A prescription to curb company failures | USAEMALL.com

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“Professional judgment is a critical feature of any audit,” according to the UK watchdog, the Financial Reporting Council, which in 2022 urged auditors to sharpen their scepticism. An independent mindset is particularly important when it comes to assessing whether a business is a “going concern”. Alongside internal controls and the potential for fraud, deciding whether a company risks going bankrupt is a critical focus for auditors. It is here, according to new research, that UK firms are falling short.

The Audit Reform Lab (ARL), a think-tank, says auditors failed to sound the alarm before 75 per cent of big UK corporate collapses between 2010 and 2022. While auditor performance is poor, partner pay is high — and rising — and regulation is ineffective, it points out.

It is understandable that auditors sometimes hesitate to pull the trigger on going concern warnings. Assessing future threats to a business is hard, as the unforeseen impact of pandemic and war has shown in recent years. Fraud — another area where auditors could be more alert — sometimes undermines their attempts to root out the truth. Conflicts of interest with more lucrative non-audit opportunities are a potential distraction for big firms.

Warnings can deter suppliers and customers from shipping goods or paying bills and tip the company into a self-fulfilling crisis of cash and confidence. By including a “material uncertainty” paragraph in published accounts — or suggesting they are considering such a clause — accountants therefore put themselves on a collision course with their clients’ management and board.

No wonder some critics believe auditors should confine themselves to certifying that accounts are true and fair and leave it to other stakeholders to draw their own conclusions about the likely impact of risks ahead.

As ARL rightly points out, however, a “material uncertainty” paragraph is “a warning, not a prediction”. It is not clear how many alarms auditors raised over the same period at companies that did not go bust, but that is preferable to issuing an opinion that a company is solid when it is not. Only this month, the FRC fined PwC and EY for failures in their audits of London Capital & Finance, the investment group that collapsed amid scandal in 2019. A lack of professional scepticism and failure to identify and assess risks of “material misstatement” were among the watchdog’s criticisms.

Nobody should underestimate the cost of improved scrutiny. The FRC’s 2022 judgment guidance urged auditors to stand back to see the big picture on any audit, which sounds simple. But it also included an illustration of good practice in which, in order to verify the directors’ going concern assessment, the audit partner consults cash flow modelling, debt-financing and ethics experts — all under pressure from the client and against a tight timetable.

Regulatory reform would help, as the FT has consistently argued. But the outgoing UK government repeatedly watered down and eventually withdrew plans for a stronger watchdog — the Audit, Reporting and Governance Authority (Arga) — despite the recommendations of multiple reviews. A frustrated head of the FRC complained recently that the body lacked the funding and the weapons to hold audit firms properly to account.

“Better quality audits now” is unlikely to be an electoral rallying cry for any of the parties in the coming election. Unless a new government acts, however, to avoid more corporate failures the UK must continue to depend on the best efforts of an underpowered regulator and the willingness of auditors to have more tough conversations with directors.