Critical Analysis of Auditing Failures, CMA Report and Reforms

This report critically analyzes the failures of the Big Four accounting firms – PwC, KPMG, EY, and Deloitte – in auditing major companies like BHS and Carillion, highlighting their inability to spot financial fragilities leading to significant losses. It examines the Competition and Markets Authority (CMA) report, revealing its shortcomings in addressing fundamental issues regarding competition and audit quality, such as the lack of auditor liability and insufficient incentives for improved work. The report argues for structural splits within audit firms, preventing them from offering consultancy services to audit clients, and criticizes the CMA's reluctance to remove barriers to entry in the market. It concludes by questioning the CMA's fitness for purpose, given its failure to propose meaningful reforms despite repeated audit failures and lobbying influences, emphasizing the need for more robust regulatory actions to ensure audit quality and protect stakeholders.

The big four auditors are failing – and the
watchdog’s report won’t change that
Prem Sikka
The near-collapse of BHS, Carillion and the bailed-out banks wasn’t
spotted. The CMA’s remedy shows it is not fit for purpose
Thu 18 Apr 2019 17.44 BST
What do BHS, Carillion, Conviviality, Quindell, Aero Inventory,
the Co-op Bank, and London and Capital Finance have in
common? They were all audited by the big four accountancy
firms – PwC, KPMG, EY and Deloitte – which audit 97% of FTSE
350 companies and collect 99% of audit fees. In each case, these firms
collected huge fees and delivered little of any public value. Their failure to
spot the fragility of those businesses resulted in the loss of jobs, savings,
pensions and tax revenues.
Yet the victims of these failures have no legal recourse to seek compensation
because auditors owe a “duty of care” only to the company that hires their
services, not to any individual stakeholder or creditor.
Despite their inability to spot the flaws in the financial statements of banks
which led to the 2007-08 financial crash, the auditing industry escaped
meaningful reforms. After the BHS and Carillion failures, the government
passed the buck to the Competition and Markets Authority (CMA). Yet its
long-awaited report, published today, fails to address the fundamental issues
about competition or audit quality.
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Compare it with other businesses: anyone selling toffees has to ensure their
product is fit for purpose and will not injure their customers. However, that
logic does not apply to auditors, and the CMA does not even address this
central issue. Without these potential liabilities, audit firms have insufficient
economic incentives to improve the quality of their work.
The CMA calls for an “operational split” of the big firms, that is, audit and
non-audit arms need to be separated internally by Chinese walls. The idea is
that this would somehow dissuade auditors from selling non-audit services
to big corporations and reporting on the very transactions that they
themselves have created. But this will not work: the lure of profits is too
strong. Big firms claim to have Chinese walls to prevent their tax divisions
from targeting their audit clients for the sale of tax-avoidance schemes, but
court cases have shown otherwise.
Instead of an operational split, a “structural split” is needed. Under this,
audit firms would do audit only, and neither the firms nor any of their
associates would be permitted to sell any form of consultancy to audit
clients. Such a reform is called for in a report I worked on for the Labour
party, and also in a report by the House of Commons business committee .
The CMA proposes joint audits for most FTSE 350
companies by a big four and a mid-tier firm. This may make
a marginal difference to the market, but the authority shies
away from removing barriers to entry to that market: the
government requires that all auditing firms need to be
under the ownership and control of licensed auditors. This prevents
technology and other companies from entering the market and challenging
the big accounting firms’ dominance. Despite a brief to promote competition
and choice, the CMA has totally ignored the issues.
The big question is whether the authority’s new proposals would have made
any difference to recent audit debacles at BHS and Carillion. BHS had been
audited by PwC for over a decade before its demise in 2016. An investigation
by the Financial Reporting Council, the audit regulator, showed that the PwC
partner responsible for audit spent just two hours on the case. The work was
left to junior staff, including one with one year of post-qualification
experience, who failed to perform adequate tests to verify assets,
investments, loans, income, costs and even whether BHS was a going
concern.
KPMG audited Carillion for 19 years, and also sold consultancy services to
the company. Carillion had worthless contracts of more than a billion pounds
in its balance sheet. It had aggressive accounting policies and failed to
recognise the falling value of assets such as goodwill.
Today’s CMA proposals would make virtually no difference to the audit of
BHS or Carillion. Its report does not call for public information about the
composition of the audit teams, time spent on audit by each grade of labour,
the list of key questions to be asked by auditors and the required replies, or
recent regulatory action against the firm or anything else that might dissuade
auditors from being too close to management.
Many audit failures have shown that the longevity of
auditors’ term in office results in chumminess with
directors and impairs their scepticism. Yet the CMA is
content with the current rules, which only require major
companies to change their auditors every 20 years. The
CMA washes its hands by saying that it wants to empower audit committees,
consisting of non-executive directors, to deal with the appointment and
Watchdog calls for
UK's big four
accountancy firms
to be split up
Read more
Top auditors ‘loss-
leading on fees’
and undercutting
rivals, MPs say
Read more

oversight of auditors. It neglects to note that all the bailed-out banks, along
with Carillion and BHS, had such committees. They failed, and the CMA does
not ask why.
This is the third unsuccessful attempt by the UK’s competition authorities to
tackle the dysfunctional auditing industry. Under the weight of lobbying and
political interventions, previous reports in 2006 and 2013 shelved the long
overdue reforms. Now, despite a stream of audit failures, meaningful reforms
are once again being taken off the agenda. It is time to ask whether the CMA
itself is fit for purpose.
•Prem Sikka is a professor of accounting at the University of Sheffield
Topics
Accountancy / Opinion
Competition and Markets Authority/ BHS/ PricewaterhouseCoopers/ EY/ KPMG/ Deloitte/
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