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Audit: a profession in crisis

by Alan Nelson

Imagine an industry controlled by a handful of players. Customers are compelled by law to buy from one of them and such regulation as there is has been delegated to their own cosy club. Scandal after scandal makes headlines, and stakeholders have fundamentally lost confidence.

If you think that sounds like a dystopian saga, you'll understand why people are talking about a crisis in the audit profession.

But is the fuss really justified? Are the corporate collapses and scandals really the auditors' fault? It seems self-evident that if a company collapses, or turns out to be riddled with fraud, when the auditor had only recently given it a clean bill of health, there are going to be some red faces around. But is that really fair? What is the role of the auditor?

Let's look at some of the recent high-profile cases to see what the accounting issue was in each one, and whether it is fair to criticise the auditors in question.

Tesco

First up is Tesco, who back in 2014, announced that they had overstated their profits by £250m (later upgraded to £326m), a revelation that wiped £2bn off their valuation in a single day.

The problem involved booking supplier contributions that were conditional on hitting sales targets that were never likely to be reached. So what was the accounting issue and should the auditor, PwC have spotted it? We're talking here about revenue recognition, a pretty fundamental accounting concept. IFRS 15 wasn’t in place back then but the rules were not substantially different, and it does seem to be the job of the auditor to sign off on the appropriate application of the rules, so it was hard to see PwC avoiding criticism.

However, that is exactly what happened. In June 2017, the FRC announced that it was calling a halt to its 2˝ year investigation on the grounds that there was "not a realistic prospect" that PwC would be found guilty of misconduct.

Patisserie Valerie

Next let's look at Patisserie Valerie. The café chain went into administration in January 2019 after it revealed a black hole in its accounts to the value of £94m. The problems here were quite different. With 5 people arrested by the Serious Fraud Office, this one is a case of fraud rather than an inappropriate interpretation of the standards.

So does that let the auditors off the hook? David Dunkley, Chief Executive of Grant Thornton certainly thinks so. In evidence to the Business, Energy and Industrial Strategy Committee on the future of audit, he argued that there is an expectations gap between what an auditor does and what the public think they do. "We are saying [the accounts are] reasonable." he said. "We are not set up to look for fraud... we're not giving a statement that the accounts are correct". Now statements like that are inevitably going to raise eyebrows,

Carillion

On January 15th 2018, construction giant Carillion collapsed under the weight of a £1.5 billion debt. It employed around 40,000 people in the UK and abroad and managed a vast number of government contracts, building hospitals and managing nearly 900 schools. The problem wasn't entirely new. Concerns about the growing debt had been expressed as far back as 2015. So again, what was the issue, and should the auditors have spotted it? Here we are dealing with the most fundamental accounting concept of them all - Going Concern. KPMG were heavily criticised for rubber stamping figures that misrepresented the business. They signed off on accounts that did not give a true and fair view of the company's performance. Surely that is something they should have been able to spot.

BHS

Finally, let's consider BHS. From 2000, the retail chain had been part of Philip Green's Arcadia Group, but in March 2015 it was sold for £1 to Retail Acquisitions Ltd, which was run by Dominic Chappell, a serial bankrupt. 13 months later, on April 25th 2016, the chain entered administration with debts of £1.3bn including a £571m pension liability.

PwC came in for severe criticism but was that fair? The FRC thought so. They said that the 2014 accounts were "incomplete, inaccurate and misleading". The key issue was that they stated that Philip Green's Taveta, BHS's owner, would provide financial support. But at the time the audit was signed, BHS was only days away from being sold for £1, after which the guarantees of financial support would no longer apply. It seems hard to believe that they had no knowledge of that and if they did it is a clear case of a post balance sheet event.

So, we have looked at four cases, and they are all different. Three of them involve accounting issues, the other is a straight forward case of fraud. Even the accounting issues are different in each case:

  • Tesco involved managers taking an overly aggressive approach to revenue recognition. That's human nature. We’ve seen it before time and again. It’s why IFRS 15 was introduced and the auditors need to get close enough to understand and police it.
  • Carillion was a case of accounts being signed off when the business was no longer realistically a going concern. That is pretty fundamentally the role of the auditor. Although with a big account, refusing to sign it off is a massive step, auditors do need to stand up and be counted on that issue.
  • BHS involved a post balance sheet event. It is hard, when the process is nearly complete and something comes to light, to call a halt to everything. But sometimes auditing is not about making friends.

So what happens next? We have no shortage of reviews telling us what should be done: The Kingman Review, Professor Sikka’s review for the Labour Party, BEIS Select Committee Review, The CMA Review, The Brydon review, BEIS Consultation on Kingman, to name but a few!

Some practical steps look likely to come out of the BEIS work to decide what to do with the recommendations of the Kingman Review. They have divided it into three groups:

  1. Stuff they want and can just happen
  2. Stuff they want but will require primary legislation
  3. Stuff they aren’t so sure about and want more time on

Meanwhile it seems as though all the major firms have announced a review of their audit function. This may be a serious and thoughtful attempt to address the issues, but a cynic might view it a different way. The regulators have been criticised for the slowness of their action in these cases. When cases do finally come to the point where firms are censured, it is all too easy for the PR machine to crank into action with the line, "That was years ago and we have changed so much that it was almost a different firm."

In the meantime, auditors need to be whiter than white. These issues are not complex – any student accountant would know why they are red lights. And although a few high-profile scandals and collapses get more publicity than the thousands of good audits, we do need to do better.

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