Monday, 18 June 2018

Does the Audit Industry Represent “Too Few To Fail”? A Flawed Diagnosis

In today’s post, the focus will be on an industry that has been covered a lot here in Financial Regulation Matters. Recently, two auditors, in particular, having been making the headlines for all the wrong reasons, and as a result there have been calls for the industry to be ‘broken up’. However, how realistic is that call? There is a potential issue within society whereby calls are made that have no substance nor any understanding of the dynamics at play, so in this post we will look at the industry in closer detail to see just how realistic that large-scale call actually is.

In the wake of the Enron Scandal and the collapse of Arthur Andersen, in addition to a massive reputational breakdown of the wider audit industry, the term ‘too few to fail’ was put forward as a suggestion for why the industry could simply carry on with their business once the news cycle has turned elsewhere. In the last year, these suggestions have been repeated, with there being an increased focus on the ever-reducing level of competition within the audit industry. These claims have only intensified on the back of recent public failures, with PwC recently being fined a ‘record’ amount by the Financial Reporting Council (£6.5 million) for its role in the collapse of BHS, and with KPMG being singled out today in an FRC report. Though the FRC is clear that all of the ‘Big Four’ audit companies ‘feasted’ on Carillion as it delved ever more into crisis, the report singled out KPMG, noting that there had been an ‘unacceptable deterioration’ in the quality of KPMG’s work in particular. This comes just a week after KPMG was fined £3 million for its ‘misconduct’ when auditing the insurance software company Quindell. Predictably, this has led to a number of calls to act against the auditors, with MPs calling for PricewaterhouseCoopers to be investigated further over its role in the auditing of Sir Philip Green’s business empire. Some MPs have gone further, arguing that the ‘Big Four’ should be ‘broken up’. The MPs report on the collapse of Carillion assessed the situation with the ‘Big Four’ and found that, despite a number of initiatives to reduce the competition-related issues, there has been little to no development in that area. The report suggests that there some potential resolutions to this issue, including breaking the industry up, regular rotation of auditors and contract tendering, and also the division of audit and non-audit services. The report ends with the statement that ‘it is time for a radically different approach’, but what does that mean?

The first thing to note is that the audit industry is very much similar to the credit rating industry, which is this author’s specialism (as many regular readers will know). The reason that they are similar is not because of the services they provide, but because they are oligopolies, and that must be the starting point for any discussion. Unfortunately, the word ‘oligopoly’ was only mentioned six times in this extensive report, with the very concept of an oligopoly not being addressed. To understand this further, it is worth looking at the calls of the report and assessing them against the study of oligopolies.

I would urge anyone interested in this topic to read Corporate Power, Oligopolies, and the Crisis of the State by Professor Luis Suarez-Villa; within the literature today, it is perhaps the closest account of the realities of the oligopolistic structure in relation to finance and its effect upon society (many others look at oligopolies, but from an economic perspective). So, with regards to the calls of the MPs report, let us start with the regular rotation of auditors and the tendering of contracts.

Rotation

The suggestion is that fee-paying companies – let us not forget, companies pay for their audits, not the investors who need them – should not be able to persist with any one auditor for a period of time, for the purpose of reducing the bind that can be created by this which may lead to inefficiencies and malpractice. However, in the UK in 2014, rules were established so that FTSE 350 companies must put their contracts out to tender (i.e. rotate auditors) at least every ten years. This sounds like a positive endeavour. Yet, the report confirms that in 2016, the ‘Big Four’ ‘audited 99% of the FTSE 100 and 97% of the FTSE 250’. So, the rules have enforced change, but have in no way affected the oligopoly.

Breaking up the Oligopoly

The second suggestion of the report is to break up the ‘big four’. This would be done by simply breaking the large audit firms up into more audit firms, which would theoretically break the stranglehold of the oligopoly and simultaneously promote competition. However, the question then who says that is required or desired by the market participants? Here in Financial Regulation Matters it is often stated that the public should be perhaps the dominant consideration in financial matters, as they are the ones who pick up the pieces when things inevitably explode, but in reality the public are not considered. The consideration is for the companies who need to be audited to attract investment, and for investors who must have their capital flows undisturbed as much as possible. Even a cursory glance at the interests of these two parties confirms that neither wants more auditors (more on this shortly).

Division

Interestingly, this author’s new book on the credit rating agencies makes exactly this same argument for the CRAs, but there are a number of caveats. The suggestion is that because the ‘big four’ have two particular streams to their business – audit and ‘non-audit’ services i.e. consultancy/advisory/ancillary – then it is the case that the conflict of interests that arise from that dual offering should be removed. This is not invalid, because as the report rightly states, in 2016 the ‘big four’ recorded £2 billion in fees from audit services combined, but a staggering £7.9 billion in non-audit fees combined. This has the effect of the audit services, essentially, becoming ‘loss-leaders’ so that the firm has access to a company in order to sell it the more lucrative non-audit services – this is the very problem that engulfed Arthur Andersen and the Enron-era audit firms, so much so that they were forced to divest these arms, albeit temporarily. However, after researching this issue for a Doctoral Thesis and a Monograph, this author found that there is little appetite for this approach from the State, for a number of reasons.

The reason for all of these issues is the very concept of an oligopoly. Also, in conjunction with that concept, is the concept promoted by this author in the aforementioned book, which is the divergence between the actual and the desired. In the second chapter of that book, the focus is solely on this concept, and for good reason. The concept is based upon the notion that certain parties hold certain positions, with the noted parties being companies (issuers), investors, and the state. All of these parties have a stake in the process, and it is proposed that those stakes are intrinsically tied to the economic cycles. For example, in a boom period, the state must be seen to be encouraging business, which means encouraging investors to move their capital and for issuing companies to grow and develop, for which they need to borrow (predominantly). In this sphere, the issuing companies want to keep their operating costs as low as possible, as do the investors, in order to increase profits. Sounds simple, but if we look at the bust cycles, then there is a different sentiment put forward. The focus is on both recovery and attaining the heights of a boom period, so what is stated is often different to what is actually taking place. With respect to the audit industry, this can be seen with the competitions authority declaring that issuing companies must switch auditors at least every ten years – in terms of optics, this is very much a positive. But, if the aim were truly to protect the public and system moving forward, then the state would take aim at the oligopoly, which by its very definition does not allow for increased competition – the word itself is a derivative of a Greek word meaning ‘few sellers’. If the aim was long-term in its focus, the auditors would be forced to irreversibly divest from their conflict-laden consultancy businesses, which would serve to realign their focus on their audits and not treat them as loss-leaders. We know, however, that this has not happened. We do know that the illusionary approach of promoting competition was the approach taken, and in that sense we can clearly see the aim of the state. This is because it is imagined that the state acts for its citizens and their protections, so the calls to dismantle the auditors are based upon the notion that the auditors are causing harm, so the state must take significant action against them. However, is that version of the state a reality?

Recently we looked at the work of Karl Marx, and it is perhaps apparent that his work may be of relevance here. We saw in the wake of the Financial Crisis, or at least those who care to look saw, that the state does not prioritise the care of its citizens, but instead prioritises the care of the system. Now, some will surely respond to that by stating that to care for the system is to care for the citizen, but this author disagrees. To care for the citizen and the system would have resulted in quantitative easing, yes, but that would have been followed by extensive prison sentences to those who offended. As we know, that did not happen. What did happen was a period, that continues, of massive economic hardship for those at the bottom of society and political unrest that serves to shape the future for generations to come. Yet, amongst all of the sick dying in hospital corridors because there are no hospital beds, a surge in serious crimes like knife crimes, state-based attacks on the disabled, significant increases in those using foodbanks and many more social ills that are intensifying all the time, business is still prioritised, promoted, encouraged, and supported even when there is clear evidence that the business elite are plundering the marketplace – just think of RBS, Lloyds, Carillion, the ‘Big Four’, and many others. Many may argue, and that is of course their right, but the reality is that the state works for the system, not the public, and the fallacy that if you embolden the system you embolden the citizen is exactly that, a fallacy. So, in short, yes the audit industry is ‘too few to fail’, but in reality the number of auditors is irrelevant – their place within the system means they are immune to failure, and this is why the auditors behave in the manner that they do; they realise their position. Furthermore, the leading members of these firms and others like them are protected by their company-status, i.e. limited liability and pro-business Directors Duties. The result is that they remain protected even when proven to have transgressed, which is not a right afforded to any other lowly citizen, and soon, when the news cycles turn and the economy picks up, the focus will be on how to ensure that these very same firms grow – which, when you really take a moment to stand still and consider that dynamic, is truly remarkable.


Keywords – audit, oligopoly, KPMG, state, Marxism, business, politics, @finregmatters

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