Qualifying an audit could lead to unhappy clients and litigation risks, so it is safer to ditch clients instead, an expert has told City A.M., after several auditors dropped clients in October.
Last month three separate auditors terminated contracts with clients in compromising circumstances. At the time the reputational risk of being associated with the businesses was given as a possible explanation behind why the clients were dropped, however experts have suggested such moves are more to do with conflicts of interest.
All three retailers were facing difficult circumstances. EG Group was having problems with governance and internal controls, while Boohoo had faced accusations of abuses of employment law across its UK supply chain. For BDO, assessing the “commercial risk and reward associated with the audit of the company” led it to drop the budget chain, according to The Times.
None of the auditors have publicly commented on why such decisions were taken, and all three auditors declined to give a statement to City A.M. on why the clients were let go.
When PwC dropped Boohoo, the FT reported the decision to do so was made because of reputation-related concerns it had about continuing to work with the online retailer. Auditors have not enjoyed positive press in recent years; the FRC, the audit watchdog, found the UK’s seven main accounting firms failed a third of quality tests this year, and big name auditors have been linked to major corporate failures like Carillion and Patisserie Valerie.
Conflict of interest
But According to University of Essex emeritus professor of accounting Prem Sikka, who is also a Labour peer, conflicts of interest at firms, rather than reputational worry, could drive auditors to drop clients.
“They don’t let the golden goose get away,” he says, arguing working with a perceived ‘riskier’ business would make it easier for auditors to qualify their accounts – a qualified opinion is a statement issued in an auditor’s opinion that suggests the financial information provided by a company was limited in scope, or there was a material issue with regard to the application of generally accepted accounting principles (GAAP) – but one that is not pervasive.
“Paradoxically it would suggest a lower risk to the auditor if they act upon all the signs of the extra risk,” he added.
But because auditors can qualify accounts, it does not mean they do. Atul Shah, an academic at London’s City University, argues “almost 100% of companies never get qualified”, and rather than qualify their audit reports, auditors are dropping clients before they have to.
In order to work as an auditor, a firm must sign up to the professional body license. “One of the main legal duties of the professional body license is to audit companies independently, and where you find them doing things that are not right you have the duty to qualify an audit report,” he explains.
The city professor argues if a report is qualified, the auditor may lose the client, or at the very least make the client very unhappy.
“Furthermore, there is a risk that the qualification of the accounts may trigger a collapse of the client, which could bring with it new potential litigation risks. It is safer to avoid the risks altogether by rejecting what are deemed to be shady clients,” he continues.
“[By dropping clients] What they’re effectively saying is that rather than doing all the work properly and making an audit qualification, they’re resigning from the audit.”
But the climate is changing, Shah continues, and in the last couple of years litigation risk has increased and the reputations of large auditors have been smeared.
“From my larger picture perspective, what these firms are effectively doing is that they are indirectly first admitting the lack of confidence in their own audit quality, and they’re copping out from their professional duty and responsibility. There is ample evidence they are compromised by commercial interests,” he adds.
Litigation exposure is a risk
For Jonathan Fisher QC, a barrister at Bright Line Law, the answer is more simple: the risk of reputational damage by being attached to a potentially problematic client, along with litigation exposure, is a major concern to auditors.
“I think there is a greater degree of caution being taken as regarding existing clients and in terms of making new relationships, and I think it’s being driven by a risk of litigation and regulation,” he says.
“I think what we’re seeing is a reluctance on the part of the big four and those immediately below them, to expose themselves. There have been a number of cases where they’ve got themselves into some difficulty – litigation exposure is a real worry for them.”
Fisher, who is a part-time professor at LSE and previously sat on the Actuarial Discipline Board – the FRC’s predecessor – describes auditors, particularly the big four – as “very image conscious”.
He continues: “There’s always been a bit of an expectation gap between what the public expects of auditors and what the auditors believe they are there to deliver. I think the investing public has always seen them as being watchdogs and protecting their interests of their investments, meanwhile the auditors have always been keen to say ‘look, we’ll do our best, but we’re not detectives. If we spot something it’s great, but don’t expect us to be fraud detectives.’
“That has gradually changed over a period of the last 20 years when you have international standards coming in… I think we’re seeing the message getting home to the auditing community that that expectation on the part of the investing public really needs to be honoured and recognised.
“They’re also reluctant to take on news clients in some instances,” he adds.