Called to account

With conflicts of interest rife, the auditing industry is in desperate need of independent oversight

• guardian.co.uk, Sunday 14 December 2008 08.00 GMT

The current financial crisis has eroded confidence in audit reports issued by major accounting firms. All distressed banks received a clean bill of health from their auditors and within days some were asking the government to bail them out. In every case, rather than acting as independent watchdogs, auditors also acted as consultants to management and raked in millions of pounds in fees. The fee dependency inevitably compromises audit or independence.

Despite enjoying a monopoly of the state guaranteed market of auditing, accounting firms are highly secretive organisations. They even shy away even from revealing their profits.

Just four accounting firms – PricewaterhouseCoopers, KPMG, Deloitte & Touche and Ernst & Young – audit 97% of FTSE 350 companies. Following the US practice, the Financial Reporting Council (FRC), UK's accountancy regulator, has now published firm-specific reports.

The report on PricewaterhouseCoopers says that the "firm's policies and guidance explicitly permit internal specialists (such as tax partners) involved in audits, including "key audit partners" (KAPs), to be rewarded for selling non-audit services to those audit clients.

The report on Ernst & Young laments that an audit partner provided tax advice to his audit client and also highlights the need to improve practices for identification of risks.

The report on KPMG said that "one of the main recurring themes continued to be the lack of evidence on files that all relevant data, procedures and thought processes underpinning key audit judgments had been effectively analysed and evaluated and appropriate conclusions reached".

The report on Deloitte & Touche is critical of some aspects of the firm's training procedures and identification of significant risks at clients. The report says that "there were weaknesses in the application of the requirements concerning audit teams' fraud risk discussions and the review of Board oversight of managements' processes for identifying and responding to the risks of fraud".

The FRC reports do not identify the companies where deficient audits may have been delivered, nor the dangers of allowing the firms to continue to deliver deficient audits. Neither do they acknowledge its own role in the degradation of audits. For example, the House of Commons Treasury Committee report on Northern Rock noted that auditors PricewaterhouseCoopers received large fees from advising the bank and added that "there appears to be a particular conflict of interest between the statutory role of the auditor, and the other work it may undertake for a financial institution". The immediate response from the FRC was that "After Enron we consulted on this question of auditor conflicts of interest and there was no appetite for a blanket ban on non-audit services". In other words, big firms won't like it and we don't want to do anything about it.

The FRC is formally responsible for setting UK auditing standards and rules, but the processes are dominated by major accounting firms even though the outcomes affect depositors, borrowers and taxpayers. The cosy discussions take place behind closed doors and organise threatening issues off the agenda. The FRC has shown no interest in opening its meetings and making all documents and minutes of its meetings available to the public. It does not owe a "duty of care" to anyone affected by its regulatory practices.

In common with other products and services, an audit has to be manufactured. Organisational values, culture and pursuit of profits are key ingredients in this process. Research shows that to boost profits, accounting firms squeeze the time budgets allocated to complete audits. Many employees respond by pretending that they have done work that in fact has not been done at all. Over 60% of audit staff admits to falsification of audit work. Such matters do not attract any attention in the FRC reports.

The FRC asks no questions about the basic auditing model that expects one set of entrepreneurs (accounting firms) to regulate another (company directors). Neither party owes a "duty of care" to any individual shareholder, creditor, employee, depositor or borrower. Auditors lack economic pressures to deliver good audits. They enjoy too many liability shields and it is almost impossible for any individual stakeholder to bring them to account.

The publication of firm-specific reports may win the FRC some brownie points in the legitimacy stakes, but they do not address the deep-seated problems of auditing. A necessary first step for that is for the FRC to be independent of the auditing industry.