IN A MAJOR REVIEW OF THE UK AUDIT SECTOR, the IPPR think tank has identified glaring deficiencies in how the sector is assessing firms’ finances and governance, leaving the door open to more costly Carillion-style business collapses. The researchers warn that a large number of small-scale, silent Carillions are likely happening every year.

Auditors should act as the ‘trusted referees’ of corporate Britain, impartially flagging risky finances, communicating informatively about the state of a business to investors and society, but too often the opposite is the case, according to the IPPR.

An ‘expectation gap’ between what audit currently assesses and what it needs to assess to fulfil the expectations of the general public and achieve a sound economy is described by the report. The IPPR argues that profound reform of the sector is needed to close this gap.

The report shows that the way audits are currently conducted is enabling ‘boom and bust’ cycles, where some businesses are able to present an overly optimistic version of their finances, despite weak financial foundations that eventually lead to business collapses or seriously weakened firms.

The IPPR argues that by too often failing to help keep such financial mismanagement at bay, the audit sector is “failing society”. According to the report, current audit practices can lead to excessive risk taking and bad investment decisions whilst enabling some bosses, intermediaries and shareholders to receive large pay-outs. And the costs of business collapse ultimately fall on workers, suppliers and pension holders, with knock-on costs for the economy in the billions.

The report identifies a number of ways current practices and rules undermine the audit sector’s key role in the economy and society:

  • Lack of challenge and insufficient flagging of problematic practices: A lack of rigorous probing for useful information or challenging management, letting some firms get away with ‘aggressive accounting practices’ that paint an overly rosy picture of their finances. The audit regulator found that around one third of audits were problematic, lacking quality evidence or failing to provide adequate scrutiny. There is also currently too much ‘wiggle room’ in accounting rules and too little reporting on how it is being used.
  • Problems with consultancy: Audit firms make the majority of their revenues from consultancy services, where they advise firms on business decisions, aiming to be helpful to management. This can conflict with the purpose of the audit industry more widely, which should be to challenge management.

IPPR argues that audit reform would be a win-win for auditors, businesses, workers and the economy at large. A well-functioning audit system can drive transparency and trust, and help investors and businesses make better decisions. To achieve this, the definition of ‘audit failure’ must expand the scope of what the sector assesses, so it can live up to society’s expectations and economic needs.

Under existing rules, much of the auditing and consultancy services provided to Carillion would not necessarily have been considered failures. Therefore,the IPPR argues that in addition to failure to detect fraud or misstatements, it should also be considered an ‘audit failure’ where rules are not technically violated but firms using ‘aggressive accountancy practices go unreported.’. And it should also be considered a failure if audit-related consulting activities promote activities which go against the impartial refereeing role that auditors should strive to play.

The government is currently consulting on audit sector reform and published a white paper in March. However, there is a real risk that unambitious reform would leave some of the central problems unaddressed, according to the IPPR. The think tank argues that this process must lead to profound reform which:

  • Broadens purpose: Expand the remit of auditors to also be trusted referees of firms’ governance, climate risks and use of personal data.
  • Exposes real risks: Shine a light on aggressive accountancy practices, making it clear to investors and society if information about a firm’s finances lacks transparency.
  • Rebuilds trust: Introduce a stronger culture of challenge and public responsibility in audit firms. Structurally separate audit from non-audit businesses to avoid potential conflicts of interest.
  • Overhauls oversight: End the closeness of the audit watchdog (the Financial Reporting Council) with firms in the sector and ensure it has the powers and resources to regulate activity and assess the accuracy of audits using the IPPR’s new definition.
  • Introduces more competition: Challenge the ‘oligopoly’ of the ‘big four’ audit firms – Deloitte, KPMG, PwC and EY – who currently represent 96 per cent of the market.

The IPPR will publish two further briefing papers this year outlining in more detail how these reforms can be enacted and assessing the government’s current approach to the issue.

Carsten Jung, IPPR senior economist, said: “Auditors should be the gatekeepers helping keep financial mismanagement at bay, yet too often they are failing to do so and are failing society. To meet society’s expectations and needs, there needs to be profound audit sector reform.

“A well-functioning audit sector should be expected to flag problematic accounting practices and risky business activities before they turn into damaging debacles. However, the current legal set up does not require this from auditors.

“Restore[ing] public trust in audit firms is essential for them to become the trusted referees of corporate Britain. With this status gained, it could lead to a virtuous cycle in which trust fosters investment, business development and economic dividends.”

Shreya Nanda, IPPR economist, said: “At present, our corporate finance system does not account properly for risk, encourages firms to take on excessive debt, and allows firm insiders to prioritise their own short-term financial interests above the interests of workers, pensioners and suppliers, and the long-run financial sustainability of the firm. We need to reform this system to stop more firms going the way of Carillion, BHS and Patisserie Valerie.”

* Read The Truth Tellers: Why we need profound audit reform now here.

* Source: Institute for Public Policy Research