'Profit-seeking accounting firms cannot deliver honest and robust audits. But the government continues to indulge the auditing industry'.

Prem Sikka is an Emeritus Professor of Accounting at the University of Essex and the University of Sheffield, a Labour member of the House of Lords, and Contributing Editor at Left Foot Forward

The Stagecoach Group is the latest addition to the long list of audit failures by big accounting firms in the UK. In this case, Ernst & Young have been fined £2,205,000 for failures in the audit of the company’s 2017 financial statements.

It is the usual story of auditors being chummy with company directors, their paymasters. The Financial Reporting Council (FRC), UK’s accounting regulator, says the firm’s failures were “extensive and related to a number of fundamental auditing standards including the requirement to obtain sufficient appropriate audit evidence, adequately evaluate expert evidence, apply sufficient professional scepticism and challenge management”.

The botched areas include the audit of pension liabilities, insurance claims relating to accidents and matters relating to the East Coast Main Line franchise. In 2014, Stagecoach secured the East Coast rail franchise but felt that it did not work to its advantage. So in 2017, it sought to renegotiate with the Department for Transport. An agreement could not be reached and the company lost its franchise. However, for the preparation of financial statements, company directors assumed that a new contract would be secured, which had implications for valuation of assets, liabilities and losses. Auditors went along with the directors’ assertions and did not collect independent evidence to corroborate the assertions.

The £2.2m fine isn’t going to make much of a dent in the firm’s finances. In 2020, Ernst & Young reported a UK fee income of £2.6bn and global income of US$36.4bn. Further fines may follow as the firm’s audit of Thomas Cook, London Capital & Finance, Thomas Cook and NMC Health are also being scrutinised by the regulator.

Audit failures are institutionalised. The FRC says that 29% of the audits delivered by the biggest seven accounting firms fail to meet the quality threshold. Only 79% of the Ernst & Young audits are considered to be of acceptable quality. Only 59% of the sample audits delivered by KPMG are satisfactory, and its audits of banks were considered to be particularly poor. Some 80% of the sample audits delivered by PricewaterhouseCoopers are considered to require no more than limited improvements and 79% of the audits performed by Deloitte are considered to be of acceptable quality.

No producer of food, medicine, autos or aeroplanes could remain in business whilst routinely delivering dud products that harmed stakeholders. They would be forced to compensate stakeholders and shut-down. None of that applies to auditing firms. Audit firms don’t return fees or compensate employees, pension scheme members, supply chain creditors, shareholders and others injured by their failures. In general, auditors owe a ‘duty of care’ to the company only and not to any individual stakeholder. Most injured stakeholders are helpless.

The offending firms could be banned from securing new business for a fixed period, but regulators only levy puny fines. The fines have become another cost of doing business and are passed on to clients. Accounting firms continue to enjoy the monopoly of the state guaranteed market of external audits, and new entrants are banned. Despite the long line of dud audits, big accounting firms are rarely abandoned by corporate elites. The inevitable conclusion is that there is a market for deficient audits and incompetent auditors.

The 2016 collapse of BHS and the 2018 collapse of Carillion triggered a debate about auditing reforms. The government and accountancy trade associations managed it by commissioning reports. These included the Kingman report on regulation, the Brydon report on audit effectiveness and a Competition and Markets Authority report on the resilience of the supply of audits. In March 2021, this was followed by a government consultation paper. The result is that fundamental reforms have been organised off the political agenda.

There will be no reform of auditor liability and no new entrants in the audit market to improve competition or audit quality. Auditors will continue to be selected, appointed and remunerated by companies, albeit rubber-stamped by shareholders, just like they have been in all headline scandals. Audit files, contracts and tenders will not be publicly available to enable stakeholders to assess auditor diligence.

Auditors will continue to act as consultants to audit clients. The government is not pushing for ‘audit only’ firms. At best, it might opt for an organisational split of major firms i.e. an audit and a non-audit firm under common ownership. Such a structure will not deliver independent audits. Auditors will continue to audit the transactions initiated by themselves or their affiliates.

Following the Kingman report, the FRC is morphing into the Audit, Reporting and Governance Authority (ARGA). It will be responsible for shaping accounting and auditing standards. However, corporate capture continues unabated. Nearly three-quarters of the appointees to the UK Endorsement Board, responsible for setting accounting rules, have links with the big accounting firms, the very firms involved in headline scandals.

There is plenty of evidence to show that profit-seeking accounting firms cannot deliver honest and robust audits. But the government continues to indulge the auditing industry and there will be no respite from dud audits. Audits of all major corporations need to be performed by a state body specifically created for that purpose.

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