According to the UK accounting regulator, in the past two years, four out of five substandard audit processes are attributable to auditors’ failure to challenge companies’ numbers.
In a report published by the Financial Reporting CouncilFinancial Reporting Council, it stated that in 80% of audits deemed “needing improvement”, the effectiveness of challenge was regarded as a key quality factor.
In several high-profile collapses, auditors have failed to properly question company management. The FRC’s latest report noted problems such as relying too heavily on management letters without conducting additional audit checks, and a propensity to trust information from a client company more than external data when examining assumptions.
The FRC said that the need for proper challenge and scepticism had never been more acute, with uncertainty growing across all sectors of business due to the Covid-19 virus. The regulator concluded that new initiatives were needed to support a more robust approach to auditing.
Speaking to the Financial TimesFinancial Times, David Rule, the FRC’s executive director of supervision, said: “Robust, focused and independent challenge is vital to a high-quality audit, particularly at a time of prolonged heightened uncertainty . . . it should be front of mind for audit teams as they advance their planning for December 2020 year-end audits.”
Some of the ideas proposed by the FRC include more frequent quality checks of audits, expert training about challenge best practices, and a sweeping review of how the industry breeds a healthy culture of “professional scepticism”.
The FRC is now overseeing a series of initiatives, including increasing the level of challenge provided by auditors, in the wake of recent accounting scandals. It has already ordered that audit practices of accountancy firms be separated from their consultancies in order to improve quality and avoid conflicts of interest.
In particular, corporate failures at construction giant Carillion PLC, coffee chain operator Patisserie Holdings PLC and travel company Thomas Cook Group PLC have helped bring the issues to the forefront of public attention.
Speaking to the Wall Street JournalWall Street Journal, Karthik Ramanna, a professor of business at the University of Oxford, said: “The big issue with audit quality is the culture within audit firms: the culture is too deferential to clients’ senior management. Greater automation of the audit process is likely to result in significant changes to both buyers and suppliers over the next five years.”
Time to split
Legal experts have recommended that UK regulators separate audit businesses operationally, in order to prevent issues if a non-audit client becomes an associate of an audit client. When this happens, both clients are treated as a single entity, which risks giving rise to improper relationships.
Speaking to LondonLovesBusiness, Chris Biggs, Partner at Theta Financial Reporting, said:
“There is a huge amount of heightened scrutiny on auditing services, especially of the Big Four, looking at the overall quality of the audit, the role auditors play in terms of legislation and their public perception, and the independence of auditing services. For example, how this is impacted as firms also deliver more lucrative non-auditing consulting services to their audit clients. Clients should minimise the use of their auditors for non-audit consulting services as much as possible. This will reduce actual conflicts of interest, reduce perceived conflicts of interest and increase public confidence both into auditing firms and their clients.”
Scepticism or whistleblowing
In recent years a number of high profile cases have helped bring these issues to the public attention. Last year, the case of Amjad Rihan captivated the media, triggering calls by UK lawyers to overhaul the way companies interact with financial auditors.
In October 2019, Amjad Rihan, a former partner at Ernst and Young, made national headlines when he exposed how the firm had concealed evidence that its clients had traded illegal gold, smuggled drugs, and laundered millions of dollars.
He was involved in an assurance audit of the Dubai precious metals dealer Kaloti Jewellery International and was due to deliver an independent written opinion on the quality and integrity of Kaloti’s business practices.
But as he performed the audit, the partner noticed several serious inconsistencies at Kaloti. The company had knowingly traded gold that had been coated in silver to sidestep exporting restrictions in Morocco, as well as participating in cash exchanges of more than five billion dollars worth of gold. Mr Rihan feared Kaloti was trading with conflict materials and was being used to launder large amounts of money.
However, when Rihan reported his concerns to the Dubai Metals and Commodities Centre (DMCC), he was told to keep the information hidden. In turn, the organisation put pressure on Ernest and Young to “minimise the visibility” of the issues in its official reports. Mr Rihan escalated this within the EY network at both a regional and global level, and concerned for the safety of his family, returned to the UK later to launch legal action against the firm.
Rihan sued his former company, claiming economic loss due to breaches of duties of care. Although the court rejected the claim that EY owed the accountant a “safety duty” on the basis that it went beyond an acceptable expectation for a company, it did find that an Audit Duty did exist. It ruled that EY was liable for conducting the Kaloti audit in an ethical manner and for protecting its former-partner from the financial loss he suffered. EY had breached that duty by engaging in unethical behaviour that “swept under the rug the findings that suggested the involvement of money laundering”.
This case was deemed to be a permissible, incremental development of the law, highlighting how thin the line between professional responsibility and whistleblowing can be for financial auditors, and underscoring the deep-seated corruption being concealed as a result of unchecked audits. The judgment posed significant implications for business and human rights, supporting the growing trend that businesses can not be allowed to hide behind complicated organizational mechanisms to avoid legal responsibility.
