How to pay auditors without conflict of interest

Anthony Hilton
16 Mar 2010

Ernst & Young, the auditing firm, had a nasty few months when it was sued for several billion pounds over its role as auditor to Equitable Life, the insurance group which had a near-death experience a few years ago. In the event the case was thrown out and life carried on much as before.

Now the firm finds itself again uncomfortably in the spotlight following the report just published in the United States into the collapse of Lehman, where E&Y was the auditor.

The report highlights the way in which Lehman exploited the differences between British and American law to do transactions here which gave the impression in its American accounts that it was healthier than it was.

The report also talks at some length about the treatment of a Lehman employee turned whistleblower, who wrote a letter which apparently gave voice to his concerns about such practices.

Now the Financial Reporting Council, the body which oversees the accounting and auditing profession in the UK, has asked Ernst & Young to give it its side of the story.

At this point it is too early to know what when on between Ernst & Young and Lehman, and we must not pre-judge the outcome.

It is inevitable, however, that people question whether the firm was sufficiently robust in its dealing with the bank.

Such doubts do the image of the auditing profession no good at all but it is inevitable that such questions will be asked after every high-profile collapse unless and until something is done about the way auditors are paid.

Their role (in this country) is to give their opinion to the owners of the business on whether the accounts prepared by the directors present a true and fair view of the results for the year.

Their responsibility is to the shareholders but they are paid by the company and, though shareholders vote on the appointment of the auditors, if the company board wants to fire the firm it can usually do so without too much difficulty.

The method of paying the auditor is therefore not that dissimilar to the rating agency which exists to provide guidance to investors but which gets paid by the company to put a credit rating on its bonds.

Since the sub-prime debacle and the credit crunch and the exposure of the failings of credit agencies in their assessment of mortgage-backed securities no one defends the payment model any more, albeit they cannot come up with a better one.

The conflict of interest is obvious.

Perhaps therefore it is time for auditors to be paid differently so there is no possibility of conflict of interest when they are paid by the people they are supposed to be keeping a check on.

It would be a simple matter for auditors to be paid by the FRC when their work was done. The FRC could then either recover the money from the company directly or via some industry-wide levy.

The advantages of this are huge. First it would remove the conflict. Second it would allow the FRC to spread audit work around so that some of the middle-sized firms could grow to challenge the unhealthy monopoly of the big four. Third it would be much easier to keep a check on the non-audit activities — tax and consultancy — provided by accounting firms which have also been known to cause conflicts.

Indeed it is hard to think of any reasons against – apart perhaps from the self interest of the big audit firms.