Expectation gap of audit revisited – is this a perception gap or quality gap ?

The UK House of Commons have just released the report by the Business, Energy and Industrial Strategy Committee titled the “The Future of Audit” on 26 March 2019. It is a damning report on the state of poor quality audit on the back of a series of recent high profile corporate failures in Carillion and BHS. An alarming number of audit failures and seemingly audit quality failing acceptable standards includes the following:

  • Conviviality which went into administration in April 2018 after a £30 million tax bill was found to have not been paid. KPMG is currently under investigation by the audit regulator, the Financial Reporting Council (FRC).
  • Tech Data Ltd for which EY were fined £2.75 million after failing to obtain sufficient appropriate audit evidence and exercise professional scepticism.
  • Aero Inventory (UK) Ltd for which Deloitte were fined £4 million for misconduct in relation to its auditing of the company’s financial statements and stock valuations.
  • Rolls-Royce which was fined by the Serious Fraud Office’s relating to corruption charges. KPMG is currently under investigation by FRC for its audit for 2010 and 2013.
  • Mitie Group who posted a £42.9 million deficit after material errors had been found in its accounts. Deloitteis currently under investigation by FRC.
  • Sports Direct which was alleged that its owner Mike Ashley had made undisclosed payments to his brother’s company. Grant Thorntonis currently under investigation by FRC.
  • RSM Tenon Group for which PwC were fined £6 million due to misconduct on several accounts, including its assessment of goodwill.
  • Ted Baker for which KPMG were fined £3 million for misconduct relating to its audit
  • Domino’s Pizzas which reported a £85 million of unlawful distributions (dividend payments) over a period of 16 years.
  • Quindell for which KPMG was fined more than £3 million by the FRC for misconduct in its audit after a probe by the Serious Fraud Office.

A total of 27% of Big 4 UK audit in 2018 did not meet its quality standards (2017: 19%). In 2011/12, 44% of  audits had not met its quality standards. In the exact words of report “Not many companies can afford an 18 per cent rate of faulty products, and we are not aware of other industries in which 27 per cent of products sold are defective”.

With reference to the standard Acceptance Quality Limit(AQL) of 2.5% for major defects adopted by manufacturing industry, the standard of audit is definitely way below the perception gap due specifically to a delivery gap of audit not performing to an acceptable level of quality. Where the delivery and expectation differs, the gaps between the two would over time diminishes as long as the quality is up to standard.

It is a fundament failure of the audit if the quality gap is wider than the expectation gap. As a product, audit should be more useful and forward-looking and a provide a meaningful service to the public interest.

The current independent audit regulator FRC has been criticised for its perceived weakness in dealing with audit failures, possibly due to its non-statutory basis and the conflicted interest of its members. The fact that many former Big 4 accountants sit on FRC panels and committees creates a convoluted web of interests. Specifically, FRC’s inaction in the collapse of HBOS bank in 2008 relating to KPMG audit,  Tesco overstatement of profit relating to PwC audit as well as in Patisserie Valerie where Grant Thornton’s audit failed to spot a £94 million discrepancy in the company’s accounts, provide little assurance on the doubts of FRC’s independence over its own old boys’ club.

It has been proposed that the FRC should be replaced by a more powerful regulator, the Audit, Reporting and Governance Authority (ARGA).

In addition several points of recommendation were proposed as follows:

  • The use of graduated findings and several measures to improve engagement with shareholders. The detection of fraud is a priority within an audit and audit must demonstrate how potential fraud has been investigated. The old audit presumption of “An auditor is a watchdog, not a bloodhound” is no longer correct. The audit profession must reform and do a fundamental rethink to make audit a more useful, informative product and a more varied, interesting career.
  • To improve independence and competition, the current Big Four dominance of the FTSE 100 and FTSE 250 audit markets must be addressed by joint audit of a Big 4 and a non-big 4 “challenger” firm and how to create steps for the challenger to step up.
  • Full legal and structural separation of audit and non-audit businesses of the Big 4 to ensure audit independence and conflict of interest relating to cross-subsidies of audit and non-audit businesses.

The expectation gap has been a topic revisited many times over the years. Is this really a dead horse worth beating or has it come to a point of realisation that the horse is no longer relevant. As we discussed the disappearing of traditional jobs in the yesterday article of “Going, going and gone are the jobs” dated 23 April 2019, the audit profession is not spared from the onslaught of automation and AI. It is a question not on the horse but fundamentally we should ask whether is it a horse that we needed. A brave new world of disruption indeed, but as in all profession, the time has come for a rethink for the future of audit profession.