Re-Structuring the Audit Profession: The UK's Competition Commission Hunts the Woozle

 After the United Kingdom’s Competition Commission issued its report on February 22, asserting that the Big-Four-dominated audit services market is non-competitive, I sought to raise a flag of warning that, unless de-railed, its rush to fait accompli would soon inflict mandatory auditor rotation or at least re-tender on global-scale companies.

Diligent digging through the Commission’s augean piles of paperwork makes clear that its ostensibly supportive “research” ranges from the shallow and irrelevant to a results-driven reflection of its confirmation bias.

Comes to mind A.A. Milne’s 1926 fable of Winnie-the-Pooh and his pal Piglet, earnest and naïve, circling their own tracks around a spinney of larch-trees, and befuddled in their speculation that they might be tracking a Woozle.

 

Despite a forthright bias in favor of “auditor switching” – reflected in the finding that “incumbent auditors … face less competition for their ongoing engagements than they would were the company more willing to switch thereby reducing rivalry” -- the Commission fails to elicit any evidence-based impact of auditor tenure on audit quality.

To be sure, the Commission’s inquiry into the rate of “switching” is voluminous – building elaborate calculations in search of relationships among such elements as client size, audit complexity, geographic spread, client evolution from private to listed status, length of tenure at the start of the measured period, etc.

Yet, it does not attempt to examine, much less resolve, these two related but distinct questions:

• With the considerable number of long-tenured auditor-client relationships where the record of non-controversial financial reporting is unbroken, is there any identifiable relationship between the length of auditor tenure and the incidence of diminished quality or “audit failure”?

• As to the extremely small population of actual “audit failures” – compared to the huge number of non-problematic audits – is there any identifiable relationship between the length of auditor tenure and such failures themselves?

Nor is the integrity of the Commission’s history of the profession any better than that of their economic research. Their lengthy discussion of the early audit requirements, evolving from the Joint Stock Companies Act 1844 through to the superseding Act of 1856, omits essential facts:

• First, the terms of the 1844 Act were met by “auditors” chosen from among the company shareholders – non-professional co-investors engaged to examine and report on their company’s results, with interests not independent but precisely aligned economically with their fellows. 

• Second, it was not until the dawn of the next decade that these amateur “auditors” reached out to the nascent profession for assistance – e.g., William Welch Deloitte, then aged 32, joined Messrs. John Dickinson and Richard Atkinson, the shareholder auditors of the Great Western Railway’s accounts for the six months ended December 31, 1849, in the terse opinion dated February 8, 1850 – “Audited and Approved.”

• Third, therefore, by the Act of 1856, developments in the market for independent audit had surged forward, making that legislation essentially reactive, in the same manner as today for government regulators typically late to the party. 

Shortcomings in the Commission’s approach include a rose-tinted survey of the mid-tier firms’ “self appraisals of their capability and willingness to audit FTSE 350 companies” – noting, however, that as of 2010, the Big Four audited 99 companies of the FTSE 100, and 96% by number and 99% by fees of the entire FTSE 350.

In that context, asking a mid-tier business developer about his firm’s capability to audit a global-scale FTSE 100 enterprise would be like asking a sophomore in a fraternity house how he’d like a date with the Sports Illustrated swimsuit cover model. What possible response could be expected?

My graduate-level course in Risk Management uses a reading exercise in what legitimate, non-ideological research ought to look like – drawn from the very Victorian era when independent audit was invented, on whose history the Commission is so dim.

It’s the 1855 diary of physician John Snow, whose meticulous tracking of epidemic cholera cases around the publicly-accessible water pump at Broad Street in central London ranks among the origins of forensic medicine.

Dr. Snow’s techniques made inquiry in both directions: Not only who got sick, after drinking water from the pump – including both residents and casual visitors to the neighborhood. But also, who lived and worked in the vicinity and yet stayed well – such as brewery workers who preferred their own product to pump water, and factory hands in a facility with a separate and independent well.

By so doing, Snow avoided precisely the trap of disregarding the “absent evidence,” into which the Commission’s ends-serving inquiry falls headlong.

Confronted by Christopher Robin’s challenge that they had been chasing their own footsteps, rather than the imaginary Woozle, Pooh had the grace to concede:

"‘I see now,’ said Winnie-the-Pooh.

‘I have been Foolish and Deluded,’ said he, ‘and I am a Bear of No Brain at All.’

…. And then he brightened up suddenly.

‘Anyhow,’ he said, ‘it is nearly Luncheon Time.’

So he went home for it." 

 

Commission group chairman Laura Carstensen and her fellows should do no less.

 

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Comments

[Tony. O]

Loved the article and the Pooh comparison.