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Did the CC finally come down hard on the Big Four?

Functional stupidity.

KPMG. Photograph: Getty Images

In the aftermath of England’s crushing defeat of Australia in the second Ashes Test last weekend, the Times’s chief sports Writer, Simon Barnes, described two sorts of England fans

There were, he wrote, the “glass half-full sort” who felt the result reflected how well England had played and how good they know are as a cricket team. But there were also the “glass half-empty sort” for whom the result showed how bad Australia were and are.

Readers of the Competition Commission provisional recommendations on remedies to fix the UK audit market this week might have fallen into the same trap. Depending on your perspective, the Commission either came down hard on the Big Four (at last) or didn’t listen as intently as they might have to the demands of the mid-tier firms looking to break the Big Four’s dominance of the audit market. In other words the report apparently had something to please everyone and yet ended up pleasing no one.

The one group whose interests failed to get a look in were the boards of the businesses now expected to organise a tender for their audit every five years. One senior FTSE 100 audit committee chair pointed out that while this sounds like good practice in principle, for his business it means tendering in 140 countries every five years. As well as putting extra work on audit firms, he pointed out this would also place considerable extra demands on boards (and audit committees in particular) without demonstrable evidence it will improve the quality of the audit. It is the sort of regulatory burden the coalition government has made a lot of noise about reducing.

Putting to one side the vexed question of whether the Competition Commission is the right body to be setting the rules for audit (it is not), there is the danger once again of well-intentioned regulatory change not delivering to the intended outcome, imposing unexpected burdens and having unintended consequences. It is a great example of what André Spicer, professor of organisational behaviour at City University’s Cass Business School and Mats Alvesson, professor of business administration at Lund University in Sweden call “functional stupidity”. In a recent paper for the Journal of Management Studies, A Stupidity-Based Theory of Organizations, Spicer and Alvesson found that the unintentional encouragement of organizational stupidity might have been one of the major causes of the financial crisis.

“Our argument is that stupidity is different from irrationality,” Professor Spicer explained in an interview with Cass Business School’s InBusiness magazine. “Irrationality is an outcome, but stupidity is a process.”

It seems that the Competition Commission is in danger of imposing a whole raft of new process measures in an attempt to fix a specific problem that not everyone agrees is a problem. There is also a widely held view that auditors could have done more in the run-up to the financial crisis (when several banks were given unqualified audits), but if audit did fail in that instance, where is the logic to support the notion that auditors looking over their shoulder at a likely retender would have done anything different, or offered a more robust questioning of the basis for the valuations of loans or the pricing of risk at financial institutions? The measures announced this week would not have made a significant difference to that outcome had they been in place in 2007/8. For some this is because they are too lenient and don’t go far enough, while for others they are simply tackling the wrong problem.  

The imposition of new audit regulations and accounting regimes is an inevitable consequence of any major business collapse. Often these changes are made without questioning the role and purpose of audit.

This time at least we have projects such as the Finance Innovation Lab’s Audit Futures initiative, which is investigating exactly what role audit should play in society and business in the 21st century. The outcome from this sort of intelligent and thoughtful approach will be more beneficial to business, auditors and society than the alleged remedies proposed this week.

What is perhaps most disappointing is that this reaction to corporate failure isn’t a new phenomenon. I recently rediscovered a Demos report by Michael Power called The Explosion of Audit. In it he points out that increased auditing does not necessarily lead to greater organisational transparency. Further he suggests that audits have a near miraculous ability to be invulnerable to their own failure. As he writes, “Rightly or wrongly, corporate collapse is always accompanied by scrutiny of the role of the auditors… One of the surprising features of these experiences is that they tend not to call into question the role of audit itself. Where audit has failed, the common response has been to call for more of it. Indeed, the great puzzle of financial audit is that it has never been more a powerful and influential model of administrative control than now, when many commentators talk of an auditing crisis.”

What’s really alarming is that he was writing not last year or even 10 years ago, but in 1994, in the wake of scandals at BCCI and with Robert Maxwell’s media empire. Perhaps more alarming is that as he was writing, a little known energy company in the US (which had not long changed its name to Enron) was just starting to establish a number of limited liability special purpose entities.

The rest is history. And still we didn’t learn. Perhaps more than anything else, that is the epitome of Spicer and Alvesson’s definition of functional stupidity.

This piece first appeared on economia.