THE HOUSE OF LORDS report on the audit market presents a watershed in the development of the debate around audit since the start of the financial crisis in 2007.
It concentrates efforts on core issues for audit, is scathing in its criticism and yet is measured in its recommendations.
It’s big demand is that the Office of Fair Trading and possibly the Competition Commission begin a formal review of the audit market and its dominance by the Big Firms.
The report is emphatic in its conclusion that the Big four form an “oligopoly” and that efforts by regulators at the Financial Reporting Council to open up the market have “palpably failed”. It also lambasts buiness minister Ed Davey for being under ambitious in his approach to the audit market.
And yet their Lordships never get anywhere near the more radical suggestions for the audit market. They refused to back mandatory rotation, or joint audits or limits to how much of the market any single audit firm can hold. Nor is there a call for an outright ban on non audit work being conducted by auditors.
But it does insist that change is needed and the means to getting it is a thorough going review by the OFT. Not only should the OFT be looking at the market in general but the Lords want it to look at restrictive banking covenants; auditors’ unlimited liability; limits on ownership of audit firms and the expansion of audit to offer assurance on risk management and the clients’ business model.
None of the issues covered by the Lords are new. They have all been debated endlessly. But the report importantly brings it altogether. If however the OFT investigation takes place that would be new and it is has the potential of transforming audit, especially if it were to recommend that the role of audit needs to expand. That could radically alter the role of auditors and privately the Lords believe this is the route to getting more non Big four firms involved in the market now dominated by the Big Four.
The report will also leave bank auditors and those that implemented international accounting standards smarting. Actually, that’s an understatement. With its claim that auditors in relation to banks suffered a “dereliction of duty”, the auditors will be fuming.
The Lords go so far as to say: “We do not accept the defense that bank auditors did all that was required of them. In light of what we now know, that defence appears disconcertingly complacent.”
The Lords then go on to say that auditors may have done their duty according to the strict letter of the law, but “we have to conclude that, in the wider sense, they did not do so.”
That’s a powerful phrase auditors critics will leap upon on it to condemn the auditors.
At the risk of looking like an apologist. Given what auditors are broadly asked to do, and the unlimited liability they carry, it’s quite rational for auditors to seek to reduce their risk by sticking to a narrowly defined version of what they are supposed to do.
The Lords statement appears lacking in detail about how exactly the bank audits failed excepts to suggest they should have been looking at general market conditions. But even if that is the case, the Lords statements also implies that the real question is not really one of whether auditors fulfilled their duties but whether they had the right duties in the first place. The Lords report refers to duties in the “wider sense”. It might have been helpful to define that rather assuming we all know what that means.
Which brings us to international standards. The Lords believe they contributed to the crisis by making audits more of a box ticking exercise and failing to provide enough scope for an auditor to use his or her judgement to reach a true and fair view. Controversially, the Lords propose that the concept of prudence should return to audit as its guiding principle.
This is heavy criticism. We are six years into international standards and the International Accounting Standards Board will get new leadership this year. It will be fascinating to see how it responds.
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