Audit Quality – the problem and what we’re doing about it

You are paid to think. These were the words of the senior partner to a new intake of audit juniors – and words which I will never forget. The message, though short, was clear. A large audit firm does not hire highly educated individuals to ‘tick and bash’ invoices or cast a set of financial statements.

They hire them to apply their minds, to ask questions, to consider information received, to build a compelling case, and to ultimately reach an informed opinion. At some point the audit profession understood this. And at some point, much of the audit profession forgot this. Today, the audit profession must re-learn this.

Recent UK corporate failures, and the role of the auditor in these, have been well documented. Consider whether each of the below examples sound like an audit team applying their minds.

• Example 1: The entity collapsed with £1.3 billion in debts and a massive pension deficit, only a year after being sold for £1. The Financial Reporting Council (FRC) found that the auditors had relied on unrealistic management forecasts​.
• Example 2: After this entity went bust under £7 billion of liabilities, a joint Parliament report branded the auditors “complicit” in the entity’s aggressive accounting, saying the firm “failed to challenge management” and even “missed basic errors”​.
• Example 3: The entity crashed into administration after a £40m fraud was uncovered, involving fabricated invoices and overstated cash. The FRC investigation found a “serious lack of competence” in the audits for 2015–2017 and that the auditors “missed red flags” that should have led to suspicion​.
• Example 4: The entity’s accounts did not alert authorities to the Ponzi-like characteristics of its business. When the company collapsed, investors faced huge losses (eventually the government provided £120m in compensation).

Further, an empirical review of 250 UK companies that collapsed between 2010 and 2022 found that in 75% of cases the audit report did not include any going-concern warning in the year before the company went bankrupt​. In fact, of the 39 companies within this study that reported both a negative Net Asset Value and losses, only 20 (51%) were classified as going concern risks by their respective auditors.

What is it that causes an auditor to not apply their minds? Some have suggested it is a matter of agency – that auditors fundamentally misunderstand who their “client” is and so from the outset take up a view in the interests of management of the audited entity rather than those of employees, investors, and the broader public. They seek, from the outset, to validate management’s view rather than audit it, forgetting that an auditor’s loyalty must be to the truth, not to management.

When Carillion collapsed, it left over 14,000 employees jobless, 27,000 pensions in jeopardy, and taxpayers on the hook for at least £148 million in liquidation costs​. Corporate failure is not victimless, and it is certainly not the management of the entity who bear the brunt of the impact. It is the average worker, families, pensioners, the middle-class investor, the government fiscus, and even the British holidaymaker stranded abroad (as in the case of Thomas Cook). These are the true “clients” of the auditor.

In the UK, repeated audit failures have likely contributed to investors’ scepticism about corporate reporting. This “shaking of faith” in audits can have a macroeconomic effect: if investors fear that company accounts may be unreliable, they may be less willing to invest, thereby raising the cost of capital for UK businesses. Academic researchers often refer to this dynamic when arguing for audit reforms – they contend that restoring audit credibility is key to well-functioning markets​. One research paper makes the point that “whenever there is any revelation of fraudulent financial reporting, the investing public and the business community do not ask who is the CEO or CFO, or better still, they don’t ask what the composition of the board looks like, the first question the investing public, business community, regulators and the media are always quick to ask is who are the auditors?”

What we’re doing about it

It would be remiss of me to express the above without also noting the actions being taken by audit firms and governmental entities in an effort to improve audit quality:

• Government-commissioned inquiries to diagnose failings and recommend reforms: Various reviews have been conducted into the UK audit market and regulator, resulting in several key recommendations being made. These recommendations include additional regulatory powers to hold auditors and companies more accountable.
• Enhanced Audit Standards and Scope: The FRC has strengthened the UK auditing standards – for example by amending the standard on fraud (ISA 240) to clarify that auditors must proactively assess fraud risk and not assume management honesty. The standard on going concern (ISA 570) was also toughened after high-profile failures – auditors must perform more robust stress-testing of a company’s viability and explicitly report if there are any material uncertainties.
• Technological Innovations (AI and data analytics): The audit industry is increasingly turning to technology as part of the solution, expecting it to significantly raise the baseline quality of audits by reducing human error and catching red flags early. That said, there is recognition that the use of technology still requires the auditor’s application of judgement and professional scepticism to interpret the results. Nonetheless, the integration of AI and forensic data analytics offers significant potential for strengthening audits, particularly in uncovering fraud and evaluating cashflow projections.

By far and away the most critical required remedy is a change in culture within the profession. Ultimately, better standards and technology will fall short of bridging the gap unless auditors adopt a genuinely sceptical, probing mindset as standard practice and so audit firms must work tirelessly to instil this mindset in their staff. Many firms are working hard at this and equally acknowledge that there is distance yet to travel.

Regulators have explicitly called for auditors to show greater professional scepticism and curiosity, rather than a checklist approach​ to “completing” an audit. In other words, they have called for auditors to think. This is also my plea to auditors today.

If you would like further information or guidance, please contact us today.