June 19, 2018 / 2:01 PM / in 5 months

Breakingviews - KPMG wrist-slap shows auditors are too few to fail

The logo of KPMG, a professional service company, is seen at the company's head offices at La Defense business and financial district in Courbevoie near Paris, France. May 16, 2018. REUTERS/Charles Platiau

LONDON (Reuters Breakingviews) - By the UK accountancy regulator’s timid standards, criticism that big audit firms “must act swiftly” to improve the quality of their work is a sizeable rebuke. The power to impose larger fines adds extra heft to official censure. Still, it does nothing to solve the fundamental problem in the accounting business: a lack of competition.

The Financial Reporting Council wants at least 90 percent of audits to require only “limited improvements” – an oblique category somewhere between good and merely acceptable. But the Big Four firms – KPMG, EY, PwC and Deloitte – are going backwards. Only 72 percent of audits reviewed by the FRC in the year to February met the required threshold, down from 78 percent in the previous 12 months.

KPMG wore the dunce’s cap: the FRC found that half its audits of companies in the FTSE 350 index were flawed. That’s not entirely surprising for a firm which counted failed outsourcer Carillion and scandal-hit legal services firm Quindell among its clients. But it was not alone. Rival EY suffered the steepest drop in quality: 33 percent of its audits needed significant improvements, up from 12 percent in the previous year.

Much of the problem lies in insufficiently testing clients’ optimistic assumptions about hard-to-measure intangible metrics such as goodwill or impairments. Auditing banks is a particular concern, according to a person familiar with the situation.

In a competitive industry, public shaming should prompt clients to switch auditors, and firms to clean up their act. However, multinational companies only have four providers to choose from. Moreover, the profitability of auditing has generally declined, making it less attractive for smaller players: Grant Thornton recently announced it would no longer bid for FTSE 350 clients. Rules requiring companies to tender their auditing contracts every decade, and change auditor every 20 years, only underscore the lack of choice.

In theory, a bigger stick should help. From June 1 the FRC can levy fines above 10 million pounds for seriously shoddy work, compared with a previous high of 6.5 million pounds. In practice, financial penalties only act as a further disincentive for firms which generate most of their earnings from consultancy work. That means the FRC will probably continue to rely on “naming and shaming” to call out only averagely shoddy work. And the problem of auditors being “too few to fail” will persist.

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