The audit barons need reining in - or we'll continue to pay the price, writes Prof Prem Sikka.
It’s the latest in a series of potential scandals at accounting firms. This week thirteen people have been sued for £178m in connection with alleged fraud at London Capital & Finance.
While those facing the allegations have denied wrongdoing, the picture across the sector is a grim one.
Unsavoury audit practices were responsible for the demise of Wirecard and Patisserie Valerie. Last year, FTSE100 companies alone paid out £911m in audit fees. Across the economy, audit fees must run into billions of pounds. Yet it is rare for auditors to flag unsavoury corporate practices – and the scale of fees can’t be justified by expecting auditors just to be some spreadsheet adder-uppers.
The UK Companies Act 2006 requires auditors to give an opinion on the truth and fairness of financial statements. Accounts containing material misstatements, errors, deception and downright lies cannot be considered to be true or fair. Yet auditors continue to give a clean bill of health to accounts with a strong whiff of dubious practices. Auditors, the private police force of capitalism, deny responsibility to report fraud.
When questioned about failure to deliver effective audits, the audit industry blames directors for preparing faulty financial statements. Well, if all directors could be relied upon to prepare honest accounts, audits would not be needed. The other tactic is to ridicule people for expecting auditors to report fraud and material irregularities. This has been evident during parliamentary hearings.
When faced with questions about Patisserie Valerie audits, a senior partner of Grant Thornton told the House of Commons business, energy and industrial strategy committee that it is not the auditor’s role to look for fraud.
In the late nineteenth and early twentieth century, accounting firms considered fraud detection and reporting to be the major audit objective. Such soothing statements helped them to secure control of the lucrative state guaranteed market of external auditing. But once that mission was accomplished, they sought to distance themselves from the association of audits with fraud detection/reporting.
Judges have been very clear about how audits must be approached. In the 1958 case of case of Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen Co Ltd, the judgement said that an auditor’s
“task is to take care to see that errors are not made, be they errors of computation, or errors of omission or commission, or downright untruths. To perform his task properly, he [sic] must come to it with an inquiring mind—not suspicious of dishonestly, I agree—but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none”.
The above judgment requires auditors to be sceptical of assertions made to them by directors. They need to corroborate financial statements by independently collecting and evaluating relevant and reliable evidence, but continue to neglect such duties. Audit failures at BHS and Carillion show that auditors are chummy with directors and too easily go along with whatever management tell them. Auditors owe their selection, appointment, audit and consultancy fees to the benevolence of directors and will not bite the hand that feeds them. Profit maximisation and public protection can’t be combined.
Such issues were exposed by the collapse of Enron, WorldCom, Maxwell, Barings, Bank of Credit and Commerce International (BCCI) Madoff and many other cases. But profit maximising audit firms have always preferred to let the lying dogs sleep and collect their fees.
Unsurprisingly, many companies indulge in what one short-seller terms “legal fraud” — where companies adhere to the accounting rules and regulations but there’s still an “intent to deceive”. Yet such accounting games are rarely flagged by auditors.
The silence of auditors has inflicted huge losses on supply chain creditors, savers, employees, pension scheme members, tax-payers and investors. They rarely face lawsuits because they primarily owe a duty of care to the company and not to any individual stakeholder.
Accounting firms’ narrow interpretation of auditor responsibility is not supported by the courts. In the case of Assetco Plc v Grant Thornton UK LLP , the High Court awarded damages against auditors for failure to detect and report fraud. The judge said that auditor’s breaches of duty “included a failure to exercise proper scepticism which would have led to detection and prevention of fraud including representations and assumptions made by Management”.
Indeed, the firm admitted negligence. However, Grant Thornton appealed and on the 28th August, the Court of Appeal confirmed the judgment about auditor duties but reduced the damages from £29.8m to £20.8m for contributory negligence.
This week, the president and founder of Confirmation, part of Thomson Reuters, said that the audit industry must get “serious” and “stop pretending” that catching fraud is not part of their role. But don’t expect big accounting firms to show any remorse. They have got used to collecting mega fees for delivering little.
The audits of large companies need to be performed by a statutory body.Auditing firms have a choice. They can deliver honest, robust and socially useful audits or vacate the audit market and make way for a new institutional framework.