Auditors – watchdog or bloodhound? A role reversal

THE auditor’s duty of care in relation to the audit was considered by Lopes in Re Kingston Cotton Mill Co (No 2) 1895 2 Ch 2 at pp 288-289: ‘It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective or was said to approach the work with suspicion or with a foregone conclusion that there is something wrong. He is a watchdog not a bloodhound.’

These famous words have become a watchword for accountants caught up in litigation. What is not encompassed by these words is that these words were echoed before the modern Companies Acts and in particular the Companies Acts 1948, 1967, 1980 and 2006. They were also echoed before the importance of the stock market in allocating resources in a capitalist economy.

It follows from this that developments in the use of financial information that the importance of accounts is such that this view of accountants in their role is inappropriate and that the auditor should now be regarded as a bloodhound given the impact which defective accounts can have for investors, creditors and users of accountants.

It also fails to take into account that the accounting profession has developed significantly since the famous statement of Lopes L J. Accountants firms are now much bigger and academic learning has improved dramatically since the author first qualified as an accountant in the early 1970s.

In the early 1970s there were only two routes for newly qualified accountants – audit and tax. Since then there has been a growth in the role accountants play in financial planning, consulting of all descriptions and in the US an accountancy firm even offered to design a golf course. These developments have spurred a growth in the possibilities of conflicts.

This has been recognised by the profession, which now requires the larger firms to split off their audit function from their other activities. This is in recognition of the potential of the real conflicts experienced in the larger firms. It also recognises that there have been a number of accounting scandals over the last five years of which the Wirecard fraud is just one. Users of accounts are entitled to rely on accounts given the large sums of money incurred on the audit function and its related corollary the audit committee. It is hoped this development will result in greater efforts by the profession to reduce the number of scandals.

One area that should be looked at is the so called letter of representation which auditors require from the directors of the companies they audit. This letter arises because the auditors in effect audit the accounts of the directors. The directors are required in this letter to confirm all the material figures in the accounts and provides a classic ‘get out of jail free card’ when accounts are found to be defective. One suggested improvement would be for the accountancy profession to reform the reliance that can be placed on this letter. Another area which might be reformed is the matter of audit fees, which are currently discharged by the company on behalf of the directors.

In addition to separating the audit function, the accountancy regulators have issued proposals that will ensure auditors will be more responsible for detecting fraud in the accounts they audit. In this vein, the European Securities & Markets Authority has criticised the German regulators for their ‘deficient’ handling of the Wirecard accounting scandal. In particular they have focused on the ‘red flags’ over Wirecard’s financial reporting over the years.

The separation of the audit function and the increased pressure on auditors to detect fraud means that auditors are now increasingly being regarded and treated more like bloodhounds and not like compliant watchdogs. This is to be welcomed to say the least.

However, parallel to this development the larger accountancy firms are becoming more like ‘bloodhounds’ by growing their management consultant arms but more particularly their legal capabilities. The Financial Times reported recently that one large accounting firm had acquired a law firm which specialised in technology. This follows the trend of other larger accounting firms which have acquired, by organic growth or otherwise, substantial law practices. This development in the Financial Times noted on 4 November 2020 that as a result of this acquisition the large scale and access to technology platforms threatens some mid-tier law firms that rely on providing process-driven legal advice but have large fixed costs and charge higher fees. A few years ago, in 2015, the Royal Bank of Scotland warned that accountancy firms were ‘quietly’ starting to take market share from established mid-market law firms that were not able to invest in the technology required to compete.

In conclusion, the traditional view that auditors are only required to be watchdogs, not bloodhounds, is outdated. However whilst these developments will be good for users of accounts there is a parallel development which threatens to undermine these welcome developments. The larger firms have developed other areas such as management consultancy activities, taxation and are now increasingly developing their legal practices.

These threaten consumers and users of accounts by reducing choice and potentially giving rise to new conflicts. These recent developments should be carefully monitored by regulators as a matter of some priority and acting not as watchdogs but as bloodhounds.