Covid-19 has thrown new light on the ongoing issues that have plagued the audit sector for some time. Issues like the ones we’ve seen at NMC Health and Wirecard did not suddenly start at the beginning of the coronavirus outbreak, and nor will they go away when it eventually returns to normal. The concern is that the crisis will simply stifle efforts to increase the viability of the smaller, challenger firms to break the dominance of the ‘Big Four’. There is also the accusation that audit firms are using the pandemic as a ‘get out of jail free card’, but what are the reasons behind this – and more importantly, what are the solutions?
The pandemic is a once-in-a-generation health crisis, but it is also an economic one. All firms, big or small, have had to cut costs. Bigger firms are more likely to be able to absorb these, whilst SMEs and small businesses that operate on a much lesser scale have struggled the most to adapt to such an extreme and unprecedented situation, particularly when it comes to cashflow. In turn, this has led to the worry that smaller firms will take less risks moving forward, including competing for bigger clients because they may not be able to deal with the hit to their cashflow if something goes wrong. This would theoretically leave the ‘Big Four’ unchallenged for the larger clients, and knowing that they have fewer competitors, they might have less incentive to do the best job.
The dominance of the ‘Big Four’ may have been exacerbated by the effects of the pandemic, but the audit industry was discussing this problem well before Coronavirus hit, and numerous possible solutions have been suggested. The Competition and Markets Authority (CMA), for example, have suggested that companies should hire joint auditors, including at least one smaller firm, to strengthen the work being done. Others have suggested that the ‘Big Four’ should distinctly separate their other services from their audit branches to reduce conflict of interest.
The colossal impact the Covid-19 crisis is having on businesses is absolutely not to be underestimated, but we need to look deeper at the true issues at hand in this situation before we make the assumption that it will impact the audit reform agenda.
The heart of the problem
There is no clear evidence that either of these solutions will actually help. We need to recognise that the auditors are not solely at fault. They certainly aren’t getting it wrong out of laziness or due to conflicts of interest. Nor is competition completely down and out. Last year, Goldman Sachs announced Mazars was replacing PwC as its auditor, proof that the stranglehold of the ‘Big Four’ on the FTSE 350 was loosening ever so slightly. While increasing competition is a good thing for markets because it increases the value for the customer, it does not stop audit firms being afraid of overseeing a failure.
This fear is making some auditors use the Coronavirus impact as a ‘get out of jail free’ card. In light of the pandemic, some are insisting that clients agree to a clause absolving them of blame should the business go into administration, irrespective of how likely those firms are to survive. While this may protect the auditor, it does not help shareholders or investors, which defies the point.
The heart of the issue is simply that audit is getting so much harder to do. Assets off balance sheets continue to rise, there’s infinitely more data and businesses are moving faster to keep pace with the socio-economic climate, which is currently increasingly unpredictable due to the coronavirus pandemic. This is exacerbated by accounting treatments getting increasingly complex as well as a fundamental lack of alignment between auditors and management teams. If we want a solution, this is where we must start.
Technology, teams, and business models
The lack of alignment has been there forever. Auditors are expected to come in at the final stage and get to grips with accounts that are unclear because there is poor integration between long and short-term financial reporting, as well as internal and external reporting. With three siloed processes running at different times to produce management information (MI), statutory reports and assurance that the numbers are correct, it’s not hard to understand why problems become tricky to spot and even harder to resolve.
Addressing this problem, therefore, involves implementing analytics technology. Analytics technology can provide different views of the same underlying data, integrating the internal and external view of performance and would allow real-time insights to be provided to both management and the auditors, meaning issues could be discussed as and when they arise. The good news is that this technology already exists, but it must be noted that if the ‘Big Four’ break up, it will probably hinder rather than help the implementation of it, because they have the best chance of actually applying it.
However, to do so, the ‘Big Four’ do need to change their business model. The current Partner business model is fundamentally ill suited to a technology-based offering, as it still places an emphasis on teams of people and manual processes that need people to oversee them. A technology-based audit offering would involve people applying judgement where relevant, ensuring good client relations and retaining their accountability – but they would simply be helping to ensure the algorithm was correct, not running teams and processes manually themselves.
It is right to acknowledge that there are numerous ongoing issues with how audits are done, and the current crisis is only compounding these issues further as it impacts businesses around the globe. Technology is the answer, and it exists now. Auditors are going to have to change their business models if it will truly be implemented successfully, which is no mean feat – but it is necessary. If that happens and technology is adopted effectively, we could see a dramatic improvement in audit quality, without having to break up the ‘Big Four’ or increase competition. It is a win-win for everyone.
Simon Bittlestone, CEO of Metapraxis