Life after BHS, Carillion, & Patisserie Valerie: Is there light at the end of the tunnel for audit?

Audit scandals of the past and now

Audit scandals are not just a concern today. Famous cases of the past include the Enron scandal of 1991, in which shareholders lost $74 billion and many people lost their jobs. Arthur Anderson, previously one of the Big Five accounting firms, was found guilty of fudging Enron’s accounts.

However, it is more recent cases that have sparked a review of the audit profession by the likes of Sir John Kingman and the Competition & Markets Authority (CMA). BHS’s insolvency in April 2016 blew up in the media and it has since been revealed that PwC only spent two hours on its audits. Then in 2017 Carillion collapsed, and company directors, pension regulators, and auditors from KPMG and Deloitte were all grilled for missing the clear red flags on the business’s accounts. Carillion had a pension deficit of nearly £1bn in the end.

Then as last year drew to a close, cake chain Patisserie Valerie dominated the news because of accounting discrepancies. Forensic accountants have since found that the hole in the company’s accounts amounted to £94m.

When Patisserie Valerie first went into administration, Marie-Louise King, partner at law firm Winckworth Sherwood, said: “There was a sense of inevitability to Patisserie Valerie entering administration. Shareholders who injected further funds into the business only weeks ago will understandably be deeply concerned that that investment is now at serious risk of being lost.

“It is not unusual for the board of a company to delegate functions in specific areas, such as finance, to an individual director, and to trust that the process of audit will uncover any issues arising from that decision. However, in court proceedings arising out of the collapse of Barings plc, the court made clear that the duty to discharge the obligations of director is both collective and individual, and the appointment of a finance director does not, generally, absolve co-directors from the duty to supervise the discharge of the delegated functions. A total abrogation of the responsibility for finance, for example, would not usually be appropriate.

“Those investigating the failures at Patisserie Valerie, including the insolvency practitioners appointed, will undoubtedly be considering, among other things, the systems in place at the company, to consider the degree to which the directors, individually and collectively, fulfilled their obligation to ensure the accuracy of the accounts, and the quality of the audit.”

Speaking to Vincent Billings, partner in the corporate and commercial team at SA Law, Accountancy Age heard that shareholders’ involvement in company rescue plans tend to depend on the severity of the issues faced.

Billings said: “In less severe cases the directors of the company can deal with the rescue plans without reference to shareholders such as renegotiating with landlords and creditors.  As Patisserie Valerie was facing big problems, the company required the shareholders to agree that the discounted shares should only be offered to certain shareholders (the institutional investors).

“The shareholders could legally challenge the company on the basis that the shares were not offered to all of the shareholders.  However any such legal action was not advisable due to the company’s precarious financial situation and the potential for the litigation to push the company back into insolvency.”

Where did it all go wrong?

From the perspective of the client, Andrew Coulson, chartered accountant and founder of Dolfinblue, said: “Few auditors have impressed me in the past. This is due to a lack of understanding of the business and a tick-box sort of environment. None of it breaches audit regulations but they do hinder the audit from being the best it could be, or what people perceive the audit to be.”

Coulson described some general challenges he has faced when it comes to audit. These include:

1. A lack of consideration for why, what, and how audit tests should be performed and a lack of scepticism and over reliance on what auditors were told by clients.
2. With time being short for everyone nowadays, sometimes briefings could be weak. This doesn’t mean shortcuts were taken; they just weren’t as rigorous as they could have been. Time limits in general create a potentially damaging pressure to just get the job done.
3. Businesses often use staff with little or no experience to do the smaller job and then do not have the money to invest in training them.
4. If businesses have a high staff turnover, this too means they don’t get to understand their clients fully.
5. Finally, there is an over-reliance on staff answers without following up the audit evidence as fully as possible, which is not a breach of standards but remains problematic and the potential cause of future collapses.

Coulson added: “I think the art of scepticism is being lost and people are not being trained in this vital component of being an auditor. I’ve seen a group audit where there was a complex structure and therefore issues with risk. The level of interaction and discussion with controllers was light and no really searching questions asked.

“It could also be that my views highlight the expectation gap more than an audit failure. I remember chatting with the audit senior and pushing him on why they did XYZ but so little ABC and they couldn’t answer credibly at all, pointing towards rote task following rather than thinking what they were doing. I’ve seen this a number of times across the years and in multiple countries – it’s not just a UK issue.”

Suggestions for the future

Independence is a widely debated issue within audit. Individuals have wondered whether allowing firms to do non-audit work for their audit clients should be allowed.

Coulson thinks it should be and that this perception of a conflict of interest is not sound.

Speaking of Carillion, he said: “You just need to look at the reaction to the Carillion collapse or the claims often made against audit firms. Would Enron have arisen if there was a fully independent audit with no pressure to adopt aggressive accounting techniques?

“I have an opinion that where there is a public interest client, there is a strong argument that no non-audit work should be carried out because of this perception of a conflict as opposed to a real conflict of interest. It’s different where there are no external investors.

“I think that when you think that audit is a check on the books and processes, the auditor is potentially checking the quality of work or the advice given by members of their own firm. Although noted that for PLCs auditors cannot be involved in the accounting work, but what about tax advice? Corporate finance? It begs the wider question of just what should an audit be covering – the Kingman Review amongst others is looking at this?

“I’ve not worked much with PLCs and never in audit. However, I’ve worked for groups where my associates have had the very firm belief that the audit should be separate from other work as it gives an additional layer to checks and balances on process and governance without any possible conflict.

“One of the consequences of the Kingman and BEIS Reviews is going to be the realisation that if you strip fees to the bone there will be cause and effect. By making changes to how audits are run, managed and conducted, fees will need to increase to ensure the future audit is properly resourced and designed with the rigour demanded from the reviews. The change in scope and the narrowing of the expectation gap will require more resources and higher skills in the team, all of which costs.”*

After the Financial Reporting Council (FRC) issued a warning to the Big Four accounting firms in January this year, Professor Paolo Quattrone, chair of the Accounting Governance of Social Innovation at Edinburgh University Business School, said the rotation rules are ineffective and that the focus should be on creating a system based on the random allocation of auditors.

Quattrone said: “The rotation of auditors has proved ineffective so far. The scandal of Parmalat – the Italian food corporation that went bankrupt – where it changed the auditing firm and some physical auditors is a case in point. The big elephant in the auditing room is the conflict of interest which is embedded in the current system where the auditee pays the auditor.

“Both auditing, as it currently stands, and the practice of regularly changing auditors, create a fake veil of independence, making things more opaque – not more transparent.

“We would be better off without this veil. A contribution to a fund to pay auditing services with a random allocation of auditors to audited firms would be a well overdue and welcome shake up to the industry.”

Audit and technology

With all the audit scandals of late, those who work in and with the audit profession have been asking: how can technology help the situation?

In a recent ICAEW report, The Essential Guide to Audit Tech, Karen Wardell, partner at firm Kingston Smith, said: “Don’t be put off by the technology buzzwords or the boasts of the Big Four.”

For Wardell, firms need to be ready to embrace technologies like AI with open arms and not over-exaggerate how much it might cost them, though firms must also treat products with scepticism. Testing them is very important.

Interestingly, Source Global Research’s recent report found that a third of audit clients are breaking audit processes into parts and 44 percent are thinking about doing this. For 45 percent of respondents, this change will mean more audit work will be conducted by tech firms.

The research found that the top two technology businesses in the opinion of audit clients are IBM and Accenture. When it comes to the accountancy firms delivering the best technology services, an overwhelming 52 percent of clients felt Deloitte was the best audit firm for delivering technology for audit. KPMG were supported by 22 percent of respondents and EY by 18 percent.

Fiona Czerniawska, director at Source Global Research, said: “If you assume that some parts of the audit process will require more technology, and more technology know-how, than others, then, provided an auditor retains control of some part of the process, it would be logical to turn to technology specialists.

“In short, it’s clear that breaking the audit process down will significantly change the rules of engagement for traditional audit firms. This simple change creates opportunities for non-audit firms to become involved.

“Technology companies that might never have considered entering this market will be paying a lot of attention to the significant changes that our research has revealed are taking place right now in the audit market. When we consider the potential size of the new market that could be carved out of the existing one, it’s clear that this will be a huge opportunity for new entrants.”

Robert Collings, manager at UHY Hacker Young, said: “We’ve also got technology such as big data and AI which can start to take historic figures and project forward, adjusting for things like the economic environment and activity of competitors, meaning auditors can start to more accurately predict the health of the company over the following 12 months, for going concern purposes.

“Blockchain will aid auditors due to its very nature – the fact that ‘blocks’ cannot be changed or edited. However, it’s mass market adoption is still very far off. In the near term, especially with MTD, there’s a possibility that accounting systems could be connected via a network which collects and reconciles data. This would mean that when one company sends another company a sales invoice, it gets confirmed in the buyers books as a purchase invoice, essentially reconciling the two sides of the transactions. Unconfirmed sales or purchase invoices could then be the ones that auditors focus on.”

2019 and beyond

This year feels like a turning point. While nothing specific has been decided off the back of the Kingman Review, discussion is taking place and change for the audit industry is on the horizon. Audit professionals appear ready to find what works, even if some ideas are quite ‘out there’. There is an acceptance of a need to improve audit quality and a collective agreement to push forwards towards a brighter future.

“There’s a huge expectation gap between what auditors do and what the public thinks they do”

For Collings: “There’s a huge expectation gap between what auditors do and what the public thinks they do, and with the number of high profile company downfalls recently, that gap is only expanding. The industry has spent a lot of time and effort to bring the public’s expectations back in line with what auditors actually do, but it’s a difficult task. I wonder if perhaps auditors need to go the other way – meet the expectations of the public rather than the other way around. With so much technology around it starts to become realistic that auditors can actually review 100% of transactions, not manually, but using technology which has never been possible before.

“The larger firms have been using data analytics tools for years, but a number of SaaS solutions are coming through which means mid-tier and small firms can start using data analytics too.”

“There is, of course, a number of challenges with changing the expectation gap. First off, companies often hit the headlines when the cause of their demise is something fraudulent. When fraud is done well, it can only really be detected either by management stumbling upon it or by a trained professional with the resources to go through the books with a fine tooth comb. Auditors often get the blame for not picking up fraud which highlights the expectation gap (auditors aren’t forensic accountants). As the technology for finding fraud progresses, the technology for committing fraud also progresses.

“Then there is the fact that a number of areas in the financial statements are judgements or estimates applied by the management of the firm – essentially opinions of what is best. Opinions by their very nature are not facts, so it’s impossible for an auditor to confirm the opinion is correct – they can only state whether they believe it is reasonable.

“All in all, the actual checking of individual transactions in future audits will become much easier with the use of technology so auditors will be able to focus more time and effort on the judgemental and high risk areas. Despite what people say, technology will not be replacing the auditor any time soon because machines simply aren’t yet up to the challenge of evaluating judgements with the level of emotional intelligence that humans can.

“Tech startups shouldn’t be underestimated either – I work with them on a day to day basis and they’re developing some amazing technology which is very often stunted only by the lack of funds.

“Accountancy firms could partner with these tech startups to give them the resources they need to develop the tech, which ultimately will drive a benefit to the accountancy firm and the wider industry – whether that’s through quality improvement, time savings or something else, all of them will help push the accountancy and audit industry forward.”

*Coulson wanted to make it clear these views are his own and not representative of the professional bodies he is a member of, or the committees he sits on (or will join in 2019).