Risk & Economy » Audit » Audit profession needs to evolve

Trust in audit is under threat. The accepted purpose of audit was traditionally to provide independent assurance on a company’s financial statements; the idea being that when you know you can trust the numbers, everyone can do business with confidence. But ever since the financial crisis, questions have been asked over whether this is still enough. Such questions have now reached such a volume they cannot be ignored. Radical remedies are being suggested – but unless we take the time to examine the real underlying problems there is a risk of making things worse.

We should certainly acknowledge there is a problem. It is not just investors who have a stake in a business, but also employees, pensioners, suppliers and customers. Wider society has an interest in audit, and the audit profession needs to continue to evolve in order to respond to such needs. If it does not, it heightens the risk of undermining trust in audit, then that is our problem as auditors and we should face it head on.

However, it is critical that we get this right, and do not do more harm than good. The phrase “when all you have is a hammer, everything looks like a nail” is often attributed to the psychologist Abraham Maslow. It seems particularly apposite every time questions are raised about audit. Once again, this time in the wake of the Carillion scandal, we are hearing calls to “break up the Big Four”; a siren call that will be familiar to anyone who has been watching this space over the past few decades. But it is worth considering what people mean by this, what they would be trying to achieve, and whether it would work.

No one denies there are issues with the market structure for audit. At the top end the Big Four dominate – only one of the FTSE100, and only nine of the FTSE250, are audited by other firms. The problem is that this has become totemic for other problems. When high profile corporate failures happen, it is understandable that the spotlight is turned on the auditors. Inevitably, commentators notice – some for the first time – this level of market concentration. Some conclude this itself is the problem and that if only it could be fixed, then all would be resolved. It is only a short step from there to demanding regulation to change the shape of the audit market.

Question of scale

There are two sides to market concentration, and it is worth asking why other audit firms are not scaling up to enter this market. There are a number of potential reasons. One is the risk profile. Auditors carry unlimited liability, which may well deter smaller firms from deciding to tender for a large Public Interest Entity audit. Limited audit liability by contract has in fact been allowed for over a decade under the Companies Act 2006 but does not seem to have taken off.

Secondly, taking on a PIE client comes with a certain amount of additional regulatory oversight. This is right and proper – the Financial Reporting Council (FRC) has a vital role to play in safeguarding audit standards. But this inevitably has a knock-on effect on competition and choice, and we need to be mindful of that. Then there is the issue of fees. Given the scale of the companies concerned, it is only natural that audit work appears lucrative to the layman – but given the additional risk and regulation is it lucrative enough to make it worth a smaller firms’ while? But if it isn’t, what to do? One would win few friends at the moment demanding higher audit fees.

Then there is the issue of competition and choice. Improving one does not automatically mean improving both, and there is an argument to be made that whilst we have seen an improvement in the first, the second has deteriorated. Compulsory re-tendering and rotation every decade, which was introduced as part of the European Union’s revised Audit Directive in 2014, may well have led to greater competition but without other firms stepping into the marketplace it has done little for choice. Indeed, as incumbent auditors and some undertaking non-audit services are excluded – for entirely sound and justifiable reasons – one could even say that in practical terms choice has been reduced.

Audit cannot stand still. And it is worth remembering that it hasn’t. Over the last few years we have seen a number of changes and improvements, including auditors looking at more areas of company reports, increased assurance tools, more dialogue with clients and the Audit Firm Governance Code, which is emulated around the world. The Competition and Markets Authority (CMA) has undertaken a full investigation and published proposed remedies in 2014; it has not yet had a chance to review the effects, but when it does, there will be an opportunity to see if more needs to be done.

The status quo is not an option. But it is imperative that in seeking to fix one problem we do not create a larger one. It is important to remember that creating a “Big Five” is only one potential outcome of taking steps to change the market structure. Get it wrong and we might end up with a “Big Three.”