The Supply for Audit & Scandals Flashcards
Is Auditing a profession or a business
Professional aspects:
* Requires specialized knowledge and qualifications
* Bound by ethical standards and codes of conduct
* Expected to maintain independence and objectivity
* Committed to public interest
Business aspects:
* Operates in competitive market for profit
* Subject to economic pressures and client demands
* Must maintain financial viability
Key point: The tension arises when professional obligations conflict with business objectives.
Conflict: Professional standards increase costs → reduce short-term profits
Example: Auditor pressured to issue clean opinion vs. risk lawsuits
What are the four pillars of auditing professionalisim
Technical Competence:
* Proper qualifications (e.g., CPA)
* Continuing education
Ethical Standards:
* Integrity and objectivity
* Confidentiality
Quality Standards:
* Following GAAS/ISA
* Thorough documentation
Independence:
* Both in fact and appearance
* Free from conflicts of interest
Example: An auditor must disclose any financial interest in a client.
How does the profit motive create challenges for audit quality
Short-term pressures:
* Fee competition leading to underbidding
* Client retention concerns
* Time/budget constraints
Potential consequences:
* Reduced audit testing
* Overlooking issues
* Opinion shopping
Mitigation: Strong quality control systems and partner oversight.
What are the real world example of professional vs business tensions
Situation: Auditor discovers material misstatement but client threatens to switch firms if modified opinion is issued.
Professional response: Modify opinion but risk losing client
* Insist on proper opinion
* Document all findings
* Be willing to resign
Business pressures: Issue clean opinion and risk future liability
* Potential loss of fees
* Damage to client relationship
* Impact on firm revenue
Resolution: Ethical firms prioritize proper reporting despite short-term costs.
Why does professional standards ultimately benefit audit firms
Reputation capital:
* Builds trust with stakeholders
* Differentiates quality firms
Risk mitigation:
* Reduces litigation exposure
* Avoids regulatory sanctions
Sustainable practice:
* Attracts better clients
* Supports premium pricing
Professional satisfaction:
* Pride in quality work
* Industry respect
Key quote: “In auditing, ethics are the foundation of long-term success.”
What are the 6 main factors that influence audit fees
Client Size - Larger companies = more transactions = higher fees
Complexity - Complex structures/industries require specialized work
Business Risk - High-risk clients need more audit scrutiny
Auditor Reputation - Big Four firms charge premium fees
Bargaining Power - Sophisticated clients can negotiate discounts
Cross-Subsidization - Bundling with other services affects pricing
Example: A multinational bank pays higher fees than a local retailer due to size, complexity and risk factors.
Who exerts pressure to reduce audit fees and how?
Clients (Directors):
* Directly negotiate fees to cut costs
* Initiate tender processes (“beauty contests”)
Shareholders:
* Prefer cost savings despite needing quality audits
* Limited direct control over fee decisions
Real-world impact: 73% of FTSE 350 companies put audits out to tender at least once per decade (UK FRC data).
What are the 3 methods that drive audit fees down
Tendering
Competitive bidding forces price cuts
Firms undercut rivals to win mandates
Low-Balling
Artificially low initial fees
Recouped later via fee hikes/other services
Opinion Shopping
Clients seek lenient auditors
Creates unethical fee pressure
Regulatory response: EU mandates audit rotation to reduce low-balling.
How have audit firs responded to fee pressures
✔ Mergers & Consolidation
Big 8 → Big 4 via mergers
Achieve economies of scale
✔ Internationalization
Serve global clients efficiently
Access cheaper labour markets
✔ Diversification
Offer non-audit services
Cross-subsidize audit work
Trade-off: Potential quality concerns from excessive cost-cutting.
Why is fee pressure problematic for audit quality
Under-resourcing:
* Fewer hours spent per audit
* Less experienced staff assigned
Conflict Risks:
* Fear of losing clients may compromise independence
* “Race to the bottom” in standards
Regulatory Concerns:
* PCAOB inspections find more deficiencies at low-fee audits
How can firms balance quality and profitability (Audit Fee Paradox)
Technology Adoption:
* AI/data analytics improve efficiency
Specialization:
* Industry expertise justifies premium fees
Value Pricing:
* Emphasize quality over cost
Transparency:
* Disclose fee breakdowns to regulators
How has the audit market structure evolved
- 1980s: Big 8
- 1990s: Mergers → Big 6
- 2002: Andersen collapse → Big 5 → Big 4
- 2022: Big 4 audit 97% of FTSE 350 companies
Example: EY’s 2022 plan to split audit/advisory shows regulatory pressure
What are the main 4 problems with Big 4 dominance
Oligopoly Power
Fee-setting influence
Reduced competition
Cross-Selling Advantage
Audit knowledge boosts consulting sales
Creates conflicts of interest
Barriers to Entry
Smaller firms can’t compete for large clients
Independence Risks
“Cozy” long-term client relationships
What major reforms addressed concentration
2002: Sarbanes-Oxley (US)
Restricted non-audit services
2014: EU Audit Reform
Mandatory rotation (10-20 years)
Caps on non-audit fees (70% of audit fee)
2020: UK CMA Proposals
Operational separation of audit/consulting
Current Status: EY’s 2022 split plan underway
How did major failures impact regulation
- Enron/WorldCom (2001-02)
Exposed audit failures
Led to SOX reforms - Carillion (2018)
UK contractor collapse
Prompted UK operational separation
Data Point: Carillion paid KPMG £29m in fees but received clean audits before collapse
How can concentration issues be mitigated
✔ Joint Audits
Big 4 + mid-tier firm share work
✔ Audit-Only Firms
Pure-play audit specialists
✔ Enhanced Oversight
FRC/PCAOB stricter inspections
✔ Tech Enablement
AI tools help smaller firms compete
Example: France requires joint audits for large companies
BBCI Scandal (Early 90s)
What were the key audit failures and impacts of the BCCI collapse
- Dual-Audit Failure: Price Waterhouse and Ernst & Young both audited different parts of BCCI’s operations, creating oversight gaps in the bank’s 70-country network. Neither firm had complete visibility.
- $10-17 Billion Losses: Fraudulent activities included money laundering and hidden losses across jurisdictions. When uncovered, it was one of history’s largest bank failures at the time.
- Structural Flaws: No “home” regulator for this multinational bank allowed risks to go undetected.
- Outcome: Price Waterhouse became sole auditor post-collapse, but the scandal exposed critical weaknesses in auditing global financial institutions.
Key Quote: The UK Bingham Report called it “a scandal on a scale unparalleled in modern financial history.”
How did Enron’s (2001) collapse fundamentally change auditing
- Accounting Tricks: Used Special Purpose Entities (SPEs) to hide $30+ billion in debt while reporting fake profits.
- Andersen’s Role: Approved questionable accounting, then shredded documents during investigations (obstruction charge).
- Domino Effect: Andersen’s conviction (later overturned) destroyed the firm - 28,000 jobs lost within months.
SOX Reforms:
Created PCAOB for audit oversight
Banned most consulting services for audit clients
Required audit partner rotation
Modern Parallel: Similar to EY’s current split of audit/advisory businesses.
What did Parmalat, Carillion and Patisserie Valerie reveal about EU auditing
Parmalat (2003):
“Europe’s Enron” with fake €4 billion bank account
Exposed auditor over-reliance on management representations
Carillion (2018):
KPMG missed aggressive accounting on £1.5B contracts
Prompted UK’s 2020 operational separation rules
Patisserie Valerie:
Grant Thornton failed to detect £94M fraud
Showed weakness in cash verification procedures
Regulatory Shift: EU’s 2014 mandate for audit firm rotation every 10-20 years.
Why was London Capital & Finance (2019) a watershed for auditor liability
Ponzi Scheme: Sold £237M in mini-bonds to 11,600 investors using false promises.
PwC’s Role:
Fined £15M by FCA (largest ever at the time) for failing “whistleblowing” duty
Missed 25+ red flags in “dubious” financial promotions
New Precedent: Established that auditors must proactively report suspected fraud to regulators.
Current Impact: FCA now requires stricter monitoring of high-risk investments.
What lasting changes resulted from these scandals
Governance:
Audit committees now must pre-approve all non-audit services
Mandatory cooling-off periods before auditors join clients
Transparency:
Expanded audit reports must describe key risks
PCAOB/FRC inspection reports made public
Accountability:
FRC fines increased 10x since 2010 (max now £50M)
Individual auditor sanctions (e.g., license suspensions)
Market Structure:
UK’s 2021 “Audit Reform White Paper” proposes shared audits
Ongoing Debate: Whether reforms have actually improved audit quality.
