LESSONS FROM CARILLION: ACT NOW AND ENSURE AUDITOR INDEPENDENCE
By Mehran Eftekhar, Group Finance & Corporate Services Director, Nest Investments
With a parliamentary inquiry into the collapse of Carillion underway, Britain’s four biggest accountancy firms are facing new scrutiny. All of the Big 4 apparently failed to detect a near £1 billion overvaluation of assets in the company.
The UK’s Financial Reporting Council (FRC) is calling for the competition regulator to investigate audit failings leading up to Carillion’s collapse. One of the biggest issues the Carillion story has exposed is the varied quality of independent oversight in the business.
The FRC investigation will look at the ethical and technical standards of the auditors involved. Their independence and integrity will be under the spotlight like never before. The FRC’s Chief Executive, Stephen Haddrill, has told MPs there needs to be more competition in the major accounting and audit markets. Unfortunately, independence – or the lack thereof – is a contentious issue already debated but with little resulting action. Back in 2013, the Big 4 were heavily criticised for their close personal relationships with chief executives. Nothing was done.
Taking lessons from the Carillion example, and the countless before it, is vital for all growing businesses. Whilst the FRC’s investigations will take many months, there are crucial, simple steps businesses can take now to safeguard the quality of their own audits.
It starts with independence…
A key to delivering quality auditing and accountancy services is understanding the business model whilst remaining independent. This independence is characterised by integrity and objectivity when assessing clients’ businesses and accounts. Auditors must carry out their work fearlessly, freely, without bias and without vested interests in the audit’s outcome so that the reports they produce are accurate and correctly evidenced.
To be truly independent, an auditor must achieve something experts call ‘independence of mind’. This means that the auditor can make unilateral decisions and does not find itself facing conflicts of interest that impact upon financial reporting. Pressures from senior executives, as well as the auditor’s internal pressures to upsell additional services, and the emotional pull of interpersonal relationships are all factors that can impact on true auditor independence.
Can independence ever really be assured?
The short answer is no. But there are several steps that business leaders can take to ensure greater independence as their corporate governance framework develops.
1) Keep auditors separate from your Board of Directors
Understand that an external auditor makes their living from the fee that you pay them. Naturally, this creates pressure to work in a way that will not jeopardise engagement. Whether subconsciously or not, this can potentially impact upon the independence of the audit’s outcome. Many studies have found that the larger the fee, the more likely an auditor is to fluff their role and produce an audit that panders to their client, rather than giving them the advice they need. To avoid manipulation of figures, usually inadvertent or subconscious, auditors need to be protected from the Board of Directors in a way which allows them to challenge statements without fear of recrimination. Brief your Board and check egos at the door, if you want independent results.
2) Help auditors to understand your business
Very often audits start without understanding the client business model: a quick, tick-box exercise does not work. External auditors must have a purpose and the required knowledge of the processes they are auditing. It is very well checking historical information, but projections going forward with a comprehensive business plan provide valuable information. Make sure your auditors have transparent access to this in order to provide the most objective review possible.
3) Diversify suppliers
Often audit firms are large organisations that provide multiple services to one client. Tax advice, ICT consultancy and even marketing communications support are some of the additional services offered by the Big 4. Adding substantial non-audit fees into your professional relationship can seriously impact upon auditor independence. Reduce the auditor’s dependence on you, and preserve their independence, by shopping around for other suppliers.
4) Don’t keep using the same audit firm
Finding an external firm that you like can sometimes be a challenge, but it is important to rotate audit contracts so that personal relationships do not hamper auditor independence. By keeping the same audit firm year after year, it is nearly impossible for external auditors to not become conflicted between reporting financial vulnerabilities or failings and the need to maintain relations and contracts. Instead, when an auditor knows that their contract is to be replaced, they become inclined to produce work of an extremely high and independent quality, to avoid the embarrassment of the incoming audit team exposing their errors.
Currently the United States is leading the way in ensuring auditor independence. There is a legal requirement on businesses to review audit control procedures every three years, ensuring that external audits are carried out professionally and independently. No such system has been formally implemented in the UK. The Carillion story may see tides turning in the near future.
Businesses must ensure they are being provided with the highest quality audit reports. Follow the steps above to avoid the same fate as Carillion. Your reports will be of higher quality and you will secure the future of your business.