The collapse of Enron led to a transformation in the way American companies are held to account for their accounts. The Sarbanes-Oxley Act introduced new legal responsibilities on company directors and created a legislatively backed regulator with teeth. In contrast, the UK persisted with a form of self regulation. Until now.
The recent reviews of the audit system by the UK Competition and Markets Authority (CMA), the Kingman Review of the Financial Reporting Council and the House of Commons Business, Energy and Industrial Strategy Committee are major steps towards filling that gap and boosting accountability. But they also include a range of measures to change the way the market works.
This kind of potentially transformational programme has the ability to address systemic failings, but if it is not designed in the right way it could just as easily miss the mark, or even make things worse.
Fortunately there are decades of research into what works and what doesn’t in audit regulation. Unfortunately, the CMA does not seem to have paid as much attention to that evidence as it should have.
The CMA is right to look at the way the big four combine audit services with advisory offers to clients. There is a strong case for preventing auditors offering consultancy services to the same corporation they audit– a position some of the accounting firms have adopted. What is riskier is proposals to split the accounting firms into separately managed organisations or even break them up. This proposal is at odds with existing research which convincingly shows that audit quality is enhanced when accounting firms offer both audit and advice services. It is common practice for audit firms to borrow expertise from their advisory branches if very complex audit problems arise. Arguably, it will be impossible for audit firms to develop the same level of expertise in audit-only firms as present in their advisory service departments.
Similarly, proposals for double audits miss what the evidence tells us. There is, in fact, evidence that voluntary joint audits can be effective in driving up quality. The evidence -albeit scant- for mandatory joint audits is the opposite – as one firm has the potential to free-ride on the work of the other.
The CMA review of the market provides many true elements, and the Kingman review’s proposals may strengthen oversight and regulation. However, many of the proposals the CMA put forward seem to ignore results in the audit literature. That research points to three steps that could be considered.
First, research shows that companies enhance their access to the capital market funding if they have their financial statements voluntarily audited. This occurs as voluntary audits allow companies to differentiate themselves from companies that dispense with being audited; they suffer downgrades to their credit ratings because avoiding an audit sends a negative signal and removes its assurance value. In the current system, companies that must have their financial statements audited are less able to emit such a signal.
Second, there is potential to go further around the responsibility of companies. Research shows that after it became compulsory for companies in the USA to state that their accounting information systems works orderly, the quality of these systems have improved, which reduces the risk of auditors making mistakes.
Third, it is important that regulators make sure that the audit committee, rather than the executive committee, take the lead in appointing auditors and managing audit engagements. Research shows that the quality of financial statements improves if non-executives get more actively involved in the work the auditor performs.
Stepping back from the specific policy approach, it is also important to consider what outcome we are trying to achieve.
If society indeed requires that accounting professionals are not allowed to make mistakes, society will have to be prepared to pay a much higher assurance fee than it currently pays. For instance, Shell payed in 2014 an audit fee that amounts to 0.01% of total Sales to have its financial statements audited. The current fee structure is based on the assumption that society is willing to pay less than an audit providing full certainty (which cannot be achieved anyhow) would require.
The alternative to driving towards zero error is to come at the issue from both ends: policy to drive up quality and education to improve comprehension of what an audit means. Within an audit, many numbers are forward looking (e.g. fair values) and are therefore accurate within a range, rather than that precisely capturing a precise number. While technology will shift this over time, audits are based on samples of data and examine numbers that are uncertain by nature so can never catch every error. If society doesn’t recognise those parameters, and instead expect that auditors achieve 100% accurateness, we are condemning our policy makers to inevitable and perpetual failure whatever they propose.
Jan Bouwens is professor of accounting at the University of Amsterdam and research fellow at Cambridge University Judge Business School.