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A blog by Leon Oudejans

Is auditing a failing pyramid scheme?

20 June 2018

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Last Monday, the UK industry regulator for audit firms (FRC) published a critical report. The FRC report “says the overall quality of the audit profession is in decline” and one firm experienced an “unacceptable deterioration” in the quality of its work (Guardian). As a former auditor, I suddenly got a strange notion: is auditing a failing pyramid scheme?

The business model of audit firms roughly is like this: 

1. Organisation: a pyramid with few on top, supported by a constant influx of new recruits;

2. People: top-earning partners and well-paid staffers, who work exceptionally long hours;

3. Clients: (i) inadequate fixed fees for top-notch clients, and (ii) hours x top rates for clients that are not able to negotiate, for whatever reason (eg, due diligences, investigations);

4. Profits: the big profits are in the 2nd group of clients (“the feast“).

This reminded me of a pyramid scheme: “A pyramid scheme is an illegal investment scam based on a hierarchical setup. New recruits make up the base of the pyramid and provide the funding, or so-called returns, the earlier investors/recruits above them receive.” Note LO: italic markings in quote by me.

American novelist John Grisham had a similar notion in his 1991 book and 1993 movie The Firm. At “my” audit firm, some of the partners were thrilled by this new book. They recognised similarities in the underlying business models, and recommended this book to new recruits, like me. Fortunately, overbilling and money laundering were unfamiliar, unlike The Firm.

The decline in the overall quality of the audit profession is “firmly” rooted in its business model: client fees are often fixed, hours spent are variable, and hourly rates are ever-increasing. The quotient between Cost of “Goods” Sold and Sales is called the realisation rate. Partners and managers must maximise this benchmark, by maximising billings and minimising hours spent.

The ongoing efforts to minimise hours spent has resulted in several changes, like methodology (eg, risk management) and computer-assisted audit techniques (CAATs). In principle, comprehensive audits no longer exist. However, such efforts have mainly caused increased reputation risk for audit firms, following ongoing audit scandals (eg, GuardianTimes).

Once, the founders of the audit profession saw auditing as a public service (Guardian). Today, audit firms are commercial enterprises. However, industry regulators are moving back to the founding principles in order to (i) minimise audit scandals and (ii) restore public trust. Most likely, this difference of opinion will create a bend-or-break situation.

Recent news suggests that the UK might be the first country breaking up the audit oligopoly. Unfortunately, big “audit only” firms may have a (loss-making) business model that is too risky and unsustainable. The solution might be: better the devil you know than the devil you don’t.

Walk Like an Egyptian (1986) by The Bangles

artists, lyrics, video, Wiki-1, Wiki-2

All the old paintings on the tomb

They do the sand dance, don’t you know?

If they move too quick (oh-way-oh)

They’re falling down like a domino

Note: all markings (bolditalicunderlining) by LO unless stated otherwise

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