Germaine Chia, Transparently.ai's chief operating officer, is a former auditor. This is her first contribution to the blog.
Accounting is the universal language of businesses.
When spoken well, it communicates the economic reality of a business’ state of affairs. It measures management’s ability to steward resources, raise, and return capital to its shareholders. Ultimately, financial markets function on the efficacy of how this language reduces information asymmetry.
The plain reality is company management frequently succumbs to earnings pressure, bending truths to suit curated narratives. Whilst accounting is standardised through GAAP or IFRS, discerning the truth still requires a “fluent” reader to laboriously reconcile the narrative with the numbers.
Few investors do, and they rely on auditors for reliable readings on the state of a company’s accounts. Trouble is, we exist in an era when trust in the profession is at a low ebb, and media organisations continue to take pot shots at the industry amid its failure to detect egregious frauds like Wirecard and China Evergrande. PwC China was banned for six months after its role in auditing Evergrande came under regulatory scrutiny.
What’s wrong with auditing? To unpack this question requires unfiltered introspection.
I’ve invited former Big Four audit partners Bob Conway and Joe Howie to collaborate on a series of opinions exploring what afflicts firm culture and practice - from the weaknesses in the current business model, its inherent conflicts, the unintended consequences of non-audit leadership and to the competing agendas of regulators and inspections across the pond.
Why we are doing this
We’re embarking on this journey because data suggests the breakdown is already here.
A study by the University of Sheffield analysed 250 publicly listed companies that failed between 2010 and 2022. The findings were staggering: 75% of audit reports failed to raise a “going concern” alarm just one year prior to collapse.
A “going concern” warning is not a psychic prediction, it is a professional opinion on bankruptcy risk. The failure to provide it is a damning indictment of audit quality, a lack of skepticism or independence from management, a disregard of basic duty, or all of the above.
The performance of the Big Four firms - with their size and extensive resources - was particularly dismal. They should’ve been top of the class. Yet the study found:
EY performed the worst, warning investors in just 20% of the firms they audited; PWC 23%, Deloitte 36% and KPMG 38%. Collectively, the other auditors fared worse, providing warnings for only 17% of collapsed firms.
But the most egregious finding was that: of the 250 liquidated companies, 38 declared dividends in their final set of accounts. 10 did so while loss-making and 2 paid dividends despite reporting a loss and having a negative net asset balance, a glaring indicator of unchallenged insolvency risk.
The U.S Supreme court recently ruled that the audit opinion is a material communication, and that investors have a right to rely on the audit opinion that states the firm followed professional standards. When that opinion is falsely given, investors are worse off than had been no opinion at all. At least silence would signal the need for additional analysis or diligence.
Not all standards are made equal
As Tim Bush, Head of Governance and Financial Analysis (The Pensions & Investment Research Consultants, UK) highlights, we are seeing a form of regulatory capture where standards are no longer used to deliver a job but to pretend the job is something else entirely.
Invariably, auditors defend their performance as compliant with auditing standards. But general audits of financial statements are governed by standards that inherently limit their work scope and purpose because auditors can only offer a level of reasonable assurance and not absolute certainty. This same concept of reasonable assurance applies even in cases of fraud.
In response to a consultation paper to revise the standard, the CFA Institute likened audit standards to flying safety standards but this challenge can never be taken up because the conceptual framework - the foundation upon which all audit standards are built on - can’t bear the weight of insurance liability risk in the case of fraud.
Bush argues that the duty of care and standard for performance and delivery should be in case law and not auditing standards because these standards have been set to pitch lower than the law requires. Markets tolerate this gap because institutional investors are largely savvy enough and have resources to access alternative information for price discovery.
Regulatory capture
Up until now, the UK regulator has named and shamed audit investigations but apparently, this is now too much for the delicate sensibilities of the UK’s accounting giants. In an all too familiar display of coordinated lobbying, the Big Four and the mid-tier firms have couched concerns over “proportionate regulation” and asserted that the regulator should keep its business behind closed doors.
The industry is pushing to end the routine disclosure of companies and firms under investigation. In a market that lives and dies on trust, keeping investigations behind a velvet curtain is a step backwards that undermines investor protections and shields brand equity of the firms that failed (and some, repeatedly fail) to spot the rot in the first place. If the goal of audits is to provide confidence, this move toward opacity achieves the exact opposite.
Over the coming weeks, Bob, Joe and I will pull back that curtain. It is time to decide whether the audit profession exists to protect the public interest, or merely to preserve its own image.
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Bob Conway is a retired Big Four audit partner. He then worked at the PCAOB for 9 years leading inspection teams both in the US and overseas. He wrote the book “The Truth About Public Accounting” to help audit professionals, audit committees and regulators understand the web of conflicts that threaten audit quality. More recently, Bob serves as an expert witness in legal disputes involving auditing and accounting matters.
Joe Howie is an ex-Big Four audit partner, with over 34 years of experience. Through 2024, he co-founded the Global Assurance Risk Center of Excellence for a Big Four firm, creating industry leading capabilities to identify fraud and key risk trends in the Assurance portfolio by leveraging new technology, including AI and machine learning to harness external data to improve both audit quality and Firm risk management and led global efforts to improve client and engagement acceptance and continuance.
