Memorandum by Mr Stephen Kingsley (ADT
This note offers views on some of the issues raised
in the Call for Evidence published by the Select Committee.
1.1 A little background. Four firms
currently dominate the auditing business globally and, between
them, would appear to have over 250,000 employees dedicated more
or less exclusively to audit and assurance, generating approximately
$46 billion in fees. These figures are based on data drawn from
the firms' websites. Auditing is a thus big and costly business.
Unquestionably, stakeholders in the corporate sector, whether
investors, lenders, employees, tax authorities or regulators,
need to be able to rely on the financial information that they
receive. So, when analysts and others look at financial information
provided by corporates, they need to believe that what they are
looking at is complete, accurate and fairly presented. The notion
that an outside expert has examined this information with these
criteria in mind ought to give them the comfort which they seek.
The question isdoes it? Put another waywe all want
to see truth and fairness in corporate reporting, but is external
auditing an effective way to achieve this objective? Just as importantly,
even if external assurance is thought to be a good thing, is a
legally-mandated rules-based system operated by what is essentially
an oligopoly of four global firms the best way of delivering it?
2.1 What is the purpose of auditing?
Statutory auditing seems to have become formalised in early
English company legislation which, by creating joint stock companies,
recognised the separation of management and ownership of businesses,
and allowed external capital to be provided by people who would
have no direct line of sight to the business that they were funding.
To compensate for this, the concept of the mandatory statutory
audit emerged as way of providing assurance to shareholders as
to the truth and fairness of management's account of the way in
which their money had been put to use. This concept has been developed
over the years so that we now have reports and accounts, accounting
principles, and a persistent attempt to create some global consistency
in the way companies account and report on their operations so
as to mirror the globalisation of the market for corporate capital.
The statutory auditor has played a key role in this process and,
almost everywhere, is a mandatory element in the corporate reporting
2.2 Indeed, their role and responsibility
has been widened as the reach of regulation has itself widened.
For instance, financial institutions have detailed regulatory
reporting responsibilities which often require the intervention
of external auditors. Furthermore, the supervisors often rely
on external auditors to perform inspections.
2.3 There are, or arguably should be, stakeholders
in the audit process other than shareholders and regulators. A
case could be made for the formal stakeholder group to include
lenders, creditors, employees and the tax authorities.
3.1 Does auditing meet these needs? Does
the status quo drive companies and their auditors to do the right
things? External auditing involves the transfer of responsibility
for the accuracy and completeness of financial information from
management to an independent expert. But the transfer is not complete,
as a quick scan of a typical audit report will confirm. The extent
to which responsibility is transferred and, therefore, the extent
of auditor liability for errors and omissions, is a grey area.
From time to time, this gets to be tested in the courts. Most
often, however, it is settled behind closed doorswhich
means that the uncertainty persists. There is also uncertainty
about who is entitled to rely on information signed off by statutory
auditors. The result is confusingboth for the audit firms
and for stakeholders.
3.2 As accounting and reporting rules have
proliferated, compliance with these requirements has become both
technical and challenging. Managements understandably consult
with the auditors on such matters since they are the experts.
Equally, it should be understood that this is accounting and not
auditingand there is a big difference. Two problems arise.
First, there a clear potential for conflict here since the auditor
now "owns" the answer rather than checking it. Secondly,
the burden of compliance with these requirements is such that
the balance between ensuring compliance and "real" auditing
is now likely to be wrong.
3.3 Where management has put together a
comprehensive and accurate set of financial information and where
"there is nothing to hide", external auditing is relatively
straightforward and is unlikely to add a much value External auditors
are really needed when management does have something to hide,
and where the truth has either been massaged or masked. Unfortunately,
auditors are near-defenceless where management is intent on deceit
and is sufficiently competent to cover its tracks. Indeed, the
extensive caveats in their contracts and their reports tend to
3.4 Management may feel that the auditor
can and should be blamed when accounting and reporting issues
surface. We should remember that it is management's responsibility
to prepare financial informationas audit reports make very
clearso management really needs to be fixed with the responsibility
of any material errors, particularly if these are deliberate.
The very existence of the external auditor helps to blur responsibility
for external reporting.
3.5 Corporate accidentsfrauds and
insolvenciesoften result in assertions that the audit "went
wrong", and thus lead to action against the auditors, mainly
because they have deep pockets. When this happens, audit firms
act as de facto insurance companies and yet, ex ante, do not operate
like insurers. If they did, they would likely be much more differentiated
about the audits that they did, the scope of their work, and what
3.6 The result of all of this is the so-called
"expectation gap". This is the difference between what
auditors think they do and what outsiders think auditing meansand
the debate about it has been going on for at least the last four
decades. If anything, the gap has increased over that time.
4.1 Perhaps the concept of auditing is
flawed and should be debated? Some of the preceding arguments
might suggest that the concept of auditing is inherently flawed
and that the perhaps 150 year-old experiment with statutory auditing
should be closely examined. Why has this debate not taken place,
despite the unsatisfactory status quo? External auditing provides
a valuable "tick in the box" for all kinds of usersanalysts,
rating agencies, shareholders, bankers, trade creditors and tax
authorities to name but a few. Changing what has become a globally
accepted regime would require agreement from the key jurisdictions
(US, EU, Japan)and that is unlikely to happen any sooner
than the emergence of a contender to challenge the domination
of the Big Four. Instead, much of the debate around statutory
auditing tries to deal with two different problemsthe lack
of competition to the Big Four and auditor liability. Whilst it
might be interesting to introduce more firms into the global auditing
game, I doubt that it would change the dynamics that I have described.
In any case, given the enormous barriers to entry, introducing
a new competitor would be a real challenge. As for auditor liability,
lack of limitation clearly concentrates the mind and does not
seem to, of itself, have led to the collapse of any major firmincluding
Arthur Andersen. At best, it seems to be a peripheral part of
4.2 Issues of competition. It is
received wisdom that competition is a "good thing".
It should ensure that customers get fair prices, high quality
goods and services, and benefits from innovation. On the face
of it, the market in statutory auditing of large corporates is
a four-firm oligopoly. As a result, there is only one company
in the FTSE100 which is not audited by the four firm group. Others
can comment better than I on whether customers are damaged in
consequence. It is clear, however, that it will be really difficult
to widen market access. There seem to be a number of simple reasons
(1) Audits change hands very infrequently.
(2) Much of the selection process is in the hands
of Big 4 alumni who, apart from anything else, are possibly loath
to deal with what they see as an unknown quantity.
(3) An enforced break-up of the Big $ is likely
to prove practically very challenging.
(4) The aspirant firms, of which there are perhaps
one or two, have neither the experience, personnel or footprint
to deal with many of the complex international companies.
4.3 It may therefore be more pragmatic to
"accept" the oligopoly and to introduce some new thinking
into the way it operates.
What can be done to improve the status quo?
Here are three ideas:
5.1 The culmination of an auditor's work
is the audit report. Whilst audits may be a mandatory requirement
for listed companies and regulated financial firms in most jurisdictions,
the wording of the audit report is something which is largely
left up to the profession. This, in my view, has a number of undesirable
(a) The length and complexity of wording of the
reports has increased.
(b) The reports contain somewhat arcane phrases
like "true and fair" (in the UK) and "presents
fairly" (in the US) the precise meaning of which is not clear
to most readers and which has all too often had to be tested in
(c) It leads to "box ticking".
(d) The gap between what we all think auditors
do and what they think they do is allowed to persist.
5.2 It is worth focussing on this last point
about reporting. The latest manifestation of the problem is in
the report by Mr Valukas on the demise of Lehman. One easy step
that could be taken to increase usefulness and close the expectations
gap starts by recognising that auditing is a public service and
that what auditors say about their work is a matter of public
interest. It should follow that users, via the relevant authorities,
should state what they want auditors to say in their reports.
What the reports could say about the accounts might include comments
(1) Accuracy and completeness.
(2) Compliance with applicable accounting and
(3) Whether they "make sense".
5.3 This last point is both new and key.
Accounting and reporting standards have been, and will continue
to be, arbitraged by exploiting loopholes or inconsistencies.
Indeed, the larger the rulebooks, the likelier this is to happen.
This is not to say that this happens all the time or that everyone
does it, but it does happen. It can lead to accounts being technically
compliant but nevertheless not making much sense in terms of reflecting
reality. Insisting that auditors say whether or not the accounts
make sense would lead to better balance between the application
and application of judgement, and should serve to make their work
much more useful.
5.4 As is inevitable with any system founded
in statute, and in line with developments in other areas of society,
external auditing has become increasingly based on rules rather
than principles, reducing the need to apply judgement and experience,
to the possible detriment of quality.
5.5 There is a further point here. Standards
governing both accounting and reporting have, particularly over
the last few years, become more and more complex. The process
of standard setting, whilst not controlled by the large accounting
firms, is certainly capable of being influenced by them. The increasing
complexity seems to have led to a position where, for many companies,
the accounts are becoming incomprehensible to most readers. Perhaps
worse yet, some of the more recent developments in accounting
standards are controversial and seem to have unintended consequencesfair
value accounting comes easily to mind in this context. This suggests
a rethink and perhaps a move back towards simplicity.
5.6 Accounting is, in some senses, the reconciliation
between corporate imperative and economic reality. The auditor's
role in this process is to ensure that this reconciliation is
fair and follows the rules. Managements, quite understandably,
sometimes get caught on the wrong side of this reconciliation
and seek to take evasive action. Part of the answer may be to
make more serious the consequences of being detected. There continues
to be a significant blurring of the line between the respective
responsibilities of management and auditor. It is normally the
case that an auditor stands little or no chance in the face of
management intent on deceit. If this position is accepted, then
the response needs to be a more rigorous and unambiguous treatment
of managements who deceive.
5.7 There are some fundamental differences
between auditing and everything else that the firms do. This is
because auditing should not be about advice; it should exclusively
be about an objective assessment of someone else's work. Moreover,
the real client is not the enterprise being audited or its management;
it is the external stakeholder groupshareholders, creditors,
regulators and so on. The audit committee is an attempt to enfranchise
this group but is unlikely to do so effectively. In a very real
sense, auditing is a public service and the organisations that
deliver such a service need a culture which corresponds. The rest
of what the firms do is, for the most part, not like this, and
requires a different culture. Managing these two cultures within
the same organisation is, in my view, a serious challenge and
one which, if not handled properly, creates the risk of conflicts
of interest. This in turn can dilute the healthy scepticism with
which auditing should be conducted and the consequent willingness
to deliver "bad news". This line of argument might point
towards the mandating of "audit only" firms.
6.1 Stephen Kingsley worked in the financial
services practice of Arthur Andersen for thirty years, latterly
as head of the firm's global practice. He is currently a senior
managing director in the London office of FTI Consulting, a global
expert services firm. He is also a non-executive director of the
Co-operative Financial Services Group. The views expressed herein
are those of the author.