Prem Sikka, professor of accounting and finance at the University of Sheffield and emeritus professor of accounting at the University of Essex, puts the fall of UK construction company, Carillion, into historical perspective and explains why audit market concentration has little to do with audit failure but it rather comes down to systemic and organisational problems combined with an ineffective regulator.
‘When in a hole – deflect attention’ is an old strategy used by elites to manage awkward situations. That strategy was in full use by the Financial Reporting Council (FRC) at last week’s Parliamentary inquiry into the collapse of Carillion, a major UK construction and services conglomerate.
Carillion entered liquidation on 15th January 2018. It had about 43,000 employees (19,500 in the UK) and owed £800m to employee pension scheme and about £2bn to 30,000 small businesses. Carillion had non-current assets of £2,163m, and £1,571m of this was goodwill, which was not amortised. For the period 2009 to 2017, Carillion’s debts rose by 297%, whereas the value of its long-term assets grew by just 14%. In the five-and-half-year period from January 2012 to June 2017, Carillion paid out £333 million more in dividends than it generated in cash from its operations. Over the eight years from December 2009 to January 2018, the total debt owed by Carillion in loans increased from £242 million to an estimated £1.3 billion. The company always received an unqualified audit report from KPMG.
Inevitably, there were questions about accounting and auditing practices and the FRC chief executive was summoned to appear in front of a joint session of the UK House of Commons Work and Pensions and Business Energy and Industrial Strategy Committees on 30th January. It wasn’t long before he attributed auditing woes to the lack of “competition in the major accounting and audit area”.
We can have a debate about competition, but that is not the reason for poor audits. Since the 1970s, there has been increased concentration of audit services. The number of major firms shrank from the big eight to seven, six, five and finally after the 2001 Enron and WorldCom scandals and the demise of Arthur Andersen, the big four.
History of Failures
The presence of 8/7/6/5 major firms was not some golden era for auditing. The auditing industry has always been mired in scandals and failures. If by luck or otherwise, a company survived audit failures remained covered. Even then too many hit the headlines. The secondary banking crash of the mid-1970s highlighted pitiful auditing practices as auditors turned a blind eye to fraud. They were joined by failures at Lonrho, Pergamon Press, Ramor, Pinnock Finance, Vehicle and General, Court Line, London and Counties, Peachey Property Corporation, Grays Building Society and Milbury, amongst others.
The Department of Trade and Industry inquiry into audit failures at Roadships concluded, "We do not accept that there can be the requisite degree of watchfulness where a man is checking either his own figures or those of a colleague … for these reasons we do not believe that [the auditors] ever achieved the standard of independence necessary for a wholly objective audit". Yet to this day auditors are permitted to use audit as a market stall for selling other wares, especially tax avoidance.
The 1980s drew attention to auditing debacles as failures at Johnson Matthey, De Lorean, Euroflame, Sound Diffusion, Alexander Howden, Barlow Clowse, Levitt, Milford Docks Company, Dunsdale, and Edencorp hit the headlines. Still, the auditing industry did not mend its ways. The 1990s debacles at Maxwell, Bank of Credit and Commerce International (BCCI), Polly Peck, Sock Shop, Queens Moat Houses and Atlantic Computers showed that audit failures are deeply institutionalised. Then came the 2007-08 banking crash. Some banks collapsed within days of receiving an unqualified audit report.
The claim that more audit firms would somehow arrest audit failures has no substance.
We can’t also talk about audit market in the same terms as the market for consumer goods and services. The market for auditing is created and guaranteed by the state and handed to accountants belonging to a select few trade associations. There are no state guaranteed markets for scientists, engineers, mathematicians, or information technology experts. The normal rule of competitive markets is that those producing shoddy goods/services and deriding customers for expecting higher quality are pushed out of business. They can face mega lawsuits. But despite monumental failures that does not happen to auditors because the market is guaranteed by the state. Admittedly Arthur Andersen disappeared in 2001, but its business migrated to other accountancy firms. There was no loss to the auditing industry.
The state guaranteed market is accompanied by poor pressures. Producers of potato crisps and toffees have to ensure that the product is fit for purpose and does not injure current or future consumers. Yet there is no equivalent requirement for auditors. In the 1970s and 1980s, auditing firms traded as partnerships with each partner having ‘joint and several’ liability. Even those, supposedly more biting liability arrangements, did not deter scandals and failures. There was no evidence to show that the UK courts made excessive damages awards against auditor, but their liability was eroded by the 1990 Caparo judgement and the Companies Act 2006. The advent of limited liability partnerships (LLPs) gave auditors even more liability shields. It is almost impossible for stakeholders to sue auditors for negligence. Such developments have diluted the pressures to deliver good audits.
One might look to regulators, such as the FRC, to exert pressures for improvement of audit quality, but that is deficient too. Through the FRC, the auditing industry effectively sets its own standards. These have encouraged a checklist mentality. The standards are low enough but even then as the FRC inspections show many major firms fail to meet them. The FRC has done little about that. Its occasional investigations take years and the resulting fines, if any, are passed on to the professional body of the errant auditor. The FRC has failed to examine its role in nurturing audit failures.
The public accountability requirements for the auditing industry are low. At any mention of public responsibility, firms wheel out the rusty arguments about the expectations gap. Stakeholders are not told anything about the audit contract; composition of the audit team, time spent on audit, questions asked, material replies received from directors or regulatory action against auditors. Audit files remain secret. There is no opportunity to glimpse the quality of audit. Auditor (re)appointment resolution tabled at company AGMs is not accompanied aby any meaningful information. The transparency and public accountability revolution has bene shunned by the auditing industry. None of the auditing standards issued by the FRC set a benchmark for auditor accountability to stakeholders.
Audits are manufactured within accounting firms and organisational culture is a key part of that process. In common with other capitalist organisations, firms deploy various systems to maximise profits and squeeze labour. This has consequences for the quality audits.
Audits are generally labour intensive and within firms there are pressures to increase profits. Individuals are subjected to performance appraisals and often their promotion and financial rewards depend on contribution to profits. Firms can increase profits by charging higher fees, but clients may resist such moves. Firms might use more audit juniors or change the mix of junior and senior staff to reduce costs.
An alternative is to squeeze time budgets and expect audit staff to beyond the designated hours, i.e. week-ends and evenings, to complete the tasks. With lower liability pressures, firms may also undertake less stringent audits. A body of research has consistently shown that tight time budgets have dysfunctional effects on audits. Faced with inadequate time budgets, many audit staff admit to adopting irregular practices, ignoring awkward and time-consuming items and falsification of audit work i.e. working papers show that something has been done but actually not done at all. The pressures to come under time budgets may help to increase profits and mediate internal performance appraisals, but they deliver poor audits.
Audit firms partners are supposed to review the audit files for completeness before signing-off the audit report. But a false audit schedule looks like any other. Without a replication of the audit process no partner can tell whether the required audit work, assuming it is of a good quality has actually been done.
The organisation dynamics, a key part of the audit production process, are totally neglected by the FRC. Its inspection regime is a checklist approach, ticking the boxes to see that the firm has complied with minimalist auditing standards. The FRC chief tried to deflect attention at the parliamentary hearings but did not totally succeed with that strategy and at one stage a legislator described it as “useless”
Carillion, BHS, the 2007-08 banking crash and other episodes provide plenty of evidence to show systemic and organisational problems. Auditors have rarely exposed predatory practices that enabled financial enterprises to report higher profits and pay unwarranted dividends. Since the 1970s, regulatory structures, codes of ethics, audit reports, auditing standards and disciplinary arrangements have been tweaked, but on the terms specified by the auditing industry itself. Inevitably, there has been little meaningful change. The FRC has a poor record and its capture by the audit industry has become a major barrier to change. Its removal and replacement should be a priority for any government seeking to rebuild confidence in corporate governance.
Prem Sikka is professor of accounting and finance at the University of Sheffield and emeritus professor of accounting at the University of Essex. And he is the 2017 recipient of The Accountant & International Accounting Bulletin's editor’s award: The Abraham Briloff award for extraordinary contribution in promoting transparency and public accountability of businesses.