Is audit fit for purpose?

Is audit fit for purpose?

Shortly after Wirecard collapsed this year, renowned short-seller David Einhorn hit out at auditors for failing to find a fraud that was “hiding in plain sight”.

The German payments group, which had been investigated by the Financial Times for years, filed for insolvency after admitting that €1.9bn of its cash probably did not exist. EY, Wirecard’s auditor, had signed off the group’s financial accounts for more than a decade. 

In a letter to investors, Mr Einhorn, head of hedge fund Greenlight Capital, lambasted EY. “Rather than investigate the fraud allegations, the auditors continued signing the annual financial statements.” 

The Wirecard scandal, along with the collapse of businesses such as Carillion, the outsourcing group, and Patisserie Valerie, the café chain, have shone a fresh spotlight on the audit role and whether its ultimate clients — company shareholders — are being properly serviced.

“Given the numbers of scandals there have been, I don’t think you can say the audited financial statements give you assurance as an investor. I think there is a big question over how much you can trust an audit,” says Fiona Reynolds, chief executive at Principles for Responsible Investment, an organisation focused on sustainable investing. “Audit is long overdue reform.” 

Stephen Davis, a senior fellow at Harvard Law School, goes further. “There is a global crisis in audit. Much of what audit has been doing in the past is now less relevant.”

Audit issues have come under intense scrutiny in the UK in the wake of Carillion’s collapse in 2018 © Daniel Sorabji/AFP

While auditors missing fraud is alarming, shareholders also list an array of other problems with the audit and accounting industry. Long-running concerns include the dominance of the Big Four (PwC, Deloitte, KPMG and EY); potential conflicts of interest when auditors also do non-audit work; and length of tenure, with some firms auditing company accounts for decades. 

Some of these issues have come under intense scrutiny in the UK in the wake of Carillion’s collapse in 2018. A number of reviews into the sector have called for reforms to increase competition, but the accounting watchdog stopped short of calling for a full-break up of the big four.

There have also been regulatory interventions elsewhere in recent years, such as in Europe, where the audit function now has to be put out to tender every decade. 

Broader questions are also being asked over whether the current system overseeing company accounts and the audit function are fit for purpose.

Andy Howard, global head of sustainable investment at Schroders, the UK’s largest listed fund manager, says accounts were designed for businesses that existed many decades ago when many companies had “factories and inventories in the yard” and balance sheets were staked with physical assets.

“It’s the challenge of having an accounting system that’s designed for a relatively stable world where companies were characterised by their physical assets, not the world we live in today that’s relatively uncertain, fluid and unknown and where intangible assets dominate,” he says.

He says the era of huge tech companies, including Facebook, Alphabet and Apple, which have significant intangible assets as well as rising concerns about emerging risks, such as climate change, have exposed deficiencies in the system.

These factors, he says, are not adequately addressed in company financial statements and accounts and audits no longer look fit for purpose.

“They don’t work particularly well for businesses focused on human capital. The nature of the information we need as investors to understand businesses is changing,” says Mr Howard. 

“People recognise that there are other things that don’t fall into financial statements. That’s partly the reason why sustainability is now becoming such a big focus. Understanding how companies make money and how sustainable their profits are is more important than dissecting how much money they make,” he says.

Because of this lack of data in company accounts, various alternative standard setters have emerged, such as the Sustainability Accounting Standards Board. But many shareholders want the data to be audited and ideally included in existing accounts.

One large investor said auditors are aware of the issue. “They keep going through all these projects, such as how to incorporate ESG [environmental, social and governance issues], but they don’t get anywhere. What is needed is almost a reassessment of what audit does.”

Michael Izza: ‘We are keen to see some of these issues reformed’ © ICAEW

Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales (ICAEW), says the audit industry is already undergoing huge change, linked to the reviews in the UK and increased attention globally.

“We are keen to see some of these issues reformed. There are things we need made fit for the 21st century. Investors are knocking on an open door,” he says.

He points to the Capitals Coalition, a group housed at the ICAEW, that is looking at how issues such as natural and human capital are valued in accounts. “This is how accountancy is evolving and these are the sort of things investors are interested in,” he says.

Others highlight different expectations on the audit role.

Natasha Landell-Mills, head of stewardship at Sarasin & Partners, a UK asset manager, says there is a question over whether the auditor is trying to implement and ensure compliance with accounting standards, or whether it is to give shareholders and other stakeholders a “true and fair picture of that business, in particular the level of capital and reliability of those profit numbers”. 

She cites the example of Carillion, which collapsed despite “apparently following all the right accountancy standards”. 

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“If the police are enforcing the wrong laws, that’s an issue. If we get more competition in audit that’s good, but it doesn’t solve the problem if they are enforcing the wrong thing,” she says. 

Yet shareholders rarely take the auditor to task at annual meetings, with just a few notable exceptions, such as at SIG, the UK building materials group where investors voted against Deloitte’s reappointment in 2018. 

Sarah Wilson, chief executive at Minerva, a shareholder adviser, says it is “extremely rare” for shareholders to vote against the auditors, particularly when compared with remuneration. 

So far this year, across the FTSE All Share, only eight companies suffered shareholder dissent of 5 per cent or more on auditor remuneration, while 29 groups were targeted over auditor re-election, according to Minerva. 

Audit “is one of those things that people overlook as geeky and say we will leave to experts”, says Ms Landell-Mills. “But that allows scope for an industry not to be held to account, which is what we have seen over the years. It has gone on a track which has taken it away from delivering what long-term shareholders need.”

Stephen Davis, a senior fellow at Harvard Law School: ’Maybe in the aftermath of Wirecard there might be a fundamental rethink of audit at the European level’ © Andreas Gebert/Reuters

Mr Davis argues that the audit industry needs a reset in order to be relevant today — and that shareholders have a role to play in that.

“Maybe in the aftermath of Wirecard there might be a fundamental rethink of audit at the European level,” he says. “It’s not just about an audit missing fraud — although a huge issue — it is about risk and opportunities that are relevant to companies in the 21st century.”

But he adds that even though audit functions are meant to be done for shareholders, investors do not show enough interest in the subject.

“Most asset managers aren’t staffed with the resources or skills to be able to take full advantage of what the audit [function] can do.”

Mr Izza echoes that call for more shareholder involvement. “Investors have enormous ability to change the market. One of the things the accountancy system would like is more investor dialogue.”

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