Bad audits – a problem with incentives

The first article in this two-part series looked at how the accounts and annual report gave no hint of the impending collapse of Carillion and highlighted a surprise £40m accounting black hole at Patisserie Valerie. This article considers the role of the auditor and why the system of incentives  may mean audits fail to identify large errors in company accounts.

The objective of an external audit by an independent auditor, according to the Financial Reporting Council, is to obtain reasonable assurance about whether a company’s financial statements “as a whole are free from material misstatement”. It is accepted by accountants, if not the general public or politicians, that it is not an auditors’ job to detect fraud. The Chief Executive of Patisserie Valerie’s auditor Grant Thornton confirmed this to the Business, Energy and Industrial Strategy Committee on 30 January 2019 as part of its inquiry into the future of audit. This caused some consternation among the Committee members who thought an audit should find fraud. Strictly speaking he was right. Following a landmark case in 1896, re Kingston Cotton Mill Company, the judge clarified that auditors have a role more like that of a bloodhound than a watchdog meaning that they are not supposed to seek out fraud; it is their job, however, to detect material misstatement of the accounts however caused which includes material misstatement caused by a fraud. As with Carillion we can reasonably expect auditors to spot when accounts are massively wrong. In the case of Patisserie Valerie we can expect the auditor to spot a missing £40m when material to the accounts and as the reported profit for the year ending 30 September 2017 was just £16m a £40m fraud would have been material. The Times and others have disclosed that a forensic investigation by PwC for the company identified a £40m fraud involving forged company minutes, forged signatures on bank contracts and fictitious invoices for shop refurbishments. The PwC report has not been made public but reports suggest the fraud had been undetected for at least three years.

According to the Financial Times the motivation for the fraud was “trying to keep people happy. Luke Johnson had certain expectations. He is hard-nosed and results-driven. It was easier to fiddle the numbers than admit to bad results.”

Keeping people happy may have been the incentive to perpetrate a fraud. Let’s consider the incentives to ensure accounts are reliable and an audit is thorough. The diagram shows the main incentives for each of the main players involved in the preparation and audit of a set of accounts.

On the left we have people who we can reasonably expect will want fair, balanced and understandable accounts and a good audit. Junior auditors, new to the profession will want to do a thorough job and keep their bosses, mainly the audit senior happy. We expect non-executive directors (NEDs) to ensure the accounts are right but they have little real incentive to do so. They would probably prefer a quiet life to looking for problems in the accounts and risking being called trouble makers. For each day they work they are paid a fraction (around 10%) of what a chief executive would earn so why should they try to second guess what management say? Shareholders ought to want reliable accounts but what they really do not want is bad news so will not thank a board or an auditor who reveals problems before they have had a chance to sell their shares.

On the right we have people who may not really care if the accounts are reliable, may avoid following up possible problems or even worse manipulate them or stand idly by knowing that accounts are misleading. By the time an auditor becomes an audit senior or manager, a few years into their career, they will be under no illusion that what the audit partner wants is an audit done profitably within budget. The financial budget will be based on estimated hours for different parts of an audit. The time budget is likely to be challenging, leaving little or no time for audit staff to look into problematic audit findings. An auditor soon learns it is wise to look the other way rather than escalate an unresolved audit finding for a manager or partner to worry about. Auditors who are too dogged in their job may find themselves looking for another position. The audit partner’s main concern will be to have a profitable audit and hopefully procure more profitable consulting work for the team. S/he knows that raising problems with the client could jeopardise getting consulting work and even lose the audit contract. The audit firm as a whole wants to be highly profitable and avoid public censure or negligence claims although it is willing to accept both to an extent as the price of doing business.

Finally we have executives whose main priority may be to keep their jobs and maximise their performance related pay. It has been conclusively demonstrated by peer-reviewed research that executives have manipulated earnings to boost their pay. It is also well known that pressure to meet expectations can lead people to corrupt behaviour. I have written more on this in a publication by Transparency International looking at the role of formal and informal incentives in corrupt behaviour.

As the broken see-saw in the diagram suggests the system is broken. The Competition and Markets Authority has been looking at what’s wrong with audit and reported in December. The CMA proposes legislation to separate audit from consulting services. Although the report makes 91 references to incentive it does not look at the incentives within audit firms in the way set out above. As a result any reforms are unlikely to address the real problems which are lack of professionalism by auditors and incentives to look the other way rather than do a good job. The Big Four audit firms seem likely to act before legislation comes into force and ban themselves from offering non-audit services to FTSE 350 audit clients. Time will tell whether this amounts to little more than placing a fig leaf over the problem. There is not much room for optimism.

Written by Paul Moxey, SAMI Fellow and a chartered accountant and fellow of ICSA – the Governance Institute. He is also Visiting Professor of Corporate Governance at London Southbank University, a Fellow of SAMI Consulting and author of a text book on corporate governance published by ICSA. In the past he has been both an external auditor and the CFO and company secretary of a listed company and responsible for the preparation of reliable accounts.

The views expressed are those of the authors and not necessarily of SAMI Consulting.

SAMI Consulting was founded in 1989 by Shell and St Andrews University. They have undertaken scenario planning projects for a wide range of UK and international organisations. Their core skill is providing the link between futures research and strategy.

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