Reliance on Compliance threatens the Audit Profession

Are auditors’ reputations going the way of those of the banks through hiding behind compliance, and if so, what are the implications?

Banks’ fall from grace

In the last thirty years or so, what used to be known as the banking profession has become a byword for unprincipled behaviour, mis-selling to, and ruthless exploitation of its customers, coupled with a casual disregard for the rest of society. Unforgivably, these giant uncontrollable financial institutions expect that same society to bail them out when their operations go disastrously wrong, as they regularly do, on the basis that their collapse would threaten the stability of society generally. This may be an unfair view of the banking industry as a whole, but they have brought it on themselves. Nearly every large bank and many smaller ones have been tainted at some point.

Some of the most notorious examples of egregious behaviour include:

  • selling mortgages to people who could never realistically afford them
  • bundling poor risks with good risks in complex derivatives and packaging and selling the whole security as good risk
  • mandating the purchase of unnecessary payment protection insurance to borrowers
  • selling expensive financial hedging instruments to business customers knowing their unsuitability or likely ineffectiveness
  • providing money laundering facilities on a grand scale
  • providing tax evasion facilities and the means of improperly hiding taxable wealth
  • conducting high risk own account trading underwritten by implicit public guarantees.

These have resulted in staggering penalties in recent years amounting to tens of billions of dollars in fines for individual banks, and massive regulatory responses. The attendant bureaucracy has, inevitably, made life more difficult for the average customer, while the penalties inflicted on the individuals creating these problems are perceived as being few and far between.

So the reputation of the banking industry is in ruins and will remain so for as long as the people who suffered at their hands are alive.

Are Chartered Accountants firms still professional?

What is happening to the once respected audit profession?

Disclosure: the writer is a Fellow of the Institute of Chartered Accountants, admitted fifty years ago, and this article is an attempt to prevent his profession from going the way of the banks.

Two generations past, the leading firms of chartered accountants were, indeed, regarded as the standard bearers of a profession. As partnerships, limited to twenty partners in the UK, but often with fewer, it was possible for these firms to maintain a culture of the highest standards of professionalism. And though there was still a hierarchy, the leading firms were distinguished more by their size than by the perceived quality of their professional services. However, in the late 1980s, the writer was asked to review the business of a UK firm of chartered accountants, ranking in the mid-teens, and the exercise was a revelation. By then, the leading firms were drawing away from the pack, and the leading eight or nine were recruiting only the best qualified candidates for training and, except in specialised areas, the services provided were superior in quality as well as quantity to those of the second tier. Since then the pressures on the mid-ranking firms have led to a progressive absorption of the smaller by the bigger and by the end of the 1990s the leading firms numbered just five. Then came the demise of Arthur Andersen and now there were four. These Big Four are regarded as the only firms capable of auditing the major global companies, so, for example, pretty well all the FTSE 100 companies are audited by one or other of these Big Four.

And four it has remained since 2002, as the regulatory bodies stand in fear of the collapse of one of these, which would lead to the Big Three and even less competition.

But these are not small professional firms of accountants. They are huge businesses, with Deloittes leading the field with global revenues approaching $40bn, and KPMG number four with $26bn. Number five, BDO, has revenues of just $8bn, a huge gap. Deloittes employs over a quarter of a million people worldwide.

Audit is the key to the client’s door but also the vulnerability

A large percentage of the income of the Big Four derives from non-audit activities, but audit is invaluable in providing them with a guaranteed annual presence in their core client base, and the opportunity to sell extensive non-audit services to these audit clients in most countries round the world. However, the threat to their reputation comes primarily from these very audit activities. The occasions when their consultancy work is criticised are often when it follows on from failure of audits to spot imminent problems or from ill-advised client relationships.

The thrust of this article, therefore, is to consider the approach which these audit firms take to clients in the context of the approach which they take to the corporate governance of those clients. And the universal failing is the reliance on compliance.

In a recent article we wrote about the failure of regulation to prevent corporate governance scandals over the past twenty years, and the fact that all the firms quoted had apparently complied with regulations before they blew up. Let us now look a little more extensively at the corporate governance scandals and the involvement of the audit practices prior to their public exposure. Below is a list of 42 corporate governance scandals over the past twenty years or so.

Corporate Governance Scandals with Big 5 Auditors

Co-op Group
Gol Linhas Aéreas Inteligentes
MF Global
Miller Energy
Public Company Accounting Oversight Board,
Rolls Royce
RSM Tenon
Taylor Bean & Whitaker
Thyssen Krupp
Waste Management
Weatherford International
Wells Fargo

We have discussed approximately half of these in this website over the past few years, but the list is by no means comprehensive. The significance is that in all of these cases, one of the Big Five audit firms was involved. The audit score is:

PwC: 15
KPMG: 13
Deloittes: 7
EY: 6
AA: 3

In the most memorable of these, the result was the collapse of the audit firm concerned – Arthur Andersen. In other cases penalties were imposed on the Big Four firm, and in some cases partners left the firm as a result. But the cumulative effect is becoming a major threat to the reputation of these firms, and by extension to the auditing firms and the accountancy profession generally. In a recent blog, the chief executive of the Institute of Chartered Accountants in England and Wales wrote (regarding the Carillion collapse and the appearance of KPMG and Deloittes in front of the UK Joint Parliamentary Committees examining the affair):

“Yesterday was not a good day for the accountancy profession. The latest joint hearing into Carillion …..produced some damning verdicts on the limitations of audit and the role it plays in corporate governance”.

This is damaging the reputation of the profession

Indeed, it wasn’t a good day for the profession. Possibly the most damning comment was from one MP who said

“I wouldn’t hire you to do an audit of the contents of my fridge”.

This scathing remark was addressed to two of the Big Four leaders of the accounting world.

In the case of Carillion, once again, whistleblowers had earlier made clear their concerns about the accounting procedures adopted, and the investment community was shorting the shares, so how could the auditors sign off the accounts and afterwards maintain that they stood by the accounts as signed? Again and again, the defence of the audit profession is that they followed the rules and couldn’t be expected to pick up things that didn’t involve breaking of the processes and procedures around those rules and regulations. Does common sense not come into this somewhere? There seems to be an enduring reliance on the famous case of re Kingston Cotton Mill Company, 1896, in which Lord Justice Lopes said, amongst other things:

“An auditor is not bound to be a detective….He is a watchdog not a bloodhound.”

However, he also said:

“It is not the duty of an auditor to take stock….there are many matters in which he must rely on the honesty and accuracy of others”

Times have moved on, and the expectations of auditors are rather more demanding now. Consequently the reputational damage suffered by auditors who do not pick up fraud or other illegal practices is increasing year by year. The corollary of the superior position and reputation enjoyed by the Big Four is that they are expected to be able to uncover sophisticated misbehaviour, let alone misbehaviour that is reported inside the company and widely rumoured in the public domain. How long will this defence of “I followed the rules” be tolerated by the public and politicians, even while it is excused by the profession’s own regulators?

Things must change and expectations are changing

There seems to be an unspoken understanding between big business and the accounting profession that business will maintain compliance with codes and regulations, while the auditors will restrict themselves to examining how well those businesses comply with the codes and regulations. Hence business can turn a blind eye to softer issues like the growth of unethical cultures and potentially detrimental effects on society, while these issues are outside the remit of the auditors. Further, there is the perennial question mark over the issue that, notwithstanding the fact that the auditors are acting in the interests of the shareholders, they are, of course, appointed and paid by the management.

But the worm seems to be turning, and the big investing institutions are now increasingly turning to a wider assessment of corporate governance in assessing the performance of the companies in which they have invested. Most significantly, Larry Fink, CEO of Black Rock, the world’s largest fund manager, recently called for firms to make a “positive contribution to society”, and we have ourselves recently drawn attention to the increasing emphasis on ESG in investment decision making. Moreover, there is an increasing awareness in big listed companies of the need to project their socially responsible side to the public and to investors, to protect and enhance their brand image. Indeed, at a recent gathering organised by Corporate Citizenship, under the auspices of the Institute of Chartered Accountants in London, representatives of corporate investor relations departments spoke of their desire for credible, independent verification of their socially responsible activities, similar to the audit of financial accounts conducted by the audit practices.

Of course, the corollary is that, to be credible, these audits ought to be able to pick up less reputable behaviour and shine a light into dark corners.

So here surely, is the way forward for the audit profession, to address the self-evident failings in the current approach to auditing, and to take the opportunity to certify a broader range of behaviours as demanded by companies and investors.

Auditing must embrace holistic corporate governance

We have been preaching for over twenty years the need for corporate governance to be defined holistically, and this is increasingly being accepted and adopted worldwide, both by bodies like the OECD and in the newer codes of corporate governance.  It is now time for the audit procedures to broaden their approach and to develop a holistic examination of their client companies’ corporate governance, going beyond a reliance on compliance. The framework of our Five Golden Rules has stood the test of time, and would enable the auditor to express in the certificate, as used to be the case, that the report and accounts presented a “true and fair view” of the state of the company’s affairs.

Failure to start tackling this “reliance on compliance” issue will lead to more and more occasions where the Big Four are associated with corporate governance scandals. The threats then are:

  • initially to the Big Four firms and their reputation and brand, leading to political pressure for the audit function to be separated into a discrete business – this has been on the political agenda for many years, but has thus far been generally fended off
  • subsequently to the accountancy profession itself, through the damage to the qualification of chartered accountant, and potentially the related professional bodies

It is perfectly possible that the developments in big data, artificial intelligence and blockchain could transform the audit function, and a case could then be made for the function to be carried out by a new Big Tech discipline and removed from the Big Four altogether. The Big Four would then become the consultancies that they already are in all but name, but the accountancy profession as a whole would be the loser.

In a subsequent article we will outline our proposals for the audit of the future, addressing the performance of a company through holistic corporate governance and abandoning the dangerous reliance on compliance.


Click on a tab to select how you'd like to leave your comment

Leave a Reply

Your email address will not be published. Required fields are marked *