1.0 A2 Assessment [Audit Failures – KPMG and Carillion Group Case]
Auditing in accounting refers to a process of examining or inspecting various books of account by a certified auditor to make sure that a company’s financial statements are accurate and follow regulatory guidelines (Schmitz and Leoni, 2019, pg. 338). Proper auditing is crucial in any organization because it gives stakeholders a reasonable assurance to make more investments. In addition, accurate auditing helps in minimizing the possibility of fraud or any financial misuse (Appelbaum et al., 2020, pg. 16). The company in our case study, KPMG, had outsourced a reputable auditor Carillion Group to conduct an audit for the period 2014 to 2017. However, Carillion Group did not follow industry standards and ethics when conducting this audit, leading to a compulsory liquidation by Financial Reporting Council (FCR) in 2018.
KPMG is a company that comprises a network of professionals in 146 countries providing advisory services to their clients (McKenna et al., 2022). The company brings together insights and technology solutions that help mitigate Environmental, Social, and Governance (ESG) challenges (Tien et al., 2022). The company hired Carillion Group to audit its financial books between the years 2014 to 2017. Carillion Group is a well-renowned British multinational construction and facilities management company that offers various financial services. The company was formed in 199 through a demerger from Tarmac Construction and Materials Groups and became independent in construction and financial support services (Patil, 2021). In 2006 the company acquired Mowlem, a well-renowned construction company that saw significant growth in its asset base while adding new capabilities to its portfolio.
The company faced many financial challenges in 2008 when the world was facing a major economic downturn (Smyth, 2022). This was mainly attributed to the cancellation of major construction projects and the delay in payments. The company later in 2011 announced that it had shifted focus to construction and would now focus on support services, specifically in the energy and infrastructure sectors. In 2018, the company secured numerous contracts both in the public and private sectors (Santos, 2020). Due to management and operational issues, the same saw the company’s profits shrink, with difficulties being pegged around contract payment delays and problems with cashflows. Discussions with lenders and stakeholders did not bear fruits, and the company was forced to enter into a compulsory liquidation, significantly affecting its employees, suppliers, and other players in the wider construction and support service industry.
FCR investigations on Carillion Group occurred when the company secured several financial statement audits with KPMG. Its collapse raised a lot of questions about the effectiveness of KPMG’s audit process and the accuracy of the financial reports it provided. FCR investigations on Carillion Group focused on KPMG’s credibility and integrity when handling financial statements (McLaughlin et al., 2021). The report which FCR gave highlighted key areas where the company had failed to exercise professional skepticism. Critical findings included incomplete testing of KPMG’s financial assumptions, failure to challenge and evaluate Carillion’s reports, and insufficient evidence gathering about KPMG’s financial reports (McLaughlin et al., 2021). These findings saw Carillion being banned from practicing any auditing duties as well as hefty fines, which led to the liquidation of the audit firm.
1.2 Audit Quality and Potential Factors That Compromised Audit Quality
Audit quality encompasses different elements that an auditor integrates to obtain reasonable and accurate financial reports without errors (Xiao et al., 2020). Quality audits in any organization should always be conducted by a qualified auditor who is practicing or, rather, is in compliance with the current audit standards. A quality audit’s purpose is to assure the organization’s stakeholders, investors, and lenders that the financial information provided is accurate and can be relied upon (Xiao et al., 2020). A financial statement audit is one of the common types of quality audit in any organization. It aims at examining organizations’ financial statements, including balance sheets, income statements, and cash flow statements, to ensure that they match the current industry regulatory standards. Compliance audits are another type of audit that requires quality audits in any company. This ensures that a company adheres to specific operational laws, including tax and regulatory compliance. To conduct an accurate audit, auditors perform various procedures with the aim of collecting reliable evidence which can be used to support the final financial information. Some of these procedures include examining supporting financial documents. Performing internal test controls and even conducting physical inspections of the company’s assets. Auditors must always maintain credibility, integrity, and professionalism when performing an audit because this is what makes them make useful recommendations that the company can rely upon when designing “going forward” strategies or making future decisions (Xiao et al., 2020).
Several factors may have compromised the audit quality in the Carillion Group audit case. Failure of KPMG management challenging the audit results. We have seen that from the FCR investigation reports, KPMG did not challenge or even evaluate the results that the outsourced auditors presented. It is important for the management to scrutinize the financial information provided, which can help in identifying any underlying errors or over-valuation of assets. Failure to do this could have led to Carillion producing a compromised, low-quality audit report. Another factor that may have compromised the quality of the audit report is over-reliance or too much trust in the Carillion auditors by KPMG. Remember, from the case study, we have seen that Carillion had conducted audit reports for reputable brands and had built a big name in the UK market. In addition to this, the company had conducted prior audits of KPMG for the previous years. This might have possibly led to the KPMG management over-trusting Carillion Group results too much because of the previous successful years. KPMG failed to perform independent verification of the audit information presented by Carillion. If they could have done this, they would have possibly identified any inconsistencies and eliminated them before the report was published. The other factor that may have led to a compromised audit quality is insufficient testing of the financial statements by Carillion Group. If they had performed in-depth testing of these statements, they would have possibly identified inconsistencies in terms of contract valuations or even revenue recognition. Another factor is complex and opaque financial structures (Rose et al., 2020, pg. 43). Carillion would re-organize itself each and every year trying to find ways of making more and more profits. Failure of auditors to understand the real company’s financial position and unclear financial processes, which included off-balance sheet transactions, may have contributed to the audit compromise. The other factors contributing to the audit quality compromise are assignment pressures and working under unclear protocols. The company was working to strictly meet some set financial targets and stakeholders’ needs. They conducted this audit under so much pressure and strict timelines, which prevented deep study and examination of KPMG’s financial statements.
1.3 Social and Economic Consequences of Audit Failures
Audit failure can have devastating consequences on any organization. One of the social consequences that a company might suffer due to audit failure is the loss of public trust (Hammami and Hendijani, 2020, pg. 57). failure to conduct accurate audits means that the given financial reports are false, and this may make the general public lose trust in the organization. Loss of public trust may mean that clients will disappear, and the company may start making losses. Audit failures may also have a negative impact on stakeholders and other investors. Shareholders depend on the published financial reports in order to make financial decisions. Inaccurate financial information may make the investors feel insecure about their investments and demotivate their willingness to make further investments which cripple the growth of that particular company. Audit failures may also affect the employees. Financial distress may affect workers emotionally, which in turn affects their livelihoods.
On the other hand, audit failures may have extreme adverse economic consequences on the affected organization. One of the consequences is financial losses (Koval et al., 2019). Audit failures lead to the publishing of false financial statements. Investors and lenders rely on that information to make financial decisions. When finally, the true financial position of the company is revealed, hefty financial losses may be witnessed by both investors and lenders. Another consequence of audit failures is market volatility and instability (Koval et al., 2019). False financial statements of a company may trigger its stock prices, leading to sell-offs and market fluctuations. This catalyzes economic volatility, which affects long-term economic stability. Another consequence of audit failure is a decline in capital markets (Koval et al., 2019). False audit reports make investors shy away from making further investments in that particular company. This makes it difficult for the company to raise even working capital and issue debts. The implication of this is a hindrance to growth, development, and overall economic expansion. Continued audit failures may force regulatory bodies to step in for scrutiny purposes. Investigations may lead to fines or increased compliance costs, increasing overall operational costs. The extra costs may become a burden to the affected company, which translates to reduced profits or even liquidation and eventual closures similar to what happened to Carillion Group.
1.4 Going Concerns and Indicators
A going concern is an ideology that assumes a company has all the needed resources to continue operating indefinitely until it reaches a point to prove the contrary through evidence that is provided in the financial statements (Ali et al., 2019). This means that a company will meet all its financial needs when they are due, and it works without the threat of liquidation. When conducting an audit, auditors usually asses the going concern of individual entities in a company while considering whether there are any indicators that may pose a threat to disrupt the ability of the company to operate normally.
In the scenario of Carillion Group, which can be generalized for other organizations, indicators for going concerns may be similar, although, on some other occasions, they may differ depending on the nature of the business, its goals, and its mandate, among other factors. Financial performance and liquidity are one of the going concerns that may affect an organization. Carillion, for instance, faced a lot of financial difficulties in 2018, which included profit warnings due to off-balance sheet transactions and cash flow challenges. Due to this, the company raised a lot of doubts to the general public and to the audit regulatory authority (FSR). Upon investigations, FSR discovered that the company had insufficient cash flow, which made it hard for it to meet even short-term financial goals. This came as a going concern, and the company forcefully obtained a compulsory liquidation that affected stakeholders, investors, and other key players in the construction and the general service industry.
Another indicator of going concerns that were evident in Carillion Group was project delays and cost overruns. Although in the previous years, the company was making major moves of accusations, it started experiencing major project delays in 2018 on construction projects which significantly affected its profitability and cash flow. Concerns were raised about its financial stability, and when it was banned from conducting auditing services, it had to liquidate. The other indicator of going concerns that affected Carillion Group was the loss of key contracts. In 2018, the company started losing key contracts and businesses, which affected its revenues and ability to perform its operations normally.
In conclusion, auditing is a very crucial process in every organization. Companies should not just conduct audits but “quality audits.” Different factors, including insufficient testing of the financial statements and failure to challenge the financial reports presented, among others, may lead to audit failures. Audit failures have devastating social and economic consequences on any organization. A company may lose public trust, which may make it lose current and future stakeholders. Audit failure may also result in huge financial losses. Finally, organizations should closely monitor going concerns indicators because they affect the future operations and success of any company.
Ali, M.N., Almagtome, A.H. and Hameedi, K.S., 2019. Impact of accounting earnings quality on the going-concern in the Iraqi tourism firms. African Journal of Hospitality, Tourism, and Leisure, 8(5), pp.1-12.
Appelbaum, D., Budnik, S. and Vasarhelyi, M., 2020. Auditing and accounting during and after the COVID-19 crisis. The CPA Journal, 90(6), pp.14-19.
Hammami, A. and Hendijani Zadeh, M., 2020. Audit quality, media coverage, environmental, social, and governance disclosure, and firm investment efficiency: Evidence from Canada. International Journal of Accounting & Information Management, 28(1), pp.45-72. https://doi.org/10.1108/IJAIM-03-2019-0041
Koval, V., Nazarova, K., Hordopolov, V., Kopotiienko, T., Miniailo, V. and Diachenko, Y., 2019. Audit the state economic security system. Management Theory and Studies for Rural Business and Infrastructure Development, 41(3), pp.419-430. https://doi.org/10.15544/mts.2019.34
McKenna, F., Pevzner, M., Sheneman, A. and Zach, T., 2022. Corruption in the Auditor Inspection Process: The Case of KPMG and the PCAOB. Issues in Accounting Education. https://doi.org/10.2308/ISSUES-2020-056
McLaughlin, C., Armstrong, S., Moustafa, M.W. and Elamer, A.A., 2021. Audit committee diversity and corporate scandals: evidence from the UK. International Journal of Accounting & Information Management, 29(5), pp.734-763. https://doi.org/10.1108/IJAIM-01-2021-0024
Patil, N., 2021 Carillion PLC: A case of failed corporate governance, awry risk management and obfuscated construction contracts. https://doi.org/10.31224/2772
Rose, A.M., Rose, J.M., Suh, I. and Thibodeau, J.C., 2020. Analytical procedures: are more good ideas always better for audit quality? Behavioral Research in Accounting, 32(1), pp.37-49. https://doi.org/10.2308/bria-52512
Santos, P.M.M., 2020. Carillion Plc: fake it til you break it (Doctoral dissertation). http://hdl.handle.net/10362/108419
Schmitz, J. and Leoni, G., 2019. Accounting and auditing at the time of blockchain technology: a research agenda. Australian Accounting Review, 29(2), pp.331-342. https://doi.org/10.1111/auar.12286
Smyth, H., 2022. Transforming the construction firm? In Describing construction (pp. 197-219). Routledge.
Tien, N.H., Thuong, T.M. and Yen, N.T.H., 2022. Enhancing independence of local auditing services by profiting from experiences of the Big4 group (KPMG, Deloitte, PWC E&Y) operating in the Vietnam market. Cogent Business & Management. https://doi.org/10.1080/23311975.2019.1605702
Xiao, T., Geng, C. and Yuan, C., 2020. How audit effort affects audit quality: An audit process and audit output perspective. China Journal of Accounting Research, 13(1), pp.109-127. https://doi.org/10.1016/j.cjar.2020.02.002