The Tories have failed to address one of the biggest scandals in the City
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The Financial Reporting Council has published its annual review of competition in this country’s audit market.
Released in the run-up to Christmas, on the same day as the Bank of England’s latest interest rate decision, the accounting watchdog’s report attracted scant media attention – which was perhaps the intention.
That’s because, in the FRC’s words, the audit market “remains highly concentrated”, with the so-called Big Four firms – KPMG, EY, PwC and Deloitte – still dominating the process of verifying and signing-off of the accounts of the large, listed FTSE 350 companies.
A competitive audit market is “essential to rebuild trust and confidence in corporate Britain”, says the FRC, given a string of auditing scandals over recent years. Yet there is little sign of the reforms needed to bring about much-needed change.
The report showed that during 2022, total audit fees of public interest enterprises – around 1,500 UK firms, with turnover exceeding £750 million – increased by 8pc, to £1.1 billion. Fees for auditing FTSE 350 companies were 13pc higher.
That sounds reasonable, not wildly out of line with inflation across the economy as a whole. Yet the Big Four auditors still earned 98pc of FTSE-350 audit fees last year – a degree of domination tantamount to an “oligopoly”.
The scope for smaller “challenger” firms to get a look in and provide the competition needed to ensure high audit quality is almost non-existent.
In 2021, only four FTSE 350 companies switched from a Big Four auditor to a smaller challenger firm, the FRC reported. Last year, the figure was even lower – just two.
The FRC also confirmed the Big Four still earn more from consultancy services than auditing – despite a long, drawn-out process of separation meant to guard against conflicts of interest.
Since US energy giant Enron collapsed in 2001, regulators on both sides of the Atlantic have raised concerns about consulting work undertaken by firms also conducting audits – as Arthur Anderson did for Enron. Auditors may not effectively scrutinise companies that are also paying them large, separate advisory fees.
Reliable, trustworthy auditing is clearly absolutely vital to the functioning of any sophisticated economy. Yet, the FRC recently found that a quarter of major audits it inspected required improvement.
And, more generally, the recent collapses of travel firm Thomas Cook, retailers BHS and Wilko and, above all, construction giant Carillion have all raised very serious questions about the ability of the UK’s biggest auditors to carry out their jobs.
This autumn, the FRC fined KPMG a record £21m over what it called “textbook errors” in its audits of Carillion – and no wonder.
In 2017, Carillion issued a rosy set of audited accounts and paid-out the highest dividend in its history. Just weeks later, the firm issued a £845m profits warning – the largest the City has seen in a generation.
The shocking collapse exposed the fact that a company responsible for hundreds of government contracts and benefiting each year from hundreds of millions of pounds of public money had mistreated its subcontractors, neglected its pension schemes and systematically cooked the books.
Yet, those same accounts had been regularly signed off by a Big Four auditor.
Ahead of last month’s King’s Speech, laying out the Government’s legislative agenda for this Parliament, a cross-party group of MPs and peers with financial expertise wrote to Prime Minister Rishi Sunak. They urged him to introduce laws ensuring UK auditing is more competitive, diluting the dominance of the Big Four.
Poor audits have sparked corporate failings leading to tens of thousands of job losses while leaving countless suppliers out of pocket when firms suddenly collapse. Great harm has been done to pensions and investments – along with the UK’s reputation as a place to do business. Yet, despite countless reviews and a white paper, audit reform remains off the Government’s agenda.
In light of last week’s FRC report, it is worth recalling just how catastrophic the Carillion collapse was – given that, seven years on, very little has changed.
Britain’s second-largest construction firm, Carillion, boasted hundreds of government contracts and employed 45,000 people. When it imploded, weeks after the accounts were endorsed by KPMG, the firm left liabilities of almost £7bn – the biggest trade insolvency in UK history.
After paying-out hundreds of millions of pounds in ever-rising shareholder dividends, the company’s directors walked away enriched – leaving half-built hospitals, roads and other vital infrastructure, a record pension deficit and subcontractors owed over a billion pounds who have never been paid.
The FRC said auditors didn’t gather enough evidence to ensure Carillion’s financial statements “were true and fair”, finding “an unusually large number of breaches of relevant requirements”.
KPMG failed to display “an adequate degree of professional scepticism”, even when statements from Carillion’s management team appeared “unreasonable” or “inconsistent”. And this despite the fact that, for years ahead of Carillion’s demise, independent analysts had been loudly warning the company’s accounts didn’t stack up.
The reality is that the Carillion contract was so lucrative for KPMG and key members of its audit team that, in the words of the FRC, such financial rewards created a “risk to their objectivity”.
And it strikes me that the lack of custodial sentences for those involved and the FRC’s £21m fine – just 4pc of KPMG’s UK profits last year and less than a thousandth of the £28bn equivalent the accounting giant made worldwide – is unlikely to discourage a lack of objectivity in the future.
Carillion exposed ghastly practices across the board – not just among the company’s management and its auditors. Why did ministers and the civil service, for instance, with Carillion’s share price enduring a near-instantaneous 70pc drop after that huge profits warning, then hand the same outfit eight new government contracts to deliver vital public services, worth over £2bn?
But the most important lesson highlighted by the sudden collapse of Carillion and various other now notorious firms over recent years is that the UK’s over-mighty big auditors must be reined in by tough legislation and genuinely stiff sanctions.
The Conservatives have singularly failed to do this – and last week’s FRC report shows how serious the situation remains.
