Memorandum by Independent Audit Limited
1. Thank you for your invitation to give
evidence to the Enquiry of the Select Committee on Economic Affairs
into the above topic.
2. Independent Audit Limited provides clients
with independent assurance and advice on matters relating to corporate
governance, risk management and compliance assurance, ranging
from board and audit committee effectiveness to the effectiveness
and value for money of their external audits. We have expertise
in financial statement auditing but do not undertake such audits
3. Concentration of the audit market on
the Big Four firms is most apparent in certain sectors, particularly
listed companies and financial services organisations. The audit
market for private companies, especially smaller ones, is very
different, with much more competition, and is not addressed by
4. There has been no systematic evidence
of audit failure relating to the recent financial crisis and in
our view it is mistaken to seek to blame individual auditors for
not having helped to prevent it. It is true that they did not
seem to see it coming, but sadly they were not alone in this.
Very few people saw the crash coming, and even those who did could
not predict its timing. Auditors fell into the same trap as most
of the rest of us, including those charged with economic policy
and regulation of the financial services industry. And while it
is true that audited accounts failed to draw attention to the
stresses building up in the financial system, this is a failing
not of individual audits but of the system within which audits
5. Criticism of auditors for their role
in the financial crisis, or rather their absence of role in preventing
it, seems largely to arise from a difference in expectations between
those of the critics and those of the profession. Some of the
critics seem to look to auditors to protect society from the ravages
of capitalism, and their views, although usually expressed with
eloquence and vigour, are perhaps better considered in a forum
other than the present one.
6. A more significant, albeit sometimes
less dramatically communicated, body of criticism originates from
people who do not wish to change the nature of economic society
but whose expectations are that audit will increase their understanding
of management effectiveness, financial strength and business model
resilience. The audit profession generally fails to meet these
expectations and it is not immediately obvious to those outside
the profession that this is because the expectations are fundamentally
unreasonable. Once again, however, this is not the fault of individual
auditors but of the system within which they have to operate.
7. The system of audit is characterised
by a number of very distinctive features, which are to a large
extent interdependent. These include:
7.1. "Clean" audit opinions have
very low information value. Most of the words in them are standard
boilerplate and are devoted to explaining what the auditor has
not done and cannot be held responsible for.
7.2. The words in a clean audit opinion
are usually identical regardless of the degree of risk in the
financial statements and the extent of rigour in the audit. They
contain nothing to identify a good audit that has licked poor
accounts into shape so that they have come to deserve a clean
opinion. A qualified audit opinion has higher information value
than a clean opinion but is not evidence of a more rigorous audit.
7.3. The most significant piece of information
in a clean audit opinion is the name of the audit firm. In the
absence of any other information about audit quality, readers
trust well-known brands.
7.4. Many investors show little interest
in the technical relevance of the audit, instead acting as if
much the most useful thing to them is their ability to sue the
audit firm for very large or even unlimited amounts in the event
of the company's accounts proving to have been misstated. This,
together with a presumption of quality, leads them to favour the
7.5. The same predisposition can be seen
in lenders, whose practice, if not their official policies, is
often to require borrowers to appoint one of a short list of large
audit firms. The evidence for this is largely anecdotal but there
seems little reason to doubt that it occurs.
7.6. The widespread perception that investors
and lenders favour the large audit firms discourages audit committees
from appointing smaller firms. For an individual audit committee
there is little to be gained by taking the risk of departing from
the safe option.
7.7. In the same way, the widespread perception
that the Financial Services Authority has a preference for large
audit firms means that financial services organisations have a
marked tendency to play safe. While the FSA has no official policy
of favouring the large audit firms, it does little or nothing
to dispel the widespread perception to the contrary, nor to encourage
greater competition in this sector of the market.
7.8. Auditing standards impose a largely
similar process on all audits. While the firms make brave marketing
efforts to differentiate their audit services, underneath the
decorative trimmings each must employ much the same approach as
required by the various professional and regulatory bodies who
govern their practices.
7.9. The economic model of the profession
is that a small number of partners profit from work carried out
by a much larger number of employees. A high proportion of an
audit firm's staff are trainee or recently qualified accountants.
They have knowledge of accounting standards and audit process
but little experience of business and even less of management.
Rules aimed at increasing the public's perception of auditor independence
have had the side-effect of restricting auditors' wider experience.
7.10. Auditing standards reflect this state
of affairs and are translated by the audit firms into methodologies
which can be completed by inexperienced staff under the supervision
of a smaller number of experienced auditors. The process required
by auditing standards is one which places a very high premium
on the completion of satisfactory documentation as evidence that
an audit has been completed and this is reflected in the firms'
and the regulators' approaches to quality assurance.
7.11. Documentation tends to become an end
in itself (an assertion supported by academic as well as much
anecdotal evidence) and is not necessarily well correlated with
what constitutes an effective audit.
7.12. The purpose of a financial statements
audit is defined by law and regulation in very circumscribed terms,
being to give an opinion on whether the financial statements give
a true and fair view and comply with accounting standards. Much
of the public expectation of audit lies beyond this tightly defined
and largely historical purpose, and is therefore doomed to disappointment
unless auditors choose to go beyond their remit. From the individual
auditor's point of view there are few good reasons to so do, and
many very good reasons not to. Liability is the most obvious one,
but it is also the case that while audit firms are very well equipped
to examine compliance they are much less well equipped to form
a view on the subjective and sensitive topics that lie outside
the financial statements remit. This is especially the case where
the opinions have to do with uncertain future events of which
a global liquidity crisis is the most extreme recent example.
7.13. Financial statements are essentially
backward-looking and contain only limited information about other
matters for which there is public demand. Information about the
risks inherent in a business model, for example, is largely forward-looking,
and to the extent that it is to be found in an annual report it
will be in the narrative section which is not subject to audit.
7.14. Accounting standards have become much
more complex and prescriptive. Although enthusiasts and the uninformed
pronounce that IFRS is principles-based rather than rules-based,
this assertion defies common sense. No statement of principles
should be measured in thousands of pages.
7.15. IFRS can introduce a high degree of
subjectivity into financial statements through accounting procedures
that sometimes require a great deal of estimation, so audit judgement
is required in relation to detailed calculations. However, the
self-referential declaration that a true and fair view is achieved
through compliance with these standards serves to reduce professional
judgement in relation to the overall picture. Whether the accounts
are "right" is reduced to compliance with the rules.
7.16. Regulators and lawyers generally attach
considerable importance to documentary evidence of compliance
with standards. Audit firms seek defence in documentary evidence
of completion of audit steps or by reference to accounting standards
which relieve them of responsibility for outcomes. Not unreasonably,
there is a very strong defensive motivation to avoid taking positions
which can be only unreliably defended by reference to subjective
notions such as "right and wrong", "true and fair"
or "professional judgement".
7.17. An increasing proportion of time spent
by auditors is spent on checking compliance with the increasingly
voluminous accounting standards and documenting the audit process.
This contributes to the cost of audit without necessarily providing
a great deal of real value.
7.18. Knowledge of how these complex standards
are elsewhere applied is a commercial asset to audit firms, and
one which increases in value with scale. Larger firms have much
more valuable knowledge of practice, as well as the capacity to
commit more resources to specialist technical roles. Any new entrant
to the audit market would need to invest very considerable amounts
in acquiring this knowledge and developing technical expertise.
7.19. The increasing burden of regulation
on audit firms and the commercial benefit of scale in accounting
expertise together create a strong rationale for yet further consolidation
in the audit sector, while discouraging fragmentation and increased
competition. The reason consolidation is rarely seen in practice
is that, as private partnerships, audit firms are usually reluctant
to give up their independence.
7.20. It is sometimes argued that increased
competition could be introduced through forced fragmentationbreaking
up the large firms. This would be immensely difficult to do within
the existing system (for example, how do you break up a large
UK firm into pieces that can function effectively without also
breaking up its international network, which is not within the
UK's power?). And given that all the other pressures within the
system are for scale and consolidation, it is not self-evident
that forced fragmentation would have a net beneficial outcome.
7.21. Audit firms compete very vigorously
when audits are put out for tender. However, for what are usually
good reasons this happens only rarely. A change of auditors might
bring a fresh point of view but it also brings ignorance, and
there is some evidence that the temporary disadvantage of the
latter outweighs the equally temporary advantage of the former.
In years when there is no tender, the fact that there is limited
market competition is largely irrelevant since price is set by
negotiation, usually using the previous year's fee as a reference
7.22. When an audit is put out for tender,
the audit firms will compete vigorously on price and on quality
of service to management, but not in practice on the quality of
audit. Because of the role of auditing standards and regulation,
their differentiation over the quality of the audit service is
restricted to peripheral matters and "froth" which clients
7.23. Some aspects of service to management
are disguised as contributors to audit quality. The most significant
of these is the large, well-integrated international network.
This is something that multinational clients appreciate, since
it simplifies the management of the audit process and gives access
to useful resources that can be deployed when and wherever the
need arises, within the constraints of the auditor independence
rules. It would in fact be perfectly possible to conduct a quality
audit of a multinational company without such resources but this
would be contrary to the presumptions of auditing standards, the
economic interests of the international networks of audit firms
and the convenience of management. Instead, the presumed need
to have such a network is allowed to remain a very significant
barrier to entry into the large company audit market.
8. This is far from an exhaustive list of
distinguishing features of audit market, but it is enough to show
the nature of the systemic problem with audit. Auditing and accounting
standards; the business model of audit firms; the liability regime;
the individual interests of investors, lenders, management and
audit committees: these and other features all work together to
give us an system which favours consolidation and discourages
innovation and competition, and whose output is increasingly what
might be labelled as "compliance" with a reporting regime
which meets the public's expectations to only a partial extent.
9. The audit partners and staff who work
in this system are, with only rare exceptions, conscientious,
diligent and highly skilled professionals who seek to make the
system work, and are rewarded for doing so. It is no criticism
of them to observe that the system fails to achieve what those
outside the system would like it to achieve. In fact, criticising
auditors or individual audits undertaken within the present system
distracts attention from the real issue, which is the inadequacies
of the system.
10. Of the separate features of the system
summarised above, there is no single one which dictates its overall
character, nor is there a clear-cut chain of cause-and-effect.
The different features fit together and support each other, and
the system functions as a whole. Consequently, it is hard to see
how incremental adjustment to individual features will succeed
in making significant change to the system. Reform of the liability
system and control of restrictions in bank covenants are probably
the most immediately helpful things that could be done, but even
these are removal of barriers rather than positive inducements
11. Moreover, there is a long history of
unsuccessful attempts to improve the situation from within. For
example, the "expectations gap" between what the public
want and what auditors do has been around for as long as auditors
can remember. Despite the profession's heroic efforts to educate
the public to want less, the gap remains. And attempts to improve
regulation by doing more of the same have made things better in
some respects and worse in others.
12. The regulation of audit and accounting
is increasingly international and the features of the audit system
described above are broadly similar in all major jurisdictions.
This provides a further constraint on the UK's ability to achieve
significant change through adjustment of the present system. So
while it might be tempting to suggest, for example, that matters
could be improved by a transformation of audit regulation, this
would be at least a lifetime's work if it had to be done on the
13. When the system of audit is looked at
in the round in this way, if leads to the conclusion that if,
as a society, we wish to see audit move away from compliance and
contribute more to economic stability by increasing public understanding
of and confidence in matters such as the quality of management
and the sustainability of business models, and if we wish to see
a market which encourages rather than discourages new entrants
and innovation, we must consider radical options that could be
implemented in the UK without needing international agreement.
For example, any or all of the following:
13.1. Leave the financial statement audit
regime largely untouched and consistent with international practice,
thus avoiding getting drawn into international dispute. Meanwhile,
in recognition of the fact that the expectations gap relates largely
to qualitative and forward-looking information, develop the requirements
for narrative reporting by UK listed companies and other public
interest entities, with a view to reducing, if not closing, the
gap. This narrative reporting should be audited, but not by the
financial statement auditor. The audit's output should be a long-form
report giving a qualitative commentary, rather than a "yes
or no" opinion. Liability should be much restricted to encourage
effective communication around difficult issues for which there
is often no clearly right or wrong answer. Regulation should focus
on ensuring that the quality of this review was apparent through
the content of the report. This framework would create a new market
in which innovation and specialist smaller firms would be able
to flourish, so long as the visible quality of their work justified
13.2. Remove the statutory requirement for
companies to have a financial statements audit and instead increase
the requirements for boards to explain how they have ensured that
they are giving a good statement of account to their shareholders.
One of the problems with audit is that the duty of auditors is
to report to the shareholders on the board's statement of account
but they are in practice appointed and overseen by the board (the
principal/agent problem). Without a statutory audit to muddy the
waters, shareholders should increase their emphasis on the accountability
of directors. In many cases, this could be expected to result
in boards choosing to appoint auditors for their own protection.
Auditors would thus be appointed by the beneficiaries of their
work, who would also be those best placed to monitor its quality.
If investors felt strongly enough about it, they could form a
shareholders' committee to appoint and manage auditors on behalf
of all shareholders (with audit fees to be paid by the company
and reported in the same way as dividends, and liability negotiated
under contract). This proposal would have the additional benefit
of mitigating the consequences if a large audit firm were to withdraw
from the market.
13.3. Distinguish the audit of consolidated
accounts for shareholders from the local audits of statutory accounts
of subsidiaries, by prohibiting the group auditor from acting
as the auditor of all but the most material subsidiaries. This
would have two benefits: it would remove a barrier to entry by
taking away the perceived need to have a well-integrated international
network, and it would force the auditor to address a multinational
company's financial reporting by reference to how well it is managed
in the context of the risks arising from its business model, rather
than on its compliance with accounting standards around the world
14. This is far from a complete review of
the wide range of topics covered in your request for evidence,
but we hope it is sufficient to make the case that improving our
system of audit will not be achieved by tweaking it. It has been
tweaked at regular intervals for decades and the outcome is always
to make the present system work better on its own terms. If we
wish to make it work well on different terms, terms which are
better fitted to the present needs of society, then we need to
be willing to think outside the present system.
24 September 2010