Lord Sikka explains why the latest reforms are unlikely to end audit woes.
In recent years, there has been a steady parade of corporate governance, accounting and auditing scandals.
Names such as BHS, Carillion, RBS, HBOS, Thomas Cook, Patisserie Valerie, London Capital and Finance, Redcentric, Quindell, Autonomy Corporation, Connaught, Blackmore Bond, Woodford Equity Income fund and many others have entered the roll of dishonour. The finance industry has mis-sold numerous financial products relating to pensions, endowment mortgages, precipice bonds, split capital investment trusts, payment protection insurance, mini-bonds and much more. Interest and foreign exchange rates have been rigged. The UK has become a global hub for money laundering, tax avoidance and illicit financial flows. Thousands of people have lost jobs, savings, investments and pensions.
Against the above background, the UK government has published its consultation paper, titled ‘Restoring trust in audit and corporate governance’, with the aim of “improving the UK’s audit, corporate reporting and corporate governance systems”. This article provides a commentary on some of the proposals.
Once again the government seeks to empower shareholders. The difficulty is that they have a short-term interest in companies as they chase higher returns. There is little evidence that they had any long-term interest in invigilating directors or auditors at Carillion or crashed banks. Shareholders at family-controlled companies, such as BHS, have incentives to prioritise their private interests. This leaves other stakeholders, such as employees, pension scheme members, and suppliers in the cold and the consultation paper has no plans to empower them.
Holding directors liable
Directors of large companies may be held personally responsible for the accuracy of corporate financial statements and in cases of errors, deception and negligence face the prospect of a clawback of a portion of executive remuneration. The difficulty is that the UK has no central enforcer of company law. Executive employment contracts are not publicly available and annual financial reports rarely provide comprehensive information.
The government’s preferred option is to seek changes to the UK Corporate Governance Code “to include provisions which recommend that certain minimum clawback conditions or “trigger points” are included in directors’ remuneration arrangements”. This will achieve little as compliance with the Code is voluntary. It does not empower stakeholders and cannot be enforced by courts.
Audit, Reporting and Governance Authority
A large part of the consultation paper is focused on audit reforms and is based upon the proposals advanced in the Kingman Review, Brydon Review and a report by the Competition and Markets Authority.
Following the Kingman Review, the Financial Reporting Council (FRC) is to be replaced by the Audit, Reporting and Governance Authority (ARGA) with extended powers for corporate reporting review function, enforcement of the corporate reporting duties of directors and calculation and disclosures of distributable reserves. It will also enforce standards for FTSE 350 companies’ audit committees
However, there is no attempt to streamline regulators. Auditors will still be regulated by the ARGA plus four recognised supervisory bodies, resulting in duplication and buck-passing.
ARGA is identified as an ‘independent’ regulator, but what will it be independent of?
Big accounting firms and corporations will continue to colonise its operations, committees and working parties. It will still follow the international accounting and auditing standards.
All this brought the FRC into disrepute and the consultation paper is silent on how the capture of ARGA by corporate interests is to be prevented.
The focus on distributable reserves is welcome, but that requires major changes to accounting practices. Balance sheets contain items based on historical costs, net realisable values, fair values, mark to model, present values and much more. The addition of these random numbers does not lead to any meaningful calculation of capital maintenance, which is essential for any calculation of distributable reserves. The consultation paper does not offer any proposals for reform.
Audit market and competition
The Big 4 accounting firms audit 97% of FTSE 350 companies and there is little choice at the top-end. The collapse of a big audit firm could cause considerable market turbulence.
However, a break-up of the big audit firms is not on the agenda. Joint audits involving big and medium-size firms would enable medium-size firms to get a toe-hold in the big company audit market, but the government does not opt for that. Instead, it calls for “managed shared audit requirement for UK-registered FTSE 350 companies”. This will compromise the independence of the junior firm even though it is will sign the audit report as an equal and share liability as an equal.
Currently, new suppliers can’t enter the statutory audit market as the law requires that the entity delivering the audit must be under the control of individuals licenced to carry out audits. This effectively prohibits technology and other businesses from entering the audit market.
The government has no plan to remove barriers to entry.
It is also worth remembering that not so long ago, the audit market was dominated by the big eight accounting firms, and there were plenty of accounting scandals. So competition isn’t necessarily going to improve the quality of audits.
Auditors are dependent upon companies for their appointment and fees. This dependency is worsened by the sale of non-audit services to audit clients. Auditors then audit the resulting transactions. BHS paid its auditors PwC £355,000 in audit fees and £3,303,000 in consultancy fees. Fee dependency buys auditor acquiescence and PwC partner backdated the audit report for good measure, too.
Public Sector Audit Appointments, an independent body, appoints and remunerates auditors of local councils and public bodies, but the government is content to let companies and their directors appoint and remunerate auditors, albeit through audit committees. All major companies involved in headline scandals had audit committees and it is hard to see how persisting with the same will yield different results. That said, the government hints that it may authorise ARGA to appoint auditors under certain circumstances e.g. when shareholders vote against an auditor appointment.
There needs to be a complete ban on the sale of consultancy services by auditors to any audit client. The best way of achieving that is to have firms whose sole business is to conduct audits. However, that is not on the agenda. At best, we may end-up with an organisational split of the big auditing firms; that is a firm with two divisions under common control, one arm selling audits and the other selling consultancy to the same client. So auditors would continue to be mired in conflict of interests. There is little chance that the auditing arm would find fault with internal controls installed by the consultancy arm of the same firm.
A major reason for audit failures is the weakness or absence of pressure points to improve audit quality. The producers of potato crisps and toffees have to ensure that their product is safe and they owe a ‘duty of care’ to current and potential consumers. However, that does not apply to auditors. At best, they owe a ‘duty of care’ to the company and not to individual stakeholders injured by their negligence.
Successful litigation against negligent auditors is rare. Therefore, threat of liability does not act as a pressure point for improvement of audit quality. Rather than reforms, the government hints that more liability concessions may be showered upon auditors.
Auditor and fraud
The consultation paper would require directors to explain the controls which prevent fraud.
Auditors would be required to report on the steps they took to detect any material fraud and assess the effectiveness of relevant controls.
The 2020 court judgment in the case of Assetco plc v Grant Thornton held that under certain circumstances auditors can be held liable for failure to spot management fraud.
The key is auditor scepticism and that can’t be addressed without dealing with issues about fee dependency and independence.
The FRC has stated that more than 80% of the audits in its sample needed “improvements required” or “significant improvements required”. Most of these were carried out by the Big 4 accounting firms – PricewaterhouseCoopers (PwC), Deloitte, KPMG and Ernst & Young. There is considerable information asymmetry between auditors and consumers of audit opinions.
For example, the BHS scandal revealed the PwC audit partner spent two hours on audit and 31 hours on consultancy. The audit team was under the day-to-day control of a person with only one-year’s post-qualification experience and the audit team mix was poor. Many of the basic audit tasks were not carried out. All this was acceptable to internal norms of the firm.
A reduction in information asymmetries can empower consumers to exert pressure on auditors to improve quality. Imagine if auditors had to publish their time budget, composition of the audit teams, time spent by each grade of labour, a list of key questions and replies secured and a list of recent regulatory action against the firm. However, none of this is on the government agenda.
A professional body for corporate auditors
Following the Brydon Review’s recommendations, the consultation paper invites comments on the possibility of creating an audit only professional body.
It is hard to see how a new body can address auditing woes stemming from lack of independence, poor liability, poor public accountability, inadequate liability and a corrosive organisational culture that prioritises profits and appeasement of corporate directors.
If anything a new body will create further barriers to entry.
When will the above be implemented? The consultation period ends on 8 July 2021.
The government has given no firm commitment for legislation and says that it will act when parliamentary timetable permits. Even after legislation, it will take many years for the reforms, such as the organisational split of audit firms and shared audits, to be implemented.
• Prem Sikka is Emeritus Professor of Accounting, University of Essex and a regular contributor to PQ