Effectiveness of Auditing in Corporate Business

UK Auditing
Introduction
The UK auditing and accounting market is one of the largest in the world with over 432 accountants per hundred thousand of population (Saudagaran, 2003, p.10), many of whom are employed in auditing firms. This paper will concentrate upon one aspect of the accountants role in corporate business, namely that of auditors. The author’s intention is to discuss and evaluate various aspects of the auditing market and duties with a view to reaching a conclusion regarding the effectiveness and efficiency of their role in the commercial market.

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Audit Market
Over the past few decades the United Kingdom audit market has seen a significant level of consolidation from a previous position of eight competitors. The industry nationally, now worth in excess of £2.4 billion per annum, is presently dominated by four firms, which are Price Waterhouse Cooper, Ernst and Young, KMPG and Deloitte Touché. Between them, these firms prepare the audits for over ninety percent of UK listed companies, including all but ten of the FTSE[1] corporations. Below this level, there is a secondary tier of between nine and fifteen auditing firms.
The big four dominance of the auditing marketplace presents serious problems for other firms who wish to enter the market. Primarily there would be the difficulty of cost together with the return on their investment into such a move. For example the largest auditing firm outside of the “big four,” has a revenue level, which is less than half that of the smallest big four firm, Ernst and Young. Add to this the economical factors of entrance and risk involved with competing against the dominance of the big four and it is not difficult to understand the reluctance of other firms to challenge the present positions (Discussion Paper, 2006).
In addition to the challenges new firms would face from present organisations, they would also be faced with having to address the current perceptions of the firms needing auditors. The situation is that most of the FTSE corporations perceive that, outside of the “big four,” other firms would not have the experience, resources or ability to manage their auditing requirements. In addition, concerns regarding quality would also be one of the major problems that would need to be addressed.
From the viewpoint of the regulators and the clients, there are concerns with regard to the low numbers of auditing practices that exist at the top end of the markets. Not only is there fear that further consolidation will reduce choice even further, but many corporate audit committee chairman believe that the present structure itself allows for insufficient choice. This is particularly true considering the fact that auditing firms cannot offer any other services to their clients, such as consultancy. The other area of the contraction of the audit market that causes worry to corporate managers and shareholders is the high increase in audit fees that has been seen during recent years as increasing corporate governance demands are implemented.
Despite the concerns regarding auditor choice, in the main confidence in financial statements in the UK remains at a very high level with investors. In a conducted survey in 2004 (Virdi, 2004) over 86% of fund managers, one of the main sources of corporate funding and investment were satisfied with the standard of financial statements, and over 87% had a fair to great deal of confidence in the auditing process. The Audit Inspection Unit (Public Report, 2006) also seemed to be relatively satisfied with the present quality levels of audits being carried out.
In general, whilst there is a reasonable level of satisfaction with current audit levels, the concerns regarding choice of auditors and the inherent problems of further consolidation within the industry will need to be addressed. In particular, there is a need to avoid the “big” firms achieving a monopolistic status.
Audit Regulations
Before 1980 and the Companies Act 1985, corporate auditors were required to be members of the four recognised accounting institutes of the UK. At that time, the industry operated on a self-regulatory basis, monitoring its own members (Gray and Manson, 2004, ch.4). This position was not seen as satisfactory as the potential for conflict of interest existed. In an attempt to address the conflict problem the European Union (EU) issued new rules, embodied in its 8th directive, which required governments to closely monitor auditors.
Subsequent to the 8th directive from the EU and the Companies Act 1985, auditors needed to obtain licences to practice from a Recognised Supervisory Body (RSB). In the early 1990’s the government also set up the Financial Reporting Council (FRC) in a move to improve auditing reporting standards.
However, as the main accounting institute’s applications to become RSB’s were accepted, ultimate control and inspection of auditors still at that time remained in the hands of the professions. Therefore, although the RSB have the power to withdraw or suspend licences, ultimately the decision still rested with the institutes. Whilst in some areas this was considered an appropriate way to address industry regulation, many felt that it still did not address the issue of conflict of interest. Because of this continuing disquiet, in the late 1990’s an independent body known as the Accounting Foundation was set up to take over some of the RSB’s responsibilities, specifically those of auditing practices.
It was the problems associated with the Enron disaster (Matt Krantz, 2001), which prompted the most significant change in the UK auditing regulatory hierarchy. Resulting from this situation, much of the monitoring and regulation of auditors was transferred to the FRC[2], which was generally well respected and considered to have the independence that satisfy financial institutions and corporate shareholder concerns. This included the Auditing Practices Board. The FRC is also responsible for ethical guidance and auditing standard guidelines.
Several bodies have been set up by the FRC to oversee, monitor and investigate all areas of the auditing profession. These include the Professional Oversight Board and Audit Inspection Unit, which have taken over responsibility for monitoring the RSB’s from the DTI. These units oversee and investigate audit firm actions and decision made throughout the audit process. The Accountancy Investigation and Discipline Board are also under the responsibility of the FRC. Whilst this unit can investigate cases referred from the RSB’s and the accounting institutes, it also has the power to launch independent investigations where the need arises. Therefore, whilst the RSB’s still control large areas of the auditing structure, such as inspection and investigation, their actions are accountable to the FRC.
Although responsibility for monitoring, standards and investigation routines have moved away from the institutes, there are still those who are uncomfortable with the level of government involvement in the auditing industry, and these call for more state control. There is some merit in this view, particularly in view of the dominance of the “big four” members on the institute committees. A recent KMPG report (Copnell 2006), confirms that shareholders are seeking much more transparency regarding issues such as qualification, suitability and compliance of the external auditors.
Ethics and Auditing
One of the issues that have received most attention with regard to auditing is that of ethics (Gray and Manson, 2004). The behaviour and veracity of auditors has come under scrutiny over the last two decades. The objectivity and freedom from influence of auditors has become a major issue of shareholder concern globally, as University of Aukland (Cheung and Hay 2004) research confirms, and the UK is not an exception. Confidentiality, promotion and new appointment procedures are other areas where auditors and expected to act in an ethical manner.
Historically, the difficulty was that there were no guidelines, monitoring or investigation procedures relating to ethical issues. Before 1989, the institutes own guides on ethical matters were seen to be inadequate. Post 1989, the RSB system made ethical compliance a regulatory part of the institute’s monitoring processes. However, this did not alter the control or investigative procedures for ethics. Following government reviews in the early years of the new millennium, and the transfer of the APB and to the FRC, responsibility on major ethical issues, such as integrity, objectivity and independence became more independent, although other ethical issues remained the province of the institutes. In addition, major investigation and complaint cases, particularly those considered to be of “public interest,” became the responsibility of the newly created Investigation and Discipline Board.
To further address the ethical issues, the ASB produced guidelines (2004). These included five major statements and one for small entities. The first of these statements outlines the compliance requirements and the identification of threats to the ethics of audits that may exist. It further outlines the safeguards that should be implemented by audit firms to avoid such threats, including the review of the audit by an independent partner in the firm and the compliance with corporate governance rules and regulations.
The second ethical statement deals with the relationship between the auditors and their clients. Within this statement, the ASB covers such items as financial relationship between the parties as well as issues that might arise from personal relationships, for example family connections or the employment on audit by the auditing firms of an employee of the client being audited. Whilst this statement allows auditors to employ experts for opinion purposes during the audit, it does stress that such experts must be independent. Therefore, this precludes an auditing firm from using the consultancy arm of its own firm.
Statement three deals with the length of association with an audit. Whilst it does not call for regular changes in the audit firm itself, this statement does make provision for the terms of service of audit team partners and members who are conducting the audit, such terms being stated not to exceed five or seven years depending upon the position of the team member. The fourth statement concentrates upon fees, litigation, gifts and hospitality. With regard to fees, the statement stresses that these should be time and skill based and not determined by any other factor. Similarly, it dictates that the level of fees should not affect the intention to allocate adequate resources to the audit work. The statement further states that audit firms should not accept appointment in any cases where their firm, whether it is the auditing department or not, is involved in litigation with the client. Finally, the acceptance of gifts and hospitality is declared unacceptable unless “its value is insignificant.” The fifth and final ethical statement deals with the issue of the provision of non-audit services to an audit client. It addresses how these pose a threat to the audit and what measures are needed to safeguard the audit firm from the perception that such a threat my have on their independence as viewed by others.
Following on from the Enron disaster, where it was considered that the auditors had lost independence and integrity, there was an international effort to restore public confidence in the auditing industry by introducing a range of regulations and rules. In the US, the Sarbanes-Oxley Act (2002)[3] was introduced, which aggressively restricted auditors from providing other services to clients and made rotation of key staff mandatory. In the UK, the Combined Code[4] was used for similar purposes, incorporating many of the aspects and demands of the Ethical Statements.
In the UK, whilst the government has set up independent regulatory bodies such as the FRC to deal with a range of ethical issues, including setting standards, monitoring and investigation into compliance, there is still little statutory requirement. Although the institutes themselves may feel that the ethical structure is too extensive and stringent, there are those who hold the opposite view. However, it is apparent that ethics and integrity are of major importance when it comes to protecting the business stakeholders, including shareholders and creditors. Incidences such as Enron have clearly shown that to leave the monitoring of such areas solely within the control of the profession does not provide the degree of protection required by other stakeholders and that this can only be achieved by independent external bodies.
Legal Actions against Auditors
Litigation against UK auditors is a complex area. In essence, any proposed litigation will be dealt with under civil law, in particular the law of contract, where there is breach of a contract between the auditor and the client, or tort law, where there is a claim for negligence made by a third party, such as banks and shareholders (Gray and Manson, 2004). The outcome of most disputes of this nature is normally based upon previous case law. The most prevalent cases against auditors tend to occur following client insolvencies, after takeovers and mergers and in incidences of fraud.
From the plaintiff’s (claimants) aspect and for their case to succeed, they have to prove that it was reasonable to expect that the auditor owed them a duty of care and that, as a result of sub-standard work or negligence on the part of the auditor, they have suffered a loss.
In terms of auditors, perhaps the most defining case in terms of the above issues is that of Caparo case[5]. In this case, the auditors had given an unqualified certificate to a corporation, which the plaintiff relied upon when making a takeover. It was subsequently revealed that the profits had been overstated. Thus, the plaintiff sued for breach of contract and negligence in tort. In settling the case is was adjudged that in the matter of contract the auditor’s responsibility, as defined in the Companies Act, was to the company as a separate entity, not individual shareholders. With regard to the question of negligence it was held that the condition of “proximity,” or relationship between the auditor and Caparo, a core issue when deciding whether negligence has occurred, was not sufficient. It was stated that the auditor could not have reasonably expected the plaintiff to have relied upon their statements for actions they took, and therefore could not be held to be negligent. This approach and definition has been held in most subsequent cases. However, in 2002, a case between Royal Bank of Scotland and Bannerman Johnson Maclay appeared to change the position in Scottish Law (Glyn Barber 2002), although this does not apply to the English courts. Here the auditors were found guilty of negligence to a third party.
To address the potential for claims, one of the conditions imposed by the RSB was that auditors must have professional indemnity insurance. Whilst most insurance companies sought to settle potential claims out of court, it did lead to continual premium increases. This, joined with the fact that the structure of auditing firms meant individual partners faced the prospect of losing all personal assets, led to increasing concern in the industry. To address these, and mitigate the fear they might lead to further industry consolidation, the Companies Act 1989 allowed audit firms to become limited liability companies. Auditor protection was further enhanced in the Companies Act 2006[6], by allowing them to reach agreement with shareholders to cap their contractual liability.
From the foregoing it is obvious that not only is it extremely difficult to succeed in a liability case against an auditing firm, but that the industry generally has been very effectual in creating greater levels of protection for their firms and individual employees in recent decades, although as a recent article (Lawsuits threaten US audit firms, 2006), shows, the threat has not been totally eliminated. However, other stakeholders are not satisfied with this position but it seems that, unless direct fraud or illegal acts can be proven, there is little chance of challenging audit firms providing their audits have been performed within the confines of the regulations and rules that have been imposed upon them by their institutes and the independent monitoring bodies, such as those within the Financial Reporting Council.
Conclusion
Over the past three decades or so, it can be seen that there have been substantial changes made within the auditing industry. Whilst there has been improvement, both regulatory and statutory, in the conduct and standards of audit work, there are still areas that need to be further examined.
Firstly, although the consensus is that standards are satisfactory, concerns over independence and transparency of reporting remain. Secondly, the concentration of major corporate audits into the “big four” firms does raise issues. These include the fear of consolidation, lack of competitive fees and difficulties in changing audit firms, as well as the problem of choosing firms for non-audit financial, accountancy and consulting work. Lastly, the issue of litigation and the audit firm’s ability to create protection against such action has caused some distrust.
A possible solution to some of these issues couple is to ensure that any further mergers are referred to the monopolies commission and, from an independence viewpoint, to look at the feasibility of de-merging the auditing arms of the firms from their other services.
References
ASB Ethical Guidance (2004). Retrieved 5 January 2007 from http://www.frc.org.uk/apb/publications/ethical.cfm
Barber, Glyn (2002). Can you still bank on an Audit. Accountancy Age, UK.
Cheung, Jeff and Hay, David. (2004) Auditor Independence: The Voice of Shareholders. Business Review. Volume 6, issue 2. University of Aukland.
Copnell, Timothy (Director) (2006). Shareholders’ Questions 2006. Audit Committee Institute KPMG LLP. UK.
Discussion Paper (2006). Choice in the UK Audit Market. Financial Reporting Council. Retrieved 6 January 2007 from http://www.frc.org.uk/images/uploaded/documents/Choice%20in%20the%20UK%20Audit%20Market%20Discussion%20Paper4.pdf
Gray, Iain and Manson, Stuart (2004). The Audit Process: Principles, Practice and Cases. Third edition. Thomson Learning.
Krantz, Matt (2001). Accounting rule for energy companies eyed. USA Today. 3 December 2001.
Lawsuit threaten US audit firms (2006). Accountancy Age. 18 September 2006.
Public Report (2006). 2005/6 Audit Quality Inspections. Audit Inspection Unit. Retrieved 6 January 2006 from http://www.frc.org.uk/images/uploaded/documents/Choice%20in%20the%20UK%20Audit%20Market%20Discussion%20Paper4.pdf.
Saudagaran, Shahrokh M (2003). International Accounting: A User’s Perspective. 2 Rev. Ed. South Western College Publishing. UK
Virdi, Alpha A (2004). Investor Confidence Survey 2004. The Institute of Chartered Accountants in England and Wales. Retrieved 7 January 2006 from http://www.icaew.co.uk/index.cfm?route=116714
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Footnotes
[1] Financial Times Stock Exchange
[2] Financial Reporting Council
[3] Available from http://www.sec.gov/about/laws/soa2002.pdf
[4] Available from http://www.frc.org.uk/documents/pagemanager/frc/Web Optimised Combined Code 3rd proof.pdf
[5] Caparo Industries plc v Dickman [1990] 2 AC 605, 618
[6] See Companies Act 2006, section 535