Auditor appointment: the Chamber of Secrets has been opened

So here we are at last: a credible body outside the accounting profession is going to take a long, hard look at the system used to appoint auditors to see if it is fit for purpose. What’s more, the Competition and Markets Authority (CMA), the body that will be doing the digging, has advised the government that it is likely to recommend legislation to address the shortcomings it clearly expects to find.

The catalyst that threw the spotlight on the issue was the collapse of Carillion earlier this year. The repercussions for jobs, the construction sector and the unfinished publicly-funded projects meant that the media and politicians were in full cry. It wasn’t long before they turned their attention from the failures of the company to the failure of the auditor to spot the problems.

In his letter to the Secretary of State for Business, Energy and Industrial Strategy, the CMA’s chairman Andrew Tyrie stated, “Carillion’s demise, and recent poor reviews of audit quality, cannot remain unaddressed.”

The CMA study will consider three main areas:

  • Choice and switching: the largest UK companies turn almost exclusively to the big four accountancy firms.
  • Resilience: are each of the big four “too big to fail”?
  • Incentives: with auditors being selected by companies rather than investors, is there too little incentive to produce challenging performance reviews.

For the moment the focus is on “big business”. There’s a perceived sense of complacency among larger auditors and their clients, and a feeling that audits are geared towards serving the needs of management more than investors.

The good news, then, is that audits of smaller companies are not currently in the firing line – in owner-managed businesses the interests of management and investor tend to coincide. However, it would be naïve to assume that any changes to the CMA’s third area of focus, auditor selection, will not ultimately have some effect outside the FTSE 350, and it’s worthwhile thinking about why the CMA is going there.

It’s probably true to say that if you were designing an auditor-selection system from scratch, you wouldn’t come up with what we’ve got.

Yes, a significant part of what we do contributes to management’s ability to improve the way it runs the business. But from an investor’s point of view the principle reason for most audits is to reassure them that the management is doing what it’s supposed to and isn’t pulling the wool over their eyes. That being the case, it is weird that we allow management to select its own police.

It would be unrealistic to think that investors themselves could appoint the auditor. In most cases they have neither the inclination nor the co-ordination to do so. So what’s the alternative?

Well, one idea is already running through the CMA’s mind. It has suggested that responsibility for procuring audits could, in certain circumstances, be moved away from audited companies to “an independent body with a public interest mandate”.

Hmm. What a busy body this will be. And how will it allocate work among audit firms? And how will this change from year to year? And what will it do to the effectiveness of the audit if the relationship with the client is imposed rather than chosen? And… well. There are lots of Ands.

Nevertheless, the underlying criticism, that audit firms are insufficiently sceptical and often fail to challenge management adequately, remains. Just because the idea of an independent appointing body leaves many questions to be answered, doesn’t mean it’s necessarily a bad idea.

I said at the outset of this blog that the CMA would be taking a long, hard look at the appointment of auditors. Actually, that’s not entirely correct: the study will not be very long at all. The CMA intends to consult on provisional views by the end of the year and to complete its work as soon as possible thereafter.

So we shouldn’t have long to wait before we find out if one of the structural bases on which we’ve built the accounting profession may be changed fundamentally. The Chamber of Secrets has been opened, indeed.

 

Blog written by Giles Scott

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