This is an audio transcript of the Behind the Money podcast episode: ‘Why auditors are missing red flags’
Michela Tindera
Over the last decade or so, wells Fargo has spent a lot of time in the headlines.
News clip
Breaking news tonight. Bank bombshell. Thousands of employees caught opening over a million accounts and credit cards without customers’ consent. Some charged fees they didn’t even...
Stephen Foley
It was one of the biggest banking scandals of the last decade.
Michela Tindera
That’s the FT’s US accounting editor, Stephen Foley. And he says, you might remember this Wells Fargo scandal that broke in 2016.
Stephen Foley
More than 1.5mn unauthorised accounts, half a million credit card applications were created by these stressed salespeople at Wells Fargo. And its billions of dollars of fines.
News clip
Relentless pressure, unrealistic sales targets, a culture built on selling as many products to customers as possible.
Stephen Foley
The revelation of systemic fraud, systemic wrongdoing across this bank was a huge shock to the system, and the banking regulators have come down on Wells Fargo like a ton of bricks.
Michela Tindera
That’s billions of dollars in shareholder value wiped out. Executives were ousted. And one of the most surprising revelations was the role that the bank’s auditors played, or rather, didn’t play.
Stephen Foley
The shock to a lot of people is to discover that the auditor, KPMG, was aware very early on of some of these internal investigations into the fake accounts scandal, but it was never flagged to investors before it mushroomed into this huge crisis.
Michela Tindera
But KPMG’s failure to flag these problems isn’t the only thing that’s been upsetting regulators and investors. Decade after decade, shareholders have raised concerns about how rare it is for auditors to catch corporate fraud. Think of Enron’s collapse in 2001, or more recently the German payments processor Wirecard in 2020. But Stephen says it isn’t just these headline-making cases. Regulators are seeing more and more flaws in the audits that they’re inspecting, and there are numbers to back it up.
Stephen Foley
We have a very big inspections program in the US that goes and samples some of the most contentious audits. And in the last year, the number of deficiencies that the inspectors found at the Big Four audit firms rose from 20 per cent to 30 per cent. It’s been climbing since Covid.
Michela Tindera
So now regulators are trying to do something about it. But will it be enough to actually prevent another Enron or Wirecard or Wells Fargo?
[MUSIC PLAYING]
I’m Michela Tindera from the Financial Times. Audit firms are supposed to put a company’s books under the microscope. But after a string of scandals, regulators say it’s the auditors who need to be examined. Today on Behind the Money, we’re looking at why auditors might miss these kinds of red flags and how regulators are trying to change the status quo.
[MUSIC PLAYING]
Hi, Stephen, welcome to the show.
Stephen Foley
Thank you very much.
Michela Tindera
So for anyone listening who doesn’t work in the audit industry, can you help us understand what an auditor’s job consists of? What do they do with their, say, 40 hours a week?
Stephen Foley
Oh, if only it was 40 hours a week.
Michela Tindera
OK.
Stephen Foley
Every auditor has just shouted at the podcast right now. It’s many, many more hours than that during busy season. So every company that puts out financial statements has to have an audit. An independent external accounting firm has to come in and say, yes, we have checked that these financial statements represent a fair and accurate picture of the company’s financial state, that it’s free from material error due to fraud or mistakes in the accounting. So they’re very often onsite across these companies. They’re going in and checking the financial systems and making sure that some of the bank accounts that claim to exist exist. They are, I think from the companies’ point of view, sometimes seen as a necessary evil.
Michela Tindera
And how important is it to have these records that the auditors sign off on?
Stephen Foley
Auditing — absolutely fundamental to the functioning of the capital markets. They offer a level of reasonable assurance that these are accurate financial statements. And that means that you and I and our pension funds can go about investing in the capital markets with more confidence than would otherwise be the case.
Michela Tindera
Right. It’s probably hard to overstate then just how crucial a role auditors play when it comes to investors’ decision-making. But of course, we’ve seen these examples time and again where auditors seem to have missed these big disasters at certain companies, you know, Wirecard, Enron, Wells Fargo. So why are auditors missing these things? You know, why don’t audit firms follow through on these sorts of issues when they come up in their own processes?
Stephen Foley
I think there’s two things going on. I think in some cases the regulations just don’t require auditors to do the kinds of things that investors expect them to be doing. And that’s a problem. In a lot of cases, of course, the auditors are just falling down on the job, not living up to their professional responsibilities. Just as I was starting to cover the accounting profession for the Financial Times, one of the first things I did was sit down and read a lot of regulatory enforcement actions against auditors to look at what does go wrong. And they’re all very human stories. If you read the legal documents, you know, it’s all a group of people trapped in a room at five minutes to midnight, with the company shouting at them that they’ve got a deadline to file their financial results. You know, there’s a lot of pressure on auditors and a lot of reasons why you might just skimp on that last step.
Michela Tindera
What are some of those reasons?
Stephen Foley
So, I mean, there’s a, it’s a tough job, right, because they are operating to very, very tight deadlines. And very often what we’re finding in the cases of faulty or deficient audits, we’re just discovering that people don’t follow the paper trail sufficiently vigorously. Regulators are often saying that auditors fail in their duty to show professional scepticism of some of the things that they’re told by management. And they don’t follow the red flags that sometimes they are seeing.
Michela Tindera
So what’s the current state of regulation in this industry? I mean how regulated is it?
Stephen Foley
This is a heavily regulated business. There are many, many auditing standards in every country that set out the roles, the responsibilities of auditors. In recent years in the US, for example, the PCAOB, which is the US audit regulator that stands for the Public Company Accounting Oversight Board, has not been especially vigorous in its enforcement. And we are, right now, in a period where regulators are thinking they need to tighten up.
Michela Tindera
So, Stephen, I know you’re based in New York here. But how prevalent are these sorts of deficiencies that you’re referring to? I mean, is this just a US problem?
Stephen Foley
No, I mean, far from it. There’s been a number of very high-profile examples in the UK of incredibly disappointing audits, most notably of the public sector contracting firm Carillion, which collapsed, and KPMG, the auditor there, paid a record fine for deficiencies in its audit. We’ve definitely got ourselves into a position where regulators feel that current regulations are not being followed sufficiently to the letter. There’s a big push by regulators, not just in the US, but around the world, to really clarify and modernise the standards.
[MUSIC PLAYING]
Michela Tindera
So regulators around the world are putting together more stringent policies for the audit industry, and the impacts could be far-reaching. After the break, we’ll take a closer look at these new rules and also examine why audit firms are pushing back against them.
[UNTOLD: POWER FOR SALE TRAILER PLAYING].
Michela Tindera
Stephen, the audit industry is failing to spot wrongdoing and it’s to the detriment of investors. So what are regulators doing to fix these problems?
Stephen Foley
So I think of it in two buckets. There’s a very big push to clarify and modernise the audit standards. A lot of them in the US, for example, they haven’t been modernised for decades. So it’s good to do a refresh of this. Also in a period where there perhaps has been a number of years of lax enforcement, I think the sort of the re-emphasising of auditors’ responsibilities and roles is very important. And you see that in the standard-setting agenda of the PCAOB over here, but there’s also efforts internationally — in the UK, as well — to clarify the role of the audits. So that’s one bucket.
Michela Tindera
OK. Sure. So the first thing is just confirming that everyone’s abiding by the existing standards. So what’s the second one?
Stephen Foley
The other is to add new responsibilities to the auditor and to add new standards and new expectations on the auditor. And of course, that’s where it gets more contentious. The biggest and most contentious issue over here in the US is a proposal from the PCAOB to expand auditors’ role in discovering non-compliance with laws and regulations. Now, of course, that’s . . . fraud as part of it, but it’s also other things like banking regulations, environmental regulations, other kinds of wrongdoing that might be a little bit like, you know, turning over a rock and seeing one co*ckroach. Maybe there’s more. And the regulator’s view is that the auditor needs to expand the net of what it is looking for and be much more vigorous in drawing it to the attention of boards of directors and potentially even investors.
Michela Tindera
And so what might that look like, practically speaking?
Stephen Foley
Well, this, I think, is where the Wells Fargo example is most pertinent. It’s one of the reasons why regulators and investors who are backing this change keep bringing up Wells Fargo. A wider net, looking for regulatory non-compliance would have forced the auditor to turn over more rocks, to do more with the information that it had. It would have given them very specific instructions about what to bring to the audit committee’s attention and investors’ attention and when.
[MUSIC PLAYING]
Michela Tindera
OK. So this would make auditors more responsible for catching fraud and other wrongdoing. But you said that the proposals are contentious. How so?
Stephen Foley
Not my job, governor, is kind of the response of auditors. They think that compliance with laws and regulations is the responsibility of the compliance departments, of management, of companies, and that they’re in the best position to make sure that a company is complying with these. Auditors keep saying, we are not lawyers. We are not going to be able to know whether this is a violation of a regulation or a law. And you’re asking us to come in and be lawyers. You’re going to make us have to hire a lot of lawyers, and that’s going to drive up cost.
Michela Tindera
And what do regulators say to that criticism?
Stephen Foley
Regulators are pushing on. They say it’s very important for all of the reasons we’ve talked about. There’s billions of dollars of investor value at stake. And by the way, investors think this is what they’re getting from an audit anyway. There’s always been talk for generations about expectations gap. This is a phrase in the profession, the difference between what an audit is and what investors expect it to be. And auditors keep saying we’re not a guarantee. We are only doing reasonable assurance. We’re not looking for everything. We’re only looking for stuff that is material to this year’s financial statements.
I talked to regulators like the chief accountants at the SEC who says to me, I’m fed up of hearing from auditors what they don’t do. It’s time. And this is one of the reasons we have this regulatory push. It’s time to be really clear about what auditing is and should be looking for and to really get investors what they think they’re paying for.
Michela Tindera
So there’s a question that’s often raised when people are talking about failures in the audit industry, and it’s that they bring up this idea of conflict of interest. You know, a company pays an audit firm to be audited, making the company an audit firm’s client. And, well, you know, you typically want to make the client happy, right? So how does that relationship play into just some of these concerns that we’ve already been talking about here?
Stephen Foley
Well, look, it’s a great question. And that is probably the central question. You know, you’re absolutely right that auditors are hired and paid by the companies that they audit. It reminds me, actually, of covering the credit rating agencies back during the financial crisis, because of course, they were putting credit ratings on bonds where they’d been paid by the bond issuer. And it turned out they were overly rosy. They were pleasing their clients. So there is a fundamental question over the model. And actually, from time to time, some pretty clever academics have a big think about whether there’s a different model that might work.
Michela Tindera
And what sorts of things have they come up with?
Stephen Foley
Well, actually, I was just rereading a suggestion that the NYU professor Joshua Ronen has been touting for a decade or two. This idea of financial statement insurance where a company would pay a premium and an insurer would assign the auditor, would pick the auditor, and people would be able to tell from how big the premium was whether people’s financial statements were risky or not risky.
Michela Tindera
So how likely is it that something like that would ever actually be implemented?
Stephen Foley
Well, let me put it this way: 15 years later, the credit rating agency model is still exactly the same. I’d put a bit of money on the audit model being about the same in 15 years too.
Michela Tindera
So we’ve talked about auditors’ resistance to these incoming regulations and how regulators are trying to push ahead despite it. So how can we expect for this to play out?
Stephen Foley
Well, the regulatory agenda is being pushed vigorously. I think there will be new regulations. The question is, I think there will be some compromises around the edges. I think everyone on both sides would like the regulation to be workable and not break the bank when it comes to audit fees. But I think that regulators globally are very committed to this agenda to modernise and in some cases enhance auditor responsibilities because we do see that the consequences of audit failures are significant.
Michela Tindera
And roughly, what’s the timeline looking like here?
Stephen Foley
It’s kind of an ongoing effort, frankly. There’s a very big agenda in the US because we have had a backlog of regulation regulations just not being updated. So that agenda for the PCAOB is very packed this year; will be very packed again next year. But I do think that regulation is going to have to keep evolving because the audit profession is keeping on evolving. The audit of today is very different from the audits of 10 or 15 years ago. There’s many, many more tools you can use to look for red flags in the data. So audit is changing quite fast. To drop the topic du jour of AI, there’s all sorts of new techniques that will evolve in the coming years as AI rolls out further. So yeah, regulation is going to have to keep evolving to keep up.
Michela Tindera
So how big of a deal is it that these regulations come through? What are the stakes here?
Stephen Foley
How big are the stakes? I think the audit, as we talked about right at the beginning, it’s fundamental to trust in the capital markets. So we’ve got to get this right.
Michela Tindera
Stephen, thanks for being here.
Stephen Foley
Thank you very much. It’s been fun.
[MUSIC PLAYING]
Michela Tindera
Behind the Money is hosted by me, Michela Tindera. Saffeya Ahmed is our producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Our contributing producer is Max Johnston from Goat Rodeo. Special thanks to Mischa Frankl-Duval. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.
