Hi

The legendary Don Hanson, who was managing partner at Arthur Andersen in Manchester in the 1970s and 80s, famously described an auditor as someone who enters the fray when the battle is over and bayonets the wounded.

His meaning was clear: being the subject of an audit of your actions and decision-making was not a pleasant experience. It was, however, the price to pay for limited liability and having investors - who were not engaged in the day-to-day running of the business - to whom the directors and managers were accountable. 

It was a rigorous process and frequently resulted in the directors having to amend their financial statements and report additional information to investors.

I shudder to think what Don would make of the state of the audit profession today. With only four large auditing firms, and a handful of medium size firms, remaining the standard of auditing has deteriorated to a woeful extent. Multimillion pound fines levied against the big four firms of accountants who carry out most audits now seem commonplace and hardly raise an eyebrow.

Successive governments have pledged to overhaul the financial reporting and auditing sector but, despite their lofty words, have failed to bring forward any substantive legislation. Auditing has largely become a box ticking exercise to confirm compliance with financial reporting standards, which are themselves incomprehensible to the average reader of accounts.

More worryingly has been the spate of business failures shortly after auditors have given a business a clean bill of health resulting in millions of pounds of losses to creditors and other stakeholders.

Against this backdrop an even more insidious trend has developed recently. Private equity firms have taken, and are actively looking to take more, stakes in auditing firms.

The leveraged buyout, as it was called then, was invented in the 1980s to be renamed as private equity in recent years, but with fundamentally the same aim. A private equity firm raises money from investors to create a fund, then creates a shell company that borrows against that fund, to buy or invest in a target business. The private equity firm merges their shell company with the target business and the debt ends up on the books of the target business.  

There is, however, nothing that too much money cannot spoil.

These private equity funds borrow at near zero rates of interest and purchase or invest in businesses with the intent to cut costs and payroll and flip them quickly. 

Between 2000 and 2022 the number of private equity firms rose from fewer than 3,000 to nearly 15,000 and the amount of money they manage rose by more than 1000% to almost $10 trillion. By the end of that period the typical business managed by a private equity firm had debt 5½ times higher than its annual earnings – or twice the level that ratings agencies would consider junk.

As well as this eye-wateringly high-level of debt, the problem with private equity is that the funds set up to raise money from investors typically have a lifespan of no more than 10 years, meaning that the private equity firm can only invest for a relatively short period of time, and will need a dash for growth, to cut costs and sell off assets to repay the debt they have borrowed and make a return on their investment.

It is unlikely that private equity investors will have a deep understanding of auditing and its objectives, and the public interest requirement to deliver audit quality. Even if they do, their overriding duty is to their investors – not, as it should be, to the stakeholders of the businesses that are being audited.

It is also worth questioning why the partners in the firms of auditors feel the need for third-party investors? It is argued that they need investors money to fund their investment in technology and AI – but these firms are already hugely profitable (the average annual profit share of a Deloittes partner is in excess of £1m). If only a proportion of these profits were re-invested, rather than withdrawn by the partners which is the current practice, significant funds for investment would be available.

It is to be hoped that the regulatory authorities, in the UK at least, prevent this trend from developing further. The quality of auditing is already too low to be damaged further by irresponsible financial engineering.

Noel Guilford