Spate of corporate failures spur change in auditing

Far reaching change is afoot in the audit world. The EU is conducting an evaluation of the audit legal framework. The UK government has entered into a consultation process on plans to reduce the dominance of the Big 4 audit firms and require large businesses to be more transparent about their finances.

And just last month, Germany passed the FISG (Financial Market Integrity Strengthening Act), which strengthened auditor liability rules and defined the need to address market concentration with joint audit as a reform option.

The catalyst for this change was a spate of corporate failures.

"We have seen that previously with the financial crisis leading to EU audit reform," says Mazars audit and assurance partner Tommy Doherty. "More recently, the corporate failures of Thomas Cook, Carillion and BHS in the UK and Wirecard in Germany have ignited a reaction."

In order to prevent such corporate failures in the future, greater transparency has been proposed.

“In the UK, for example, large businesses would need to be more transparent about the state of their finances, so they do not pay out dividends and bonuses at a time when they could be facing insolvency. Directors would also publish annual ‘resilience statements’ that set out how their organisation is mitigating short- and long-term risks, encouraging their directors to focus on the long-term success of the company and consider key issues like the impact of climate change.”

New reporting obligations would also be introduced on both auditors and directors around detecting and preventing fraud, with boards required to set out what controls they have in place, and auditors expected to look out for problems.

A study carried out last year among chief executives, chief financial officers and audit committee members on behalf of Mazars has helped inform the audit debate, according to Doherty.

“The assumption that companies only want a traditional financial audit from their provider is outdated, according to the findings. Some 96 per cent of all respondents say they would ‘absolutely value’ or ‘value’ the fact that their auditors broaden their range of services beyond financial audits.”

The research confirms that the market values a broad range of skills from auditors, including strong business knowledge and technical expertise, such as financial, tax and legal.

“Audit firms need to attract and grow talent with a breadth of expertise, which can be gained from experience in business advisory,” says Doherty. “Expanding the mission of auditors to other assurance services, such as ESG reporting, should be compatible with statutory auditing. However, when it comes to advisory services, it is important to ensure a strong management of conflicts of interests, applying strict rules.”

There was massive support for audit reform, with 93 per cent of respondents to the Mazars study saying the audit market should be reformed. Furthermore, some 87 per cent of respondents are favourable, 50 per cent of them strongly so, to the audit market evolving towards joint audit carried out by more than one statutory auditor.

Cited

When asked about the expected benefits of joint audit, respondents cited increased stakeholder confidence, reduced risk of corruption or human error, and enabling companies to benefit from a broad range of technical expertise.

Recent scandals such as Wirecard have highlighted the importance of audit quality and a key issue is the lack of auditor independence and scepticism. “As existing measures have not delivered the expected outcomes, they should be supplemented by the introduction of mandatory joint audits for complex cross-border public interest entities such as significant credit institutions and insurance companies,” Doherty contends.

“In a joint audit, the three-way relationship between the two auditors and the company improves the quality of the audit. The ‘four-eyes principle’ represents an additional control mechanism and ensures that the auditors are more independent and objective, as the risk of over-familiarity between an audit firm and the company being audited is greatly reduced.”

The company being audited would also benefit from the expertise of two audit firms addressing increasingly complex business and reporting issues, he adds.

A lack of competition is another issue to be addressed. “The current market structure poses the risk we could end up in a situation where there is simply not enough conflict-free capacity to audit major companies – with severe consequences for specific sectors and for the economy at large,” Doherty notes.

“With such market concentration regulators are confronted with the dilemma that sanctions against one of the dominant audit firms would further distort competition. A number of reforms are currently being considered, including introducing a cap on market share, the operational separation of the largest firms, and joint audit. Through actions taken in other markets to address market diversity, we can see that market concentration is solvable.”