Every UK company of significant size is required by law to publish accounts and be audited annually, this is to ensure that shareholders and other investors can have faith the the company's reported results are 'true and fair'. It is a vital cornerstone of our current economic system that people can review the performance of their current or potential investments to make informed decisions about where to put their money, and thus ensure the ongoing efficiency and public faith in the economy.
The audit industry was recently called 'the dog that didn't bark during the crisis' by the European markets chief. The failure of major bank's auditors to spot problems before the credit crunch has been the subject of deep criticism. The EU is currently proposing to break up the large audit firms on the basis that they are no longer perceived as independent from the organisations they are auditing, a fundamental requirement to do their job. The break-up will mean that audit firms can no longer deliver other services such as tax and consulting to companies that they audit, unfortunately this is where the firms make most of their profit.
The big four (PwC, Deloitte, KPMG and E&Y) dominate the audit industy (auditing almost 100% of the FTSE 100). The problem is that the business model is inherently flawed, as follows:
1. Companies are required to pay for their own audit
2. Therefore audit firms bid to provide their audit services to companies
3. An audit is something that the management of a company generally does not want to have, as it is a nuisance and delivers no real value
4. Therefore auditors compete on a low-cost basis
5. To acheive any kind of profit from a low-cost audit, auditors have to do the job quickly and cheaply
6. This means that the audit quality suffers
7. Auditors also need to keep the company happy as they are the customer paying their fees, so they don't want to raise the awkward questions
8. Management prepare the accounts that the auditors are supposed to audit, so auditors should remain completely independent of management influence
9. Big companies use their low-margin audit services as a 'foot in the door' to provide other more profitable services, such as tax and consulting
10. Essentially, auditors have to stay friendly with management to retain the audit contract and to sell the more profitable advisory services to the company
11. The more profitable services such as consulting often compromise the audit, because the auditor has a vested interest in the company and is now working with management
12. All of this means that the auditor is terrified of finding something that management do not want to hear, as they may lose the contract, and thus make less profit for the firm
There are a whole host of guidelines and ethical requirements for auditors to avoid conflicts of interest, but the truth is that the current business model cannot work. Auditors are looking for something that they don't want to find, and are therefore unlikely to find it. They are profit earning firms and do not want to jeopardise sales.
As long as the company is paying the auditors fees, is it really realistic to think that the audit can ever be independent and effective?
A commercial system whereby auditors compete for contracts on a low-cost basis is flawed. An audit is not a product, regardless of how well an audit is done, the company is not willing to pay more for it. Therefore, the key to a profitable audit is to do the minimum work to satisfy the regulations (so you dont get sued). It may make the shareholders feel better that the company has a supposedly thorough auditor, but in reality it is management that choose the auditor based on who is the cheapest reputable firm.
Auditors should not be commerical firms, but should operate more closely with the regulators, and should therefore be not-for-profit. That means that each company should be required to pay a minimum fee or a percentage of their profits for a truly independent auditor, nominated by the regulator, to audit their books. The auditor is then motivated to audit the company properly, ask the awkward questions and spend more time investigating any issues that come up, without worrying about eating into their own profit margin.
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