Auditors failed to raise alarm before 75% of UK corporate collapses, announced the title of a recent Financial Times article.

Here’s some of what the article, written by Simon Foy, had to say:

• Audit firms failed to raise the alarm before three-quarters of big UK corporate collapses since 2010, according to research, raising concerns that auditors are failing to perform one of their core functions.
• Three in four audit reports failed to provide alerts that companies, which ultimately failed, risked going bankrupt by providing a “material uncertainty related to going concern” in the year before collapse, according to a report published on Monday by the Audit Reform Lab, a think-tank at the University of Sheffield.
• Auditors are required to include a going-concern warning if they believe there is a risk that the company may go bankrupt, rather than making a prediction that it will…
• “There are serious concerns that auditors are not challenging enough,” the report said. “Of the 250 liquidated companies, 38 declared dividends in their last set of accounts. Ten of these did so despite making a loss, and two . . . did so despite reporting a loss and having a negative net asset balance, which is a strong indicator of insolvency risk.”

The article concludes by quoting the report as follows: “Until the culture of audit is reformed and a new and more effective regulator is in place, partners at audit firms will continue to reap huge financial rewards, despite continued audit failures that harm business confidence and our economy more widely,”

The FT article also quotes the report as noting that average partner pay across the Big Four rose by nearly a third to £872,500 between 2020 and 2022. Overall though, the FT summary of the article focuses more on the “failure” side than on the pay side, and as such seems like a highly imperfect summary of the underlying report itself, starting with the omission of its full title: Reward for failure: The paradox of audit partners’ record payouts amidst poor audit quality. Consider the following passages from the report:

• …the Big Four are large, multi-service providers who generate most of their profits from non-audit fees where maintaining good client relations is the sine qua non for future income. Audit services are provided on a ‘client-pays’ basis. Thus, there may be strong fee-based disincentives against providing robust audits which may upset clients and damage future nonaudit business.
• …The partnership structure of large audit and accounting firms creates a second positional rent that produces large differentials of reward and experience within the audit workforce. Audit partners are paid from partnership residuals, which accrue mainly from non-audit income, whilst benefitting from limited liability protection. Given partners are responsible for the oversight of audits, this may create a conflict of interest which opens up additional ‘opportunity spaces’ for audit failure. This risks creating a ‘Russian Doll’ effect: that the corporation is able to extract tollbooth rents from the economy, and partners are able to extract tollbooth rents from their corporation. Large all-service accounting companies may, therefore, simply take tollbooth rents from audit positions without performing the vital economic role of policing bad accounting practice.
• This situation suggests legal separation of audit and non-audit functions would be the starting point for future reform. The conflicts of interest that arise from a client-pays model, likewise, create problems. Both, however, will be politically difficult to execute. Some audit failure might therefore be mitigated by an audit culture guided by a strong mission, embedded in systems of education, training and professional representation. These are currently deficient. The mission of audit is confused – it is too focused on whether arcane and loophole-laden accounting rules are being followed, whilst ignoring whether the outputs of those rules amount to a true and fair representation of corporations’ economic position. This is allied to a box-ticking approach which works against principles of professional judgement and the necessary skepticism needed to enforce prudence. Auditing, to a greater or lesser extent, has become a form of administration which diminishes the professional status of auditors.

To sum up, the point of the report isn’t so much that audits are deficient, but that the current structure makes it almost impossible for them not to be. The point about the “confused” mission of audit aligns with the comments I’ve often made here about the excessively compliance-driven mentality that makes accountancy less appealing to new entrants. The conundrum though, one that the report rather glosses over with its reference to political difficulty, is that the analysis tends to suggest that auditors (at least at the top) should naturally be paid less than they currently are, which would only decrease the perceived competitiveness of the audit profession, and make it even less likely that the prevailing expectations for audit quality (whether or not inflated) can be met. Anyway, more to come on this…

The opinions expressed are solely those of the author.