Reforming the Audit Sector

How Many Failures Will It Take for Audit Reform?

By Christopher Thackray

One question is on the minds of investors: How does a company known for irregular accounting standards with consistent indicators of suspicious activity carry out a sophisticated global fraud that goes unnoticed by auditors for years?

On 18 September 2019, Wirecard closed at €158.30. Within 9 months, the trading of shares would be suspended at €1.28 with a cash shortfall of €1.9bn. Wirecard is the latest in a series of failed audits that blindsided investors with nondisclosure of material weaknesses in the company’s ability to continue operating in the next 12 months.

The Wirecard scandal, or the “European Enron”, is only one example of repeated material failures in applied auditing standards that have become more apparent in recent years. These failings have plagued investors and creditors, leaving them wondering whether their financial investments are safe and based upon open, accurate and ethical representations of financial statements. Though a pattern of corporate failures without reports of material weaknesses from auditors has emerged, the “Big Four” audit firms have continued to increase their share of the industry — such as the increased market share of blue-chip FTSE 100 index audits in the UK from 96% in 2017 to 100% in 2018.

In 2019, all “Big Four” audit firms failed to meet the “good quality” standard of 90 percent accuracy as laid out by the UK’s Financial Reporting Council in part because they did not appropriately challenge executive management and the board of directors. In any other industry, failures of this scale and consistency would not be allowed. Imagine a failure of this level in auditing electric supply in the energy industry. Lights out for millions. Angered citizens. Riots. Or in the case of the housing industry, the near collapse of the financial system in 2007/08 which led to an overhaul in the legal, operating and governance structures of the entire industry.

And yet, sudden corporate downfalls, such as those recently seen in the UK with Carillion and Thomas Cook, in South Africa with Steinhoff, in the U.S. with Colonial BancGroup, and in Germany with the Wirecard scandal, to name a few, lead to limited or no consequence for the auditing firms or senior auditors in positions of significant responsibility.

How many investors need to lose the value of their investments, customers lose the value of their pensions, or employees lose the security of a paying job before audit sector reform becomes a priority for governments?

Wirecard’s collapse is the opportunity for governments across the globe to address a systemic weakness in the trust and reliability of a critical economic function. In reforming the audit sector, governments must address the underlying mistrust in the legal and operating structures of the Big Four audit firms, including:

1.   Conflicts of interest

Eliminate the ability of audit firms to act in the capacity of auditors as well as consultants. This should include the legal and operational separation of consulting and audit firms operating under a single umbrella company.

2.   Accountability

Increase the significance of penalties for firms and individuals in positions of responsibility (such as independent senior auditors and the members of board audit committees for publicly listed companies) where material deficiencies in audit quality are later uncovered.

3.   Standards

Redefine auditing standards to minimize variation in interpretation between independent audit firms, with a broader assessment of executive management’s actions in addressing emerging risks to the future valuation and viability of the company.

Less than 20 years ago, the world witnessed the collapse of Enron and WorldCom resulting from complex accounting scandals and auditing failures that emerged over several years. These scandals led to the introduction within the US of the Sarbanes-Oxley Act, covering auditor independence, audit conduct and disclosures.

Whilst Sarbanes-Oxley ushered in a new era for the audit industry and set new global standards, the rules are perceived by many to have become a tick-box exercise and have, therefore, not gone far enough in addressing material weaknesses in corporate governance. This led to a number of US companies setting standards of corporate governance themselves, including the Commonsense Principles of Corporate Governance and Corporate Governance Principles for US Listed Companies.

As we learned during the 2007/08 financial crisis, and now by Europe’s Enron, self-regulation is not effective in setting the standards or providing appropriate levels of governance and penalties when companies fail to meet these standards.

The fallout from the Wirecard scandal can be viewed as an opportunity for audit reform, auditor independence and corporate governance. We must ask, what more will need to happen for governments to take action to protect investors and consumers from this systemic problem? Undeniably, self-regulation is not the answer. Now is the time for governments to intervene.

Read more here on our fight for UK Audit Reform, and let us know your thoughts.

By Christopher Thackray

Chris is a Managing Director of Periculum with extensive experience advising companies on the development of risk management, from credit and liquidity risk, to strategic, operational and reputational risk. Chris is a trusted advisor to Boards and C-suite executives across a variety of industries and is a keen author of risk management publications.