimately compromise either the quality of the audit or – in extremis , though I wouldn’t expect it in my organisation – the independence of the auditor.” One FD said that while audit fees appear to be linked to inflation, the time spent on an audit appears to be going down. “Transactions are rarely looked at,” he says. Hughes says that fees have not been able to keep pace with wage inflation in the accountancy sector. “You can’t carry on giving accountants 10% salary increases if the audit fee is growing at 2%,” he says. The types of work that auditors are taking on is increasingly expanding their functionality beyond merely signing off accounts or conducting due diligence on corporate transactions. PwC, for example, has just won an e-commerce contract from the European Commission whereby they will be putting in place the systems to ensure that suppliers who sell to the EC through electronic media are, in fact, who they say they are. This is the kind of work that Norman expects to grow rapidly: “In the US, they say that if they’re going to do business on-line and do financial transactions on-line, they need some comfort. The moment there’s a big scandal, you just watch the regulators jump and the standards appear!” PwC also acts for a US company, ensuring that its suppliers do not abuse child labour. This kind of work perhaps justifies the name change to “business assurance”, though nobody is pretending that this is anything other than an evolution in the nature of their work. Although audit skills may find wider application in this way, Hughes doesn’t expect to see a revolution in such a mature and highly-regulated service industry as auditing. “That would only be possible by a very significant technological step forward (such as) some sort of automated real-time auditing (software) embedding audit functions within a client’s systems.” Eadon says that, with new technology making it possible to generate a lot of information very quickly, there may come a time when capital markets require an audit check on more than just the annual accounts. “There is a whole spectrum of potential assurance services on other things, if those other things become information the markets use,” he says. Like the specialist requirements of environmental reporting, an expansion of the auditor’s service offering will require “additional specialist competencies”. Andersens, whose relatively short client list understates the firm’s presence in the audit market, is taking a somewhat different approach, one which might change the nature of the service. Whitmore says that his firm is pushing hard at the internal audit market: “From an internal audit point of view, you have the opportunity to go and look at processes which are fundamental to the business, but maybe more wide-ranging than having immediate financial statement impact. It may allow you to work more closely with the company management and introduce a risk-management environment which helps the management manage that business more effectively.” Whitmore suspects that there will be a gradual shift of emphasis in future, with external auditors putting more emphasis on compliance with financial reporting standards, while internal auditors look at internal controls and compliance with auditing standards. Ultimately, the idea of an integrated audit – with one firm providing both the internal and external audit service – may gain growing acceptance (our survey suggests that there’s a long way to go). “But before you can actually move the external audit away from the offering that it is today,” Whitmore says, “you’ve got to change the public perception of what the external audit is.” Last month’s audit survey questionnaire provoked the kind of response that made us think it wasn’t just the offer of a champagne prize draw that attracted readers. While it would be wrong to suggest that there is the kind of pent-up frustration that should compel auditors to barricade themselves in their palatial bunkers, it was evident that not everything is rosy in the audit garden. Many thanks to all who responded. Our survey generated responses from companies and public sector organisations responsible for over 100 audit appointments. (We even had a couple of firms of accountants reply – and not entirely favourably!) Almost all groups engaged a single audit firm, though half a dozen had two auditors. One respondent from a £10m business claimed to use eight audit firms. The average turnover at respondent companies was £88m; three-quarters of them were head office organisations while the remainder were subsidiaries of businesses with average sales of £1.2bn. Just under half of all respondents have a Big Five auditor, while the rest are split between medium-sized national firms and smaller, local firms. The winners of our champagne prize draw will be announced next month … This is a very revealing chart. First of all, it is obvious that, for everyone, cost is an issue, and a significant one for most. No surprise, perhaps, but there is a remarkable symmetry between the total pool of respondents and those who use the Big Five: clients don’t turn to the Big Five with a “what the hell” attitude to the likely cost implications. For all but a couple of (loner?) clients, the personal service or approach of the audit firm is, if anything, even more important than the cost. Auditors aren’t wrong when they say that having the right people is the most important factor in winning a mandate. Those who use a small or medium-sized audit firm apparently tend to prefer some kind of personal recommendation. Presumably, for the Big Five firms, their names speak for themselves. What may disappoint the larger auditors, however, is that there is no greater significance attached to their industry specialisation. Of course, it may be that larger businesses demand more in-depth industry knowledge of their Big five auditors than smaller businesses do of theirs – even though they all regard industry knowledge as important – but the key finding from this chart is that the USP that the Big Five have is their sheer size, their global reach and their high profile, blue-chip name. Big is beautiful. Full stop. Auditors can take heart from the fact that one-in-seven clients either specifically said they had no problems with their auditors or didn’t tick any of our boxes. (Satisfied Big Five clients scored at half that rate.) The other six out of seven, however, have objected to the level of fees, the quality of service (admittedly, an ill-defined complaint in this context) or the quality of junior staff; this latter objection is particularly damning for the Big Five accountant factories, half of whose clients have complained about this issue. About a quarter complained that auditors “don’t really understand our business” – a remarkable objection given the efforts made by the major firms to use sophisticated knowledge management technology to ensure that front-line staff and partners have all the information they need to analyse their clients against the industry peer-group. Perhaps access to knowledge management technology isn’t the same thing as “understanding”. Between one-in-five and one-in-six have had difficulties in their relationship with the audit partner – a particularly regrettable problem given the efforts made to ensure that the right “chemistry” exists between audit firm and client. About 7% of respondents volunteered, unprompted, that speed and meeting deadlines were problems they had encountered. Given the growing pressure on PLCs to report results ever more quickly, it would be surprising if this issue didn’t get worse in future years. Despite the headline-grabbing opportunities presented by a Maxwell disaster or a Wickes conspiracy, “failure to spot irregularities/fraud” is a complaint mentioned by only one-in-twelve respondents. Perhaps there are worse sins than paying your auditor too much money, but FDs appear not to think so. Despite the fees crunch over the last several years, half of our respondents still think that fees are too high – and you can count on the fingers of one hand the number who think that they are very low. It may be that auditors are walking away from unrealistically-priced audit commissions, or that FDs and audit committee chairmen are wary of compromising quality by screwing auditors’ income too tightly. Or it may just be in an FD’s nature to squeeze out costs wherever possible: while FDs think, on balance, that fees will rise over the next three years, greater pessimism comes from those who already regard fees as too high. Half keep an eye on market trends to ensure that they aren’t paying over the odds. But (unsurprisingly) those who regard cost as a significant factor in choosing an auditor are somewhat more likely to benchmark their fees against the market. Two-thirds of respondents don’t have an internal audit function. Of those that do, the vast majority are in-house teams, with just 7% outsourcing this role to another firm. While recognising that the idea of an outsourced internal audit function is still relatively new – especially outside the top companies – it’s still interesting to see that almost half of respondents who gave an answer don’t regard the internal audit role as one that can be carried out by outsiders. There’s a two-to-one majority that says internal audit shouldn’t go to the same firm that does the external audit. Thirty percent of respondents have put their audit out to tender in the last three years; most of them changed auditors as a result. While 38% of the total said that they might put their audit up for grabs over the next three years, almost half of those who have already done so recently said that they might do it again. At the same time, there is a slightly larger proportion of FDs who say that they would not put their audit out to tender again – presumably they regard it as too disruptive to sever their audit relationship too often. When asked to give a score out of ten for the service they receive from their auditors, readers awarded an average mark of 6.47 – not exactly cause for revolt, but hardly a ringing endorsement. Plenty awarded 7s or 8s, but no Big Five client offered a 9 or 10. In fact, clients of the largest firms marked their auditors more harshly, giving them 6.09 overall. The firms that we spoke to made great play of the value of the feedback that they naturally give during the course of conducting an audit. But while an average score of 5.98 isn’t so low as to cause rioting in the streets, it perhaps suggests that the feedback isn’t as value-adding as clients would like or as auditors believe. The Big Five rated 5.45 overall. Either auditors aren’t delivering value in the audit process or clients aren’t recognising it. A third of FDs gave two out of 10 or less to the value of their audit over and above compliance with statutory requirements. The average score was a lowly 4.36 – and just 3.95 for the Big Five. At the very least, what we have here is a failure to communicate. THE MERGER THAT DIDN’T HAPPEN. OR DID IT? Shortly after Price Waterhouse announced that it was to merge, creating the largest accountancy firm, we published an article looking at the implications. We think it is well worth reproduce a large, lightly-edited extract from it … While the prime purpose of the largest-ever accountancy merger may be to forge improved marketing opportunities – especially in the US – the immediate priority for Price Waterhouse and (its merger partner) has been to limit the possible damage to client relations. Within moments of the formal announcement, partners were on the phone to all major clients offering assurances of maintained standards and uninterrupted service. It was a successful exercise, according to one PW partner who said: “All clients have been quite positive, usually signing off with ‘wish you luck’.” But many competitors, both large and medium-sized, were quick to claim he could scarcely have said anything else. An alternative view, put forward by the senior partner of a medium-sized firm, is that “many companies, including large ones, may wish to reconsider the merits of seeking all services required from one massive firm”. The merger has been prompted by defensive considerations in the US. The new firm will be only marginally ahead of Arthur Andersen. (KPMG) lies not that much further behind, though well ahead of the rest. The argument is that big firms must be part of a superleague if they are to get their fair share of the fast-growing US management consultancy business. In the UK the merger has a very different impact. It will produce a clear new market leader with revenues almost double that of (KPMG). There is certainly a widespread feeling – not to mention some fear – that this merger represents the future in the UK. Ernst (& Young) was the first major firm to concede publicly that it was on the lookout for possible merger partners. Representatives of all the Big firms acknowledge that their fortunes are tied to servicing major multi