Introduction
In recent years, UK accountants and auditors have faced intense scrutiny. Criticisms stem from high-profile audit failures involving major corporations, emerging conflicts of interest, and persistent concerns over auditor independence. Notable cases underscore these issues:
Carillion (2018): The construction giant collapsed with over £7 billion in debts, despite receiving unqualified audit opinions.
Thomas Cook (2019): The travel firm’s demise followed prolonged financial distress, raising questions about auditors’ risk detection.
Patisserie Valerie (2019): A £94 million fraud was uncovered in the accounts—a discrepancy auditors failed to flag.
In each case, auditors were expected to challenge management independently. Yet these incidents reveal a troubling pattern: if issues arise even with external, unaffiliated auditors, what happens when audit firms themselves are owned by private equity (PE) and tasked with auditing companies within the same ownership structure?
It is important, however, to distinguish between the audit function and other areas of accountancy. While maintaining auditor independence is critical for audit work, private equity investments in non-audit services—such as accountancy, consultancy, tax, and advisory services—can drive innovation, efficiency, and technological advancement.
The Growing Influence of Private Equity
Anecdotal evidence suggests a growing trend in the UK accountancy sector: increasing private equity investment in both audit and non-audit areas. While PE involvement in the non-consulting aspects of accountancy can inject vital capital for growth, modernisation, and innovation (particularly in the AI age), significant concerns arise when these investments extend to the audit function.
Consider this scenario:
Private Equity Company X owns Audit Firm Y.
An auditor from Firm Y audits the accounts of Company X.
This mirrors an internal auditor signing off on external accounts—a clear compromise of the independence vital to public trust.
The Role of Internal Auditors vs. External Auditors
To grasp the conflict, contrast the roles of internal and external auditors:
Internal Auditors:
Employed within a company, they focus on internal controls, compliance, and operational improvements. While their insights aid management, their position within the organisation exposes them to internal pressures. Consequently, internal auditors are barred from approving public financial statements.
External Auditors:
Independent third parties verify financial statements for external stakeholders. Regulatory frameworks, enforced by bodies like the Financial Reporting Council (FRC), mandate complete independence from audited companies.
The Ethical Dilemma
The ethical issue is clear: auditors must act impartially to ensure that financial statements are unbiased and accurate. When an audit firm is owned by private equity and audits companies within the same ownership structure, the risk of bias escalates, undermining the independence standards designed to protect the public interest.
Even if actual bias does not occur, the mere perception of a conflict can erode trust among investors, regulators, and the public. The FRC’s recent letter (26 September 2024) reinforces these principles, stressing that both perceived and actual compromises to independence undermine the credibility of financial reporting.
Why Public Trust Matters
The financial system relies on trust. Stakeholders depend on auditors’ rigorous independence for assurance. If trust is compromised—through conflicts or perceived bias—the entire reporting ecosystem is jeopardised. Public confidence in market fairness hinges on auditors free from undue influence.
The FRC’s Perspective and the Way Forward
While the FRC’s letter acknowledges the challenges posed by private equity involvement, further action is needed to strike a balance between safeguarding auditor independence and fostering innovation through investment. Some potential measures include:
Enhanced Disclosure Requirements:
Companies House has recently emphasised the importance of full disclosure of company structures. While not all audit firms are limited companies, I believe that all audit firms should be mandated to publicly disclose their detailed ownership structures and any direct financial relationships with PE investors. This level of transparency would enable stakeholders to assess potential conflicts of interest effectively.
Operational Firewalls:
Establishing strict internal separations between the audit practice and other business functions—where private equity investments may drive growth (e.g. accountancy, consultancy, and tax services)—can help mitigate the risk of undue influence.
Mandatory Auditor Rotation & Engagement Restrictions:
Introducing policies that require regular rotation of audit firms—especially in scenarios where conflicts with PE ownership might arise—could further preserve independence. Additionally, guidelines might restrict audit firms from accepting engagements involving entities directly linked to their PE owners.
Regular Compliance Reviews:
As technological advancements such as AI reshape the industry, instituting periodic independent reviews of audit firms can ensure that reliable safeguards remain effective and are updated in line with emerging risks, particularly.
Balanced Safeguards:
It is crucial not to throw the baby out with the bathwater. While robust measures must be in place to protect auditor independence, these should be balanced with the recognition that strategic private equity investments in non-audit areas are essential for driving growth, innovation, and efficiency in the modern accountancy landscape.
Mitigating Risks Associated with Private Equity Investments:
In scenarios where private equity is involved in non-audit areas, strong bookkeeping practices can serve as a safeguard. By maintaining rigorous standards in record-keeping, bookkeepers might help mitigate the risk of errors or manipulations that could compromise the audit's independence and credibility.
Conclusion
Allowing an in-house auditor to approve external accounts would be unthinkable due to inherent conflicts of interest. Therefore, it is imperative that any private equity involvement in the audit function is carefully regulated. By implementing measures such as enhanced disclosure, operational firewalls, auditor rotation, and regular compliance reviews, the industry can safeguard public trust without stifling the beneficial capital that drives innovation and growth in non-audit areas. As the FRC’s letter from 26 September 2024 highlights, achieving this balance is critical to maintaining the integrity of financial reporting in an ever-evolving sector.
References:
Financial Reporting Council (FRC)
General information: FRC Website
FRC Letter on External Private Capital and Audit Firms (26 September 2024)
Investigation into the Audit of Patisserie Holdings PLC (2022)
Carillion (2018)
Carillion: Second Joint Report
Joint report by the BEIS and Work and Pensions Committees, UK House of Commons (16 May 2018)
FRC case updates on Carillion audits (including fines against KPMG, Deloitte, EY, PwC)
Thomas Cook (2019)
Independent Review of Thomas Cook’s Financial Reporting and Audit
By Sir John Kingman (2020) – UK Government Independent Review
Thomas Cook: Lessons Learned – House of Commons Transport Committee Report (2020)
Patisserie Valerie (2019)
Investigation into the Audit of Patisserie Holdings PLC
FRC report (2022)
Patisserie Valerie Administration Report – Insolvency Service (2019)
Insolvency Service Case Studies
Media coverage: Refer to reputable outlets such as the Financial Times (e.g. “Patisserie Valerie’s £94m black hole: How the fraud unfolded”), BBC, or The Guardian.
Comments