Auditors and the ‘Expectation Gap’

We have only looked fleetingly at the story of Grant Thornton – The British-founded ‘professional services’ company that is now regarded as one of the largest firms outside of the traditional ‘Big Four’ audit firms – and its connection to Patisserie Valarie. As the chain sits currently in administration and is ‘set to be sold off piecemeal’, the role of Grant Thornton in auditing the chain just before it collapsed has brought the auditor firmly into the spotlight. Grant Thornton’s CEO is currently facing questions from MPs and, as part of his response, he has told the House of Commons Committee that there was an ‘expectation gap’ between what is expected of audit firms and what they do in practice. In this post, we will review the story and analyse the developments, but focus more on this concept of an ‘expectation gap’ existing in relation to the auditing industry, which is particularly centralised within the financialised society we live in.

Patisserie Valerie entered into administration last week, with the chain saying that 70 of its stores would immediately close. The Financial Times is reporting that, due to its ‘unreliable accounts’, even businesspeople who specialise in purchasing collapsed companies are avoiding the wholesale purchase and are instead looking to purchase only ‘chunks’ of the failed business. KPMG, the auditor undertaking administration responsibilities has provided very limited information so far and it has been suggested that the chain’s financial figures, dating back almost six years, may not be reliable; the newspaper continues by including a quote from an unnamed source that states: ‘it’s been a very long time since I’ve seen a fraud like that. I couldn’t bid on it’. As a result, there are a number of investigations currently underway. The FRC are investigating the associated auditors under the ‘Audit Enforcement Procedure’, the SFO has opened an investigation into an unnamed individual, although it is also conducting a wider investigation into the collapsed chain. However, it is currently David Dunckley who is facing the questions. Dunckley stated that ‘we are not doing what the market thinks. We are not looking for fraud and we are not looking at the future and we are not giving a statement that the accounts are correct. We are saying they are reasonable, we are looking at the past, and we are not set up to look for fraud’. MPs responded angrily, with Peter Kyle MP responding ‘if an audit is not picking up on [fraudulent] behaviour, what is the point of audit in the first place?’. It is worth mentioning that representatives of other firms did not agree with Dunckley’s assessment, with BDO saying ‘you look for material frauds’ and Mazars saying ‘what the public expect is to be able to rely on a set of accounts’. A rival auditor was quoted by The Financial Times attacking Dunckley’s testimony, stating that ‘our worry is that he has damaged the audit profession as a whole’. The question is, is the public perception of the audit industry inherently damaged anyway?

The same article discusses how the audit industry, or at least three of its biggest players (PwC, EY, and KPMG) would be ceasing providing ‘consulting services’ to FTSE 350 audit clients by the end of 2020. We have discussed this issue of ‘consulting services’ before, primarily in relation to the conflict-of-interest issue that similarly occurs within the credit rating industry when they provide ‘ancillary services’ for those who they rate (the sole focus of the author’s first book), but it is worth asking whether this is enough to rebuild the public’s trust in this particular sector. Though there are clear historical cases of auditors’ failures, including Enron and WorldCom, the auditors will be quick to label these as ‘legacy issues’. However, if we focus more recently, we can see that the auditors, and this spread between them and not just one particular auditor, have consistently failed in their remit. Recently there has been a number of scandals involving auditing failures, including: Patisserie Valerie; Carillion; Conviviality; Rolls-Royce; BT; Mitie Group; BHS; Sports Direct; Ted Baker; and Quindell. It is bordering on the remarkable that there is even a question over the competency of these massive global firms; it is clear there is something inherently wrong with the operations of these companies.

It is difficult to pinpoint where that problem lies however, and that is assuming there is just one problem. Reviews of the associated regulators have found that, in the case of the FRC, the regulator is ‘built on weak foundations’, whilst it has been suggested by a number of observers (chief amongst which is Professor Prem Sikka) that the auditing and consulting arms of the auditors should be fundamentally split. In this author’s first book cited above, there was a discussion on the auditing industry and that fed into the calls to enforce the splitting of these two arms within the credit rating industry, and make the splitting of the arms irreversible. This suggestion was based on the fact that, after the Enron and WorldCom scandals, the US-led Sarbanes Oxley-era provided an environment where, essentially, the largest auditing firms were pushed to divest from their consultancy arms. Although the credit rating agencies (S&P in particular) went on to acquire a number of components from this divestment, there was a fundamental issue in that the Sarbanes Oxley-led divestment was done with the sentiment of encouragement, rather than enforcement. The auditors did divest, but they did so on their terms, with short periods being declared as to when they would not conduct consultancy services from that point. Inevitably, in the run-up to the Crisis, the auditors had rebuilt these consultancy arms that were directly identified as being crucial to the Enron-era degeneration in standards, and since the Crisis these consultancy arms have continued to grow. Now, with PwC, EY, and KPMG telling regulators that they will divest, it appears the same thing will happen again; the auditors will respond to public demand, but wait for the news cycles to oscillate away from the industry and then rebuild. This tremendously cyclical arrangement is continuing unabated, and many seem happy for this to be the case because it resolves an issue now, and not fundamentally.

Another aspect is that the so-called ‘Big Four’ are an oligopoly, and that is a vital understanding. The theory of the marketplace is that the firms will compete on quality and price, and what will result is an efficient sector that is affordable to the customer. However, in an oligopolistic marketplace, those elements do not exist. When one firm takes a certain action, the other members of the oligopoly will usually, and it is argued here that they must, take the very same action – this is represented clearly with the firms stating that they will stop providing consultancy services to FTSE 350 companies who they provide audit services to as well (KPMG started this sentiment and the others followed). So, if we accept this oligopoly-based theory is the truth, and it surely is, then the options available to regulators are extraordinarily limited. They cannot seek to encourage competition to disturb the hegemony within the oligopoly because an oligopoly is defined by a lack of competition. Also, increasing competition has the potential of perceptively reducing quality within the sector, and even though it may sound paradoxical, many customers would not want a potential reduction in quality even though the sector is clearly fraught with inefficiency – customers know what they are getting with the Big Four and, crucially, the validation received from the Big Four still carries value with external elements, such as investors. Whilst the value exists, the oligopoly will also exist, as is the theory of oligopolies (a great book on Oligopolies can be found here by Luis Suarez-Villa). With that in mind, the current situation is unlikely to change. What will probably happen, and it is strongly suggested here that the following is almost guaranteed to happen, is that the auditors will respond to external pressure in a manner that placates that external pressure, after which they will perform, for a while, in a manner that removes scrutiny from the sector. Once that scrutiny passes and moves onto another sector, the audit sector will re-develop the very same practices and the cycle will simply continue. If one is uncertain about the direction of a certain sector, it is usually wise to look backwards. The cyclicity within the marketplace is abundantly clear to see, if one cares to examine it within that set of parameters. If one is looking for a political victory, in the here and now, then it will be easy to overlook such a trend. It will be worth noting the current stage where it has been identified that the mix of auditing and consulting arms are one of the fundamental keys to auditor failings, and see how long the industry-led impediments on that combination actually last; it will likely be not very long at all.

Keywords – audit, regulators, business, patisserie Valerie, law, economics, @finregmatters