What is the ‘public interest’? First attempt.

Am contemplating the Introduction and Fundamental Principles of the Code of Ethics issued by the International Federation of Accountants (IFAC) and adopted by the Big 4:

100.1 A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest. Therefore, a professional accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer. In acting in the public interest, a professional accountant shall observe and comply with this Code.

There is a glossary but unfortunately no definition of ‘public interest’. Which together with the principles, not rules approach, leaves quite a lot of wiggle room between a wide conception of ‘public interest’ as, well, the public interest and a nice, modern conception of ‘public interest’ as ‘that which benefits the capital markets’.

Equally, the final sentence above could be read as implying that acting in the ‘public interest’ consists in following the Code. However, this is clarified in a fashion a bit further on when, after introducing the conceptual framework for assessing threats to the ‘fundamental principles’ (Integrity, Objectivity, Professional Competence and Due Care, Confidentiality and Professional Behavior (without a ‘u’)), the Code explains:

The conceptual framework approach assists professional accountants in complying with the ethical requirements of this code and in meeting their responsibility to act in the public interest (my emphasis).

So the accountant has to follow the Code and the public interest and in acting in the public interest follow the Code. Clear?

There follows some fairly depressing advice about what to do if one finds oneself in conflict with the Code (ultimately resign from client, team and/or job) and threats related to what happens if one brings the profession into disrepute. One other clause in the Professional Competence and Due Care section caught my eye:

130.6 Where appropriate, a professional accountant shall make clients, employers or other users of the accountant’s professional services aware of the limitations inherent in the services.

I hadn’t noticed this one before and it leaves me pondering.

The casualness of references to the ‘audit market’ is puzzling. Everyone uses the term as if it were self-evident what it means. Only a little reflection is required to realise that it isn’t obvious that there is a market for audit services in any usual sense of the term.

At the most superficial level, auditing does of course involve an exchange of money for services rendered. I’m not arguing this isn’t the case.

Equally clearly audit services aren’t priced as anonymous spot transactions on an open, liquid market. Nor are they transactions between fully free buyers and sellers. Most audits are contracted because they are a statutory obligation. Audits can only be provided by licensed individuals or firms. Prices aren’t freely negotiated or easily comparable and competition is limited. Individual consumers aren’t directly affected by or interested in audits. Notions of consumer choice don’t make sense in this context. Multinational corporations don’t ‘think’ or act like individuals. Buying an audit isn’t like buying groceries or even a car.

Does any of this matter?

Yes, it does because the dominance of the Big 4 and a lack of competition are seen as significant problems requiring urgent regulatory attention. Now probably it would be better if there were more than 4 audit firms of sufficient size to carry out the largest audits but:

It shouldn’t be a surprise that a profession which has been given a monopoly over audit tends over time to become concentrated in an ever smaller number of ever larger firms. Capitalism tends to work this way.

The link between increased competition or greater choice and improvements in audit quality is far from self-evident. Free pressure translates into time pressure in the leveraged audit model. Faster audits aren’t necessarily better audits.

Pricing for the largest audits is increasingly dictated by the audit client not by the audit firm. Unilateral and even retrospective fee decreases have become common. The Big 4 aren’t consistently good at standing up to their largest clients.

Fundamental misunderstanding of how the ‘market’ for the largest audits works is widespread and there is, consequently, a real risk that inappropriate regulatory actions will be implemented. The key priority must surely be to ensure that the quality of audits is consistently improved and that confidence in audits is enhanced. Focus on concentration in the ‘audit market’ may also be considered important but it remains a separate issue.

The Big 4 need to play their part and be more open to providing a clearer view of what is really going on in the largest audits and to discover a way of always putting principles before profits.

But these are topics for future posts.

OK so this blog isn’t going to rival Belle du Jour.

Let’s start with a few general reflections on financial audit and the Big 4. Cue extended throat clearing as someone wrote in something I once read.

As a practising, if anonymous, Big 4 audit partner I can’t claim to be independent of the firm for which I work, nor of the profession I practice. (I’m using ‘profession’ as a descriptive term here and acknowledge that it’s contestable). I aim to demonstrate that I have sufficient critical faculties to be able to present and understand balanced accounts and to enter into discussion of all viewpoints. I’m open in my views and don’t have a fixed agenda or opinion. And I can at least avoid the accusation that I’m just a disaffected ex-member of a firm.

The subject matter is daunting. There are thousands of potentially relevant academic articles. I’ve only read a small proportion of them. Associated literature, standards, policy documents, investigations, legal cases, articles in newspapers and magazines probably run to millions of pages. The Big 4 firms are vast, complex enterprises and far from static. Surprisingly, it’s hard to find much written by practicing auditors other than technical studies. There is a gap for open and informed debate with practitioners.

The Big 4 firms are social objects and they change. (I was going to write ‘evolve’ but that’s making an assumption – let’s take as a minimum starting point that they change). So a first comment and challenge. Is it sensible to assume that a policy and regulatory framework that may have made sense at one time and place (e.g. the US, post-Enron) is necessarily suitable at any time and place?

Auditors did not prevent the financial crisis. Should auditors have done better and, if so, how?

Many accusations are now flying: a lack of professional scepticism, cosiness with big clients and politicians, over-emphasis on commercial priorities, etc. And up front, I’m not going to pretend that these accusations are wrong. They mostly aren’t.

More interesting questions now are why and how did this situation arise and what (if anything) can be done to address it? What can be changed and what is the best approach to change?

Which leads me to a non-comprehensive series of further questions and challenges.

What exactly do we need from financial audit?

Is it possible to audit the largest and most complex groups in the manner in which audit is currently conceived? And if it isn’t, when did they become unauditable? Why wasn’t something done and what can be done now?

How well is audit regulation working in practice? How is it influencing the practice of audits and what are the consequences?

In many countries the current audit regulatory regimes were in place before the financial crisis. Why didn’t they ensure that audit worked better?

Are audit-only firms necessary (or even sufficient) to solve the problem? Will joint audits and/or better audit committees and/or risk committees help?

How are audit judgements made in practice and how are they influenced by regulation, by standards, by firm quality control processes, by economic incentives, etc.? Which of these aspects are relevant and to which extent?

@creditplumber asked whether auditors’ professional scepticism was compromised by non-audit services. In other words, would professional scepticism be restored by banning audit firms from providing non-audit services? No, it wouldn’t. Not in isolation.

Commercial pressures to promote non-audit services have undoubtedly had a negative impact on professional scepticism and audit quality. In some cases, they have been the predominant factor as widely documented in Andersen after the split with Andersen Consulting and the lead up to Enron and related scandals. Whatever the firms claim, they remain cultural and economic factors today. So it may be necessary to enforce audit-only firms to help solve the issue within the firms and to enhance external confidence in audit.

But dependency on a client for audit fees only remains dependency on a client. Banning non-audit services won’t solve the problem on its own. Are there better alternatives? What else needs to be done?

I’ll come back to the likely consequences of a split and the wider structural, cultural and educational implications in later posts.