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Missing target AccountingWEB Big Four auditors are 'failing to perform core function'
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Big Four auditors are ‘failing to perform core function’

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With the UK’s audit sector facing unprecedented criticism after some high-profile collapses, a new study looks at where the Big Four is going wrong.

22nd May 2024
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A report analysing why the Big Four are being “rewarded for failure” has been released. It suggested that auditors aren’t performing their core function and criticised the UK’s “ineffective regulatory, oversight and sanctions system”.

The Audit Reform Lab is behind the study, which looks at the paradox of audit partners’ record payouts “amidst poor audit quality”.

The collective of academics, consultants and activists located in the Centre for Research on Accounting and Finance in Context (CRAFiC) at the University of Sheffield analysed the audit reports of the largest 250 publicly traded companies that collapsed between 2010 and 2022.

Essential service

The deepdive found that auditors are “failing to perform their core function”, with three in four audit reports not raising the alarm that the collapsed company could go bankrupt – by providing a “material uncertainty related to going concern” paragraph – or warning in the year prior to the collapse.

“Auditors are required to include this going concern warning if they believe there is a risk that the company may go bankrupt – rather than making a prediction that it will,” it added.

As a service, audit was described as an essential one that “ensures the integrity of company reporting, and if done properly, would help to boost confidence for shareholders and other users of company accounts”.

“However, auditors are currently incentivised to maintain good client relationships, rather than apply the principles of professional scepticism and enforce prudence. The UK’s ineffective regulatory, oversight and sanctions system, and the limited liability for audit partners (under the Limited Liability Partnership business structure used by Big Four firms) provides little disincentive for this model to change.”

Serious concerns

Of the Big Four auditors, EY was found to have performed the worst – warning of going concern risks for just 20% of collapsed firms. PWC provided warnings in 23% of cases, with Deloitte at 36% and KPMG at 38%.

Auditors outside the Big Four performed even worse, providing warnings for 17% of collapsed firms.

The report found that there are “serious concerns that auditors are not challenging enough”, with the data showing that of the 250 liquidated companies, 38 declared dividends in their last set of accounts.

“Ten of these did so despite making a loss, and two – Entu (UK) PLC and Utilitywise PLC – did so despite reporting a loss and having a negative net asset balance, which is a strong indicator of insolvency risk,” it added.

Rewarded for failure

The Audit Reform Lab also analysed partner pay at Big Four firms and the fines issued by the Financial Reporting Council (FRC).

Among the findings was that from 2020 to 2022, the average pay for partners at the Big Four firms “rose by 31% to £872,500”. Also, in the most recent fiscal year, partners at Deloitte “earned over £1m on average in pay and those at PwC close to £1m”. KPMG and EY “also reported their highest ever partner earnings”.

From 2015 and 2022, it was discovered that regulatory fines for poor audits were on average “just 0.16% of revenue and 0.85% of profits for Big Four firms”.

“These small fines are not enough to materially affect partner pay – providing an insufficient deterrent, and enabling firms to continue to be rewarded for failure,” said the study.

It notes that in any other context, the “appearance of declining quality and increasing pay would lead to claims that an industry exhibits ‘reward for failure’ characteristics”.

However, the report added: “But in the audit industry that narrative has rarely appeared: failure and pay are instead approached as separate and discrete phenomena.

“Gatekeepers hold powerful structural positions. Auditors could use their position as gatekeepers to raise standards, but when the incentives are wrong, those positions can be misused to extract rents whilst doing little about audit failure.”

The report stressed that with the Big Four being “large, multi-service providers who generate most of their profits from non-audit fees where maintaining good client relations is the sine qua non for future income”, and audit services being provided on a ‘client-pays’ basis, there may be “strong fee-based disincentives against providing robust audits which may upset clients and damage future non-audit business”.

Recommendations

The Audit Reform Lab has laid out four main recommendations to address what it considers to be a “structural problem”.

The first is a “new mission for audit”, provided by a new regulator. This would see auditors exercise independent judgement and professional scepticism to “verify whether a true and fair view of a company’s assets, liabilities, financial position and profit or loss is being presented”.

The second is a “reformed culture of audit”, which proposes the legal separation of audit and non-audit services as the starting point for any future reform.

“The client-pays model also creates too many conflicts of interest and needs reform,” it added.

“Although these recommendations are likely to receive opposition from the audit industry they are, in our view, necessary pre-conditions for change and have been discussed in government reports, as well as external advocates for reform.”

The third suggestion is a new regulator for audit via the recommended Audit, Reporting and Governance Authority (ARGA) to replace the FRC, with the final one being greater partner accountability for audit failure.

“This would include a reformed sanction regime to target partner incomes and reduce moral hazard,” it said. “Limited liability privileges should be removed.”

Each of the Big Four firms declined to comment.

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Replies (8)

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By Paul Crowley
22nd May 2024 15:05

If nobody knows how to do an audit anymore, what is the point of new regulators. Better to just increase the penalties. Maybe then they would figure out how to do an audit.

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Replying to Paul Crowley:
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By FactChecker
22nd May 2024 21:47

Quite ... but not "just *increase* the penalties" ... levy them directly on individuals (i.e. not let them be amortised across the partnership as a 'cost of doing business').

Thanks (7)
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By Tobby
23rd May 2024 07:53

Highly qualified and motivated by greed.

My experience of working for one such firm was least amount of work for the largest possible fee.

Solve the greed motivation and you will solve the problem.

I once completed a piece of work which my ledger recorded costs of less than £2k and was instructed by the client partner to bill £15k.

The disappointment was the client paid!

Disenchanted with a big four I resigned.

HB

Thanks (4)
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By Geoffo3@@
23rd May 2024 08:57

I would suggest introducing a fine and penalty point system to punish firms for shoddy audits.After 12 points, they have their audit licence suspended for 4 years.If this is done,chances are audits will improve dramatically.

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By Mr J Andrews
23rd May 2024 09:33

No doubt the 'Big Four' will see the Audit Reform Lab report with respective comments :
''....Yes, we are aware.....'' ''.....so what......'' ''....it's part of the budget......''
and ''.......#### happens.....''

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By Self-Employed and Happy
23rd May 2024 09:38

Easiest way to solve this is to make the partners themselves liable for fines, then as long as they have displayed they have done everything within their scope and power to do the job correctly they'll be fine.

I would even section off the Audit work as a completely separate business whereby the Audit Partners get rewarded directly with their sections performance not the business as a whole, maybe it would encourage more people into Audit.

For as long as they chase fees and not results, for as long as there is a distinct lack of objectivity then the problems will never go away.

Thanks (3)
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By Runagood Team
23rd May 2024 14:53

Surely the answer that statutory audit companies pay an annual audit fee into a pot that randomly allocates an auditor annually who must have no other relationship with the company?

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By HL86
29th May 2024 19:34

One wonders which professional body governs these companies/individuals and how HMRCs efforts to bring in further governance/oversight into the accouting world will help... just a thought

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