Auditors or Frauditors?

Accounting scandals surrounding the Big Four auditors are far from being a thing of the past. The UK Cabinet Office sent a letter to KPMG in early December 2021, saying that KPMG risked a ban on bidding for public contracts if it continued to be involved in accounting scandals. Around the same time, PwC partners in Germany were accused of evading €11m in VAT.

These news stories are the latest in a string of headlines surrounding audit firm scandals, suggesting that there may be a larger scale problem in this sector…

Big Four, Big Scandals: Historical Headlines:

Who Are The ‘Big Four’? The ‘Big Four’ auditors (EY, PwC, Deloitte and KPMG) are a group of auditors that have a very high market share in the audit sector. Together, they currently audit all of the 100 largest companies listed on the London Stock Exchange. Examples of companies audited by the Big Four include Vodafone, Aston-Martin (EY), Barclays, BT (KPMG), HSBC, Rolls-Royce (PwC), Avis and Morgan Stanley (Deloitte). These firms also audit some of the UK’s top law firms. For example, in 2019, Law.com found that more than 40% of UK’s top 50 law firms including Freshfields, DLA Piper and Ashurst were being audited by Deloitte, while PwC was auditing 3/4 of the ‘Magic Circle’ firms: Clifford Chance, Allen & Overy and Linklaters. 

Audit firms, and particularly the Big Four, have been involved in various scandals over the years. One of the highest profile scandals in the UK was the dramatic collapse of construction company Carillion in January 2018 after large debts, where KPMG was involved in the audit process. Thomas Cook is another well-known name in this space: the British travel company ultimately collapsed under debts in September 2019, and was audited by EY. A high-profile international scandal was the large-scale fraud by Wirecard in Germany leading to the company’s collapse in June 2020 – this company was audited by EY. Each of these scandals have different fact patterns, but what brings them together is that the respective companies were audited by a Big Four firm, and each audit failed to detect any substantive problems which may have prevented the collapse. 

Where these scandals are UK-based, they may be investigated by the Financial Reporting Council.

What is the Financial Reporting Council (FRC)? The Financial Reporting Council is the regulatory body responsible for regulating auditors in the UK. Its purpose is to increase transparency and integrity in corporate governance, reporting and audit, and it does so by setting regulatory standards, monitoring auditors and enforcing its standards.

The FRC is currently investigating KPMG’s involvement with Carillion, as well as EY’s audit of Thomas Cook. It has imposed numerous fines on the Big Four, including its highest fine of £15 million issued against Deloitte over its failings in the audit of software company, Autonomy. Some other examples of Big Four fines are a £13 million fine to KPMG over misconduct in a private equity sale of manufacturer Silentnight, and a £10 million fine to PwC over its audit of company BHS. It is difficult to find which law firms represent the Big Four in such investigations, but given their size, it can be expected that they are represented by strong in-house legal teams and the biggest and most reputable law firms. 

Flaw-dit: Underlying Issues:

These headlines lead us to wonder why there have been so many accounting scandals in the sector. 

A big problem is the lack of competition in the sector, as the Big Four have almost all of the market share and thus also control of the audit market. Even as emerging audit firms such as BDO and Grant Thornton have gained some market share, the Big Four still dominate the market in 2021. Few markets have such a strong oligopoly; for example, one might argue that the Magic Circle law firms have a similar dominance in the UK legal services market, but this market is becoming more competitive through US law firms and, ironically, the Big Four as they are starting to provide legal services. 

There is also an underlying issue that audit firms may be overly compliant to a manager’s wishes, creating a risk of conflicts of interest where audit firms conduct a tick-boxing exercise rather than exercising critical professional judgement in their auditing, leading to a potential erosion of accounting standards. The standards that currently apply in the UK are the IFRS Accounting Standards, which are known to be more business-friendly than other standards, for example those in the US.

Enforcement, as well, seems to be ineffective. The FRC has been criticised as being too “light touch” in its investigation of the Big Four firms, often taking years to start investigating relevant scandals and imposing, in relative terms, low fines. To illustrate this point, KPMG reported $32bn global revenue in 2021: relative to this, even a fine in the tens of millions is insubstantial.  

The Big Reform: Suggestions for Change:

Given the legal and regulatory weaknesses, there have been several suggestions for change in these areas and earlier this year, the Government commissioned a report on possible reforms.

Crucially, new regulations could limit the market power of auditing firms. For example, there could be a cap on the number of large companies that a single auditor can work for, as was suggested by the FRC. This would help the competitive environment, but would not necessarily improve the quality of the audit services provided, or the integrity of audit firms. The Competition and Markets Authority, which is specifically responsible for ensuring that markets remain competitive, has also provided some suggestions, including mandated joint audits between Big Four firms and smaller firms. This could allow for a balance between the bigger and smaller audit firms, but may not be as operationally efficient.  

There could also be an overhaul of the law applying in this area more generally. For example, a suggestion included in the Government report is to impose new professional duties on auditors, such as to take a wider range of information into account when auditing and to consider whether financial statements provide a “true and fair view” of a company, which may make the professional standards more stringent, similar to those for solicitors. This would be a more effective solution to increase integrity in the space, but would not address the dominance of the Big Four firms, which could continue to cause problems. 

Another key point addressed in this report was the suggestion to give the FRC more powers and/or more funding, to more effectively regulate the sector. It is important that this is addressed in conjunction with legal or regulatory reforms so that these can be properly enforced, but this reform would not make a substantial change on its own. 

While all these suggested changes have some benefit they could provide to the market, the latest news suggests that reforms are being scaled back to allow the UK’s business-friendly approach in the audit sector to be upheld. It remains to be seen what reforms will be made and, crucially, whether these will stop the Big Four’s scandals.

— For more information and an in-depth analysis, please see the 2018 report by the Financial Times into reasons of the audit market’s failings and suggested reforms, one of the main sources of the content of this article.

Leila is a Cambridge Law graduate, currently working as a paralegal at a Silver Circle firm in its Investment Management department. She is interested in many aspects of corporate and financial law, and is pursuing a career as a commercial solicitor.