Over the past 30 years the 12 largest firms, through various consolidating moves, became the Big-8, then the Big-5 and, following the Enron/Andersen debacle 14 years ago, settled down as the “Big-4” who alone possess the reach, technical capability and manpower to conduct audits of the worlds largest enterprises.

Although second-tier contenders like BDO and Grant Thornton have impressive multinational capability, this tends to be outweighed by an “institutional perception gap”: if lenders and advisers to a deal are more comfortable with a Big-4 auditor in place, there will be little resistance – though that comfort may have more to do with size than competence.

illogical imbalance

This illogical imbalance may soon change due to deep stakeholder disaffection: there is a limit to how much investors are prepared to endure when they feel let down by the auditors. There is a limit to their patience when the litany of blame-game excuses are trotted out, such as the notion that scrutinising pre-acquisition due diligence is a “matter for the Board”. In the case of the Co-op [See Accountancy, November] that “matter for the Board” masked a disaster in loan book recoverability that brought the company to its knees, where it still languishes.

At Tesco [see Accountancy, November] accelerated recognition of commercial income and delayed cost accruals was a brazen breach of nursery school accounting rules on matching income with costs. Investors now expect auditors to expose the most blatant management and governance lapses before they cause a loss of billions in shareholder value.

Misconduct the norm

Banks’ venomous conduct has become so normal that it is scarcely newsworthy

Over the six years since the financial crisis blew up banks in the USA, UK and Europe have been fined tens of billions of pounds for a plethora of dodgy deals: mis-selling of mortgages, interest-rate swaps, payment protection insurance, money laundering, rigging Libor and currency markets, breaching sanctions, aiding tax fraud and violating securities laws. Banks’ venomous conduct has become so normal that it is scarcely newsworthy.

Yet if such egregious behaviour causes bank auditors any concern, there is little evidence of it. That is what must change. When corporate ethics languish in the gutter, the very notion of true and fair accounting becomes a sick joke. Might it not be salutary to read this in an audit opinion: “the financial statements take no account of material regulatory penalties that the greed-obsessed management is bound to incur”?

The EU may be a surprising role model, but its Court of Auditors has qualified, for the 19th year running, its opinion on the EC accounts: multinationals claiming small business relief; officials pocketing 5 times the rate for their jobs; claims for subsidies for “grazing land” with buildings and roads on it; previous years’ recommendations completely ignored. And so on. While seven billion euros were paid out improperly, Britain was asked to cough up an additional 2.1 billion. Here’s a clue: the Court of Auditors carries no risk of being sacked by the “client”!

Audit focus must shift

Assessing the sustainability of management’s business plan is the key to a solid audit. If a bank is furiously mopping up mortgages in the bond market it is not enough for auditors merely to check the book entries. In the last crisis did auditors actually test mortgage files for evidence of borrowers’ solvency?

Carrying £1 billion of debt, bearing annual interest costs of £100 million, against an asset base made up almost entirely of goodwill, is hardly a sustainable business model, as Towergate bondholders now know to their cost. Yet it has been building up for years.

The existing audit matrix is not fit for purpose. Change may come in the form of legislation – such as a Glass-Steagall equivalent that truly divorces audit work from advisory, tax, due diligence and consultancy; or a seismic dose of litigation; or an overwhelming groundswell of public opinion and investor disaffection.

Or the instatement of personal accountability: the President of New York Federal Reserve now suggests a new form of pay that would leave senior management on the hook for a share of regulatory fines imposed on their employer.

The battalion of cheesed-off shareholders might support such a move with enthusiasm.