The much needed reform of corporate auditing

The collapse of outsourcing company Carillion only four months after receiving a clean bill of health from its auditors is just the latest in a long line of accounting failures to have hit the headlines since the Enron scandal in 2001.

In every case, the consequences have been the same: much frothing at the mouth in the media, tough-talking and threats of reform from the regulators, and bland statements from the accountancy firms in question leading to essentially no change at all. Now, with the news that Grant Thornton is withdrawing from the market for large-company audits, the cartel effect of the Big Four accountancy firms (PwC, Deloitte, KPMG, and EY) has been intensified.

So the market is heavily stitched-up: companies have to have an audit, and only the Big Four have the scale to take on the task for large multinationals. Meanwhile, although audit itself has become commoditised, the firms use it as a basis to cross-sell their lucrative tax and consultancy work, which means they are likely to be ‘captured’ by powerful clients whom they don’t want to offend. The reform of corporate auditing never looked as if it would be an easy fix.

Tim Morris, Professor of Management Studies, Saïd Business School, and Karthik Ramanna, Professor of Business and Public Policy, Blavatnik School of Government, argue that all attempts so far have been merely ‘tinkering’. In order to solve the deep-rooted problems in audit, we need to change the nature of the game in a profound way.

Tim Morris: The Big Four will not have any incentive to raise their game until there is a competitive threat to their cartel

The regulators’ chance to act effectively disappeared long ago when the original Big Eight accountancy firms gradually combined to form the four survivors we know and love today. A cosy cartel that can neither get any smaller nor grow again to a competitive number means it is difficult to exert much by way of sanctions or real influence over them. The existence of only four firms means there is little real threat which might serve to change their behaviour and make them raise their own game. Furthermore, it is not clear that a separation of audit and other functions would make any difference to sub-par audit performance even if it reduced the power of clients to capture their own auditors.

The reality is that the big firms will take the rough with the smooth, and consider the occasional (not really very big) fine to be just the price of doing business. We used to think a reputation for the highest standards mattered to these firms but, frankly, it doesn’t any more. A reputation for being ‘OK’ and having the scope to do large-scale audit work is what they have and they like it.

In fact, in their own minds they think they are doing a good job: their professional standards are as strong as they need to be, notwithstanding the odd mistake. There is no ‘disrupter’ like Tesla, Airbnb or Amazon to break them out of their complacency.

However, what may change the situation is the widespread use of AI and some loosening of regulations. This could allow new entrants to create automated systems which do a better job than the auditors and are allowed to provide the audit service in some form. But that would mean a profound change in the way we privilege auditors and other professionals and give them exclusive rights to perform certain types of work.

Karthick Ramanna: Competition alone may not be enough – what’s happened to ethics?

Indeed, the regulated nature of auditing is a source of some of the problems we see today. What makes it worse is the fact that the Big Four, thanks to their size, market dominance, and political power, have played an outsized role in setting the rules of the industry, and have done so to their own advantage, largely insulating themselves from liability.

Having said that, deregulation would mean throwing the baby out with the bathwater. Capital markets need auditing. Back in the roaring and unregulated 1920s, many companies did not supply audited financials. Their accounting gimmicks were implicated in the stock-market crash of 1929 that ushered in the Great Depression. More recently, there have been systemic failures in other, less regulated markets for verification – such as credit ratings in the run up to the 2008 financial crisis.

I think there is a bigger underlying problem that is simply the lack of public morals in markets today. Despite a general recognition among academics that profit-seeking alone cannot be the purpose of the corporation, the structuring of most business and economics courses means that it is quite possible for the majority of graduates to enter the workforce without ever properly considering the ethics of profit-seeking. Even if they have, these young leaders are then incubated and promoted by the existing corporate elite – some of whom are (with some notable exceptions) responsible for the continuation of the current problems.

New types of competitors would certainly shake up the audit market and make the incumbent firms think more carefully about audit quality. But allowing these new competitors to perform audits would entail some rewriting of the rules – and we all know who would be first in line to offer their help. How can we make sure we don’t yet again allow the fox to construct the audit henhouse?

Read more about this topic in Professor Ramanna's article for CapX: The trouble with accounting's Big Four