The issues we have been seeing in the audit sector have been ongoing for some time. Issues like the ones seen with Patisserie Valerie, Carillion, Metro Bank and Conviviality did not start at the outbreak of Covid-19, and they are unlikely to go away when it eventually dies down. Yet, some have expressed concern that the crisis will stifle efforts to increase the viability of the smaller, challenger firms to break the dominance of the Big Four accounting firms.
Squeeze on Profits
All firms need to cut costs to survive the pandemic, but comparatively speaking these measures will hit mid-tier firms harder and more quickly as they operate on a lesser scale. With smaller firms more likely to feel the squeeze, the worry is they will be less able to compete for the “bigger” clients—they simply cannot afford to take on more risky audits because if something goes wrong, they might not be able to take the hit to their cashflow. This will leave the Big Four unchallenged at the top of the game and leave them with little incentive to do the best possible job—or so the narrative goes.
But, as an industry we were talking about this problem well before Covid-19 hit and multiple possible solutions have been suggested. Some have called for the Big Four to distinctly separate their other services from their audit branches to reduce conflict of interest, in a similar way to banks’ ring-fencing regulations post 2008.
Others, including the Competition and Markets Authority (CMA), have suggested that companies should hire joint auditors, including at least one smaller firm, to increase competition, strengthen the work being done and encourage further scrutiny of the balance sheet.
Whilst the current pandemic has highlighted the audit failure issue, a big concern is that regulators believe that a break-up of the Big Four would solve it. It won’t. And doing so would have negative consequences for clients from a tax perspective too.
For any company, getting their tax services from their auditor brings two benefits. Firstly, the provider has a deeper knowledge of the company resulting in better, up-to-date and cheaper services. Secondly, additional services are essentially “pre-audited” before being provided to the business to ensure they don’t pose an issue.
The colossal impact the Covid-19 crisis is having on businesses is absolutely not to be underestimated, but we need to look deeper at the true issues at hand in this situation before we make the assumption that Covid-19 will impact the audit reform agenda.
The Real Problem
It is not clear that either breaking up the Big Four or increasing competition would actually help. Neither addresses the fundamental reasons why these failures are happening. We need to recognize that the auditors are not solely at fault. They certainly are not getting it wrong out of laziness or due to conflicts of interest, their careers mean too much for them to do that. Take Sports Direct (U.K. sports shop) as an example—following the departure of Grant Thornton, no one wanted to step in for fear of irreparable reputational damage.
Nor is competition completely down and out. Last year, Goldman Sachs announced Mazars was replacing PwC as its auditor, proof that the stranglehold of the Big Four on the FTSE 350 was loosening ever so slightly. Indeed, increasing competition is a good thing for markets because it increases the value for the customer—for example, allowing challengers into the market may also reduce the cost of tax services as the Big Four look to offer bundled services at greater value to retain clients.
That said, even a first-year economist would be swift to point out that increasing competition in a market where there are similar players adopting the same delivery model increases pressure on pricing, but often not on quality.
Neither does increasing the competition for audit firms stop them all being afraid of the same thing —overseeing a failure. Some are using the Covid-19 impact as a “get out of jail free card.” In light of the pandemic, some are insisting that clients agree to a clause absolving them of blame should the business go into administration, irrespective of how likely those firms are to survive. This protects the auditor but does not help shareholders or investors, which defies the point.
The problem is not lack of competition, or conflict of interest. The heart of the issue is that audit is getting so much harder to do. Assets off balance sheets continue to rise, there’s infinitely more data and businesses are moving faster to keep pace with the socio-economic climate. This is exacerbated by accounting treatments getting increasingly complex as well as a fundamental lack of alignment between auditors and management teams. So where do we go from here?
All About Analytics
The lack of alignment has been there forever. There is poor integration between long- and short-term financial reporting, as well as internal and external reporting. Audit is a third entirely separate and “after the event” process. With three siloed processes running at different times to produce management information (MI), statutory reports and assurance that the numbers are correct, it is not hard to understand why problems become tricky to spot and even harder to resolve.
Better MI and technology can help hugely. Implementing analytics technology will provide real-time insights to management and could provide the same to auditors, allowing them to discuss issues as and when they arise. They can deal with them there and then, rather than having to flag a problem well after the event when nothing can be done about it. The technology already exists, and breaking up the audit firms will hinder rather than help the implementation of it.
To do this truly successfully, the Big Four might have a more delicate issue on their hands: changing their business model. The partnership business model is fundamentally ill-suited to a technology-based offering: there is a limited balance sheet to invest in it and the delivery model is predicated on teams of people and manual processes that need oversight. People are still at the heart of a technology-based audit offering—applying judgment where relevant, ensuring good client relations and retaining their accountability—but they would be served by an algorithm not a team of people. The partnership model will need to go if real progress is to be made.
Yes, there is an issue with how audits are done, and the current crisis is impacting this just as it is impacting many other sectors at the moment. However, the fundamental problems with the industry responsible for the spate of failures last year were there well before the virus outbreak, and we still need to address them.
Technology is the answer, and it exists now.
Getting there is not necessarily about increased competition or breaking up the Big Four, it is about changing their business model. If that happens and technology is adopted effectively, we could see a dramatic improvement in audit quality while allowing the audited firms to continue to benefit from the valuable tax services they currently procure from their auditor. It is a win-win for everyone.
Simon Bittlestone is CEO of Metapraxis, U.K.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.