The Investment Association has warned that the audit sector is suffering from a decline in quality reporting and is “too big to fail”.
The UK trade body’s comments are in response to the Competition and Markets Authority’s review of the statutory audit market which it launched earlier this month in response to growing concerns over conflicts of interest within the sector.
This year has seen several major blow-ups resulting from major accounting mishaps, starting with the collapse of the government backed construction firm Carillion in January.
Aim-listed drinks provider Conviviality went belly-up months later after revealing a spreadsheet error had inflated profits by 20% and Patisserie Valerie recently discovered a £40m hole in its accounts.
‘Worrying decline in quality’
Although the IA noted “instances of audit failure have been relatively isolated” it said there has been “a worrying decline in quality” of reporting this year.
In June 2018 the Financial Reporting Council noted that there had been a decline in audit inspection results and warned that “the Big Four audit practices must act swiftly… if they are to achieve the targets for audit quality”.
Liz Murrall, director of stewardship and reporting at the IA, said the results were troubling particularly for investors “who rely on high-quality audit as a key plank of the investment and stewardship processes”.
The IA sees the decline in quality as symptomatic of “a lack of real choice in the market”.
It said investors were concerned by the fact the Big Four appear to be “cosily competitive” with each other and that there is “little evidence of the development that a fully competitive market can bring to meet market needs”.
Non-Big Four need not apply
This problem is compounded by the fact that internal audit committees, particularly those from FTSE 350 companies, are too often reticent to appoint a firm that is not one of the Big Four on the basis they don’t possess the resources to deal with a larger and more complex business.
The fifth largest auditor in the UK, Grant Thornton, which oversaw Patisserie’s books for more than a decade, is currently being skewered for missing the multi-million pound discrepancy in the Aim-listed cafe chain’s accounts.
But the smallest of the Big Four firms, KPMG, was the auditor in charge for the other two corporates that blew up this year – Carillion and Conviviality.
Smaller auditors have also been discouraged from throwing their hat in the ring because of the costs associated with tendering a major audit, which larger firms can absorb more easily.
Too big to fail
The small concentration of players in the market has also left the regulator hamstrung when it comes to penalising offenders, the IA said.
“There is a serious risk with such a small pool of auditors dominating the market that regulators feel unable to impose significant sanctions without risking driving one of the key players out altogether,” said Murrall. “The prospect of the Big Four becoming the Big Three risks making the audit sector too big to fail.”
To address the lack of competition in the sector the IA said that non-Big Four members need to scale up their operations to meet the needs of the market.
“In return, companies should be inviting a range of firms to tender and investors would expect that only the large multinationals should be restricting their choice to the Big Four,” Murrall added.
It suggested that a market share cap that sets a limit on the proportion of large companies the Big Four can audit would create more diversity in the sector and would be preferable to a ‘forced break up’ which would take a long time and be fraught with legal difficulties.
