Home Regulation & Compliance Yet another attempt to reform the audit profession

Yet another attempt to reform the audit profession

by AppliedCG

In the first part of this article, we looked at the four published official investigations into notorious recent corporate collapses and the deemed associated audit failures, namely the BEIS Commons Committee Report, the Kingman Review, the CMA Report and the Brydon Report, and we summarised the proposals of the BEIS departmental White Paper. Here we give our assessment of the result of these reviews, the BEIS White Paper, which is intended to lead to legislation in this area. As such, it will target boards of directors, the audit and accountancy profession and shareholders of major companies, so its potential impact will be profound.

So we felt it would be instructive to revisit earlier articles we have written on the subject and look at how effectively the White Paper addresses the failings of audit and governance as we see them.

Early warnings re Audit

Back in 2014, we reported on a thought-provoking speech by the Chairman of the UK Auditing Practices Board to a group of Chartered Accountants, in which he suggested that the traditional audit had been de-professionalised and commoditised, and, coupled with the progressive deterioration of financial reporting into incomprehensibility, had contributed to a major loss of trust in the accounting profession. He called for a rethink as to the purpose of the audit and the type of experience an auditor should bring to the task.

We commented that, unfortunately, over the past thirty to forty years the accounting profession has introduced more and more accounting standards, so that the audit report now essentially relates to compliance with those standards, and the auditor stays as far as possible away from expressing a view as to the underlying position, lest the firm be sued at a later date if the company gets into trouble.

Traditionally, an audit was commissioned by the shareholders to check on the stewardship of the directors. Now all the major stakeholders would look to the auditor’s report to assure them that the company with which they were involved was being soundly run. But the requirements of the different stakeholding groups varies significantly in terms of the information they need. And, we said, it is arguable that shareholders and potential investors, in particular, are much more interested in the continuing viability of the company’s business model, whether the company is being soundly run and whether it is exercising its responsibility for accountability in an open and transparent way, than out-of-date financial reports.

We identified three problems: firstly, individual opinion has been effectively replaced by accounting standards; secondly, financial reporting is not universally trusted, giving as an example such fundamentally controversial accounting policies as “mark to market” which can produce results which are so threatening to the business that they can be legitimately challenged by business managers who arguably are better placed to judge the meaningfulness of those policies; and finally, the auditor’s report ducks two of the key matters on which the stakeholders would most value their opinion, namely the ethical soundness of the culture and the continued viability of the business model.

Three years ago we published an article about the evolution of the big accountancy firms from professional practices into global businesses. In the late 1980s, the leading firms were drawing away from the pack, and the leading eight or nine were recruiting only the best qualified candidates for training and, except in specialised areas, the services provided were superior in quality as well as quantity to those of the second tier. Following the demise of Arthur Andersen, there were just the Big Four, and these were regarded as the only firms capable of auditing the major global companies, so, for example, all the FTSE 100 companies were audited by one or other of these Big Four. And, as we said, four it has remained since 2002, as the regulatory bodies stand in fear of the collapse of one of these, which would lead to the Big Three and even less competition.

But, as we also said, these are not small professional firms of accountants. They are huge businesses, with Deloittes leading the field with global revenues approaching $50bn, and KPMG number four with revenues three times that of BDO, leader of the “challenger” pack.

Does the Business Model still work?

Auditing is a mature industry and, as such, has all the corresponding characteristics: strong competition (dominated by a few leading players) and low margins, leading to the complaint of the audit profession that companies won’t pay big enough fees to their auditors for them to do as comprehensive a job as they might feel necessary to have a better chance of picking up all and every problem.

The only compensation is that, notwithstanding mandatory limits to the number of years an auditor can stay with a client before the audit has to be re-tendered, the major clients are obliged to have audits, and they share their favours with just the Big Four. Hence, despite its low rate of growth, audit is a provider of work which keeps giving, and always to the same recipients.

However, by comparison, consultancy is a growth industry and has much higher margins. Hence, therefore, the Big Four have been chasing revenue in this field for many years, to the extent that income from these wider sources greatly outweighs that from auditing, and generates better margins and the opportunity to create world-leading positions in new fields. This is a point addressed by all the reports we analysed in the first part of this article.

Audit is the key to the client’s door but also the vulnerability, since a large percentage of the income of the Big Four derives from non-audit activities – currently as much as 80%, but audit is invaluable in providing them with a guaranteed annual presence in their core client base, and the opportunity to sell extensive non-audit services to these audit clients in most countries round the world. However, the threat to their reputation comes primarily from these very audit activities, and we listed some forty recent company scandals involving the Big Four. In the hearings of the BEIS Parliamentary Committee, possibly the most damning comment was from one MP who said

“I wouldn’t hire you to do an audit of the contents of my fridge”.

This scathing remark was addressed to two of the Big Four leaders of the accounting world.

It has been noted that in the case of Carillion, whistleblowers had earlier made clear their concerns about the accounting procedures adopted, and the investment community was shorting the shares, so how could the auditors sign off the accounts and afterwards maintain that they stood by the accounts as signed? It is barely believable that again and again, the defence of the audit profession is that they followed the rules and couldn’t be expected to pick up things that didn’t involve breaking of the processes and procedures around those rules and regulations.

Three years ago, we asked: how long will this defence of “I followed the rules” be tolerated by the public and politicians, even while it is excused by the profession’s own regulators?

It is now time, we said, for the audit procedures to broaden their approach and to develop a holistic examination of their client companies’ corporate governance, going beyond a reliance on compliance.

Putting it simply, the public expect an audit to uncover wrong-doing, and they take it for granted that the audited financial statements (which few understand) will represent an accurate picture of what is currently going on. Phrases such as “a going concern” are interpreted as “currently healthy and good for many years to come”, and the technical definitions and qualifications are not understood and generally ignored. The damage to the reputation of the accountancy profession has led to action being taken by unsympathetic law-makers.

Meanwhile, the incentive for the big firms is to deliver the audit as efficiently and cost effectively as possible and to make their money by selling additional professional services which deliver higher fees and higher profitability. Thus the audit will naturally be limited to compliance with the regulations.

Additionally, divergence from this regulatory compliance, and the “safe harbour” it provides, lays the auditors open to legal action from potentially aggrieved parties regarding losses resulting from actions taken after relying on opinions expressed by the auditors.

But the traditional responsibility of the auditor to the owners of the company, has been progressively broadened by legislation over the years to include a wider group of stakeholders. Nonetheless, the shareholders are essentially still the targeted beneficiary of the audit, and the accounting standards-oriented approach bemuses non-experts. They read disclaimers, look on these as cop-outs, and don’t understand why common sense doesn’t apparently come into the audit.

We identified two aspects which need to be seriously addressed when looking at the purpose of the audit in today’s world. The first is the stakeholder dimension, where there is growing worldwide acceptance of the legitimate interest in corporate activities by a much wider group than simply the investors and the managers. And the second is the definition of corporate governance which is becoming progressively more holistic. Hence the audit should now really be about checking the governance of companies, not merely about the financial statements. And the definition of corporate governance should be holistic, not simply compliance with the codes drawn up by the accountancy profession. Additionally, the auditors should examine the performance of the board, as this will shine a light on the company’s ethical behaviour and the strength or otherwise of its governance.

Political challenges

Three years ago, we commented that politicians are never backward in spotting and exploiting an issue which looks damaging to the public, can generate popular appeal, and for which they think they can’t be held to blame. Firms going bust after clean audits, resulting in loss of jobs and damage to pensioners, where the directors appear to emerge unscathed financially, leads to a search for scapegoats. And beyond the board, the City elite, including the regulator and the well-paid auditors, are a natural target.

We noted the defensive moves by the regulators, levying larger and larger fines on the Big Four firms following investigations which lead to condemnation of their audit practices in cases of company failure or misdeeds. And we noted the alternative views about the way forward.

On the one hand, concern about the growing impact of politicians’ appeal to populism leading to regulation being framed in “the court of the people”. And secondary legislation being pushed through Parliament to avoid the full debate required for primary legislation, with the concern that this is likely to lead to more layers of legislation. Hence worries about the inevitable consequence of unforeseen side effects and bureaucracy, while failing to meet the supposed objectives of better governance.

Then an alternative view that big corporations have lost the trust of the public, and are accountable to nobody at the end of the day. So, in a world of no principles, principle-based regulation is always going to fail, and the focus instead should be on laws which are sufficiently detailed to make corporate leaders clearly and personally accountable for the behaviour of the companies they run.

Finally, the growing importance of the wider stakeholder interests and behavioural concepts such as diversity, as addressed in the UK Companies Act of 2006. Hence the contention that reporting to stakeholders as a wider group is now beyond challenge, and that companies need to introduce measures to determine the impact that their activities have on the society in which they operate. This is reflected in developments like MSCI’s ESG indices and raises the issue whether, and how quickly, the audit profession picks up the need to report on these wider issues.

Corporate Governance Codes

The BEIS White Paper, addressing issues in corporate reporting and audit, includes corporate governance in its subject of review. So it is appropriate for us to refer to articles we wrote fairly recently on the Corporate Governance and Stewardship Codes.

We have noted that Corporate Governance has been, and continues to be interpreted as having a wider role than simply what directors should be doing to look after the interests of the owners of the companies on whose boards they sit.

We observed that regulation has been dragged along in the wake of these developments, in consequence trying to reflect evolving views as to what is good practice in corporate behaviour, embracing such concepts as ethical investing, responsible investing, corporate social responsibility and ESG.

Crucially, the UK Companies Act 2006, which followed some ten years of wide consultation, took this significantly more open view of the responsibilities of directors in governing companies than its predecessor Acts. In critical sections it is very specific about the new, much broader, duties of directors.

In regard to the Companies Act, the most important section from our immediate point of view is S 172, whose provisions state:

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a)        the likely consequences of any decision in the long term,

(b)        the interests of the company’s employees,

(c)        the need to foster the company’s business relationships with suppliers, customers and others,

(d)       the impact of the company’s operations on the community and the environment,

(e)        the desirability of the company maintaining a reputation for high standards of business conduct, and

(f)        the need to act fairly as between members of the company.

In earlier articles, we have discussed the Stewardship Code, which we recommended should be scrapped on the grounds of its major overlap with the provisions of the 2018 version of the Corporate Governance Code. And we pointed out that there was minimal overlap between these Codes and the provisions of the 2006 Companies Act, most of their regulatory clauses being concerned with routine board practices and protocols rather than the underlying obligations of sections 170 – 177 of the Companies Act.

Our view was that, as a result of this failure to focus on the clauses and intentions of the Act, there have been continuing failures in governance, which have led to increasing disillusion with corporate behaviour and regulatory ineffectiveness in the minds of the public. And, sadly and predictably, all this white noise of criticism leads inexorably to yet more layers of ineffective regulation from regulators who don’t take a holistic approach, and have just a superficial view about the intentions of the Companies Act.

A company is an independent legal entity. It is not owned by the shareholders, whatever they or BEIS may think. They merely have a right to share in the rewards that come from its successful operations, and are thereby granted limited liability protection from the adverse consequences resulting from its unsuccessful actions. The company itself does not have limited liability.

However, the directors are in a very different situation. They are legally responsible for its behaviour and its long-term prosperity, and the Companies Act spells this out in the sections mentioned above.

The role of the board of directors is to ensure that the company’s goal is still appropriate, that the strategy to achieve it is still valid, that the company has the capacity to achieve it and that the behaviour of those involved stands up to ethical scrutiny and is subject to openness and accountability. Having made these assessments, its job is to determine appropriate changes, and set a new course, as necessary. In other words, what has been called the directors’ dilemma: to take the company forward, while protecting the present.

To pick up a recently popular term, an appropriate Purpose is one which is a viable long-term commercial goal, and which by its very nature is in sympathy with the main stakeholders, and reflects the fact that the company is an independent entity, and not in thrall to any particular stakeholder group.

Our Conclusions

 Let us first remind ourselves of the problem the civil servants at the Dept of BEIS are attempting to solve. In recent years several high profile companies have folded with revelations of misrepresentations of their earlier corporate and financial health. There is also a string of other examples where the auditors have failed to flag serious problems. In consequence, responding to highly critical public reaction, the politicians have decided that “something must be done”.

Our earlier remarks on the subject, reiterated above, identified the key issues:

  • The need for the board to fulfil its responsibility, spelt out in the Companies Act, to safeguard the long-term future of the business, recognising its holistic relationship and accountability to all the key stakeholders
  • The need for the audit function to assess the performance of the directors in fulfilling that broad role, and for the report and accounts to reflect reality rather than restricting themselves to compliance with regulations and accounting standards
  • The importance of determining the actuality by engaging directly with the key stakeholders rather than relying on information fed to the auditors by the company.

The BEIS White Paper takes on board most, though not all, of the recommendations in the earlier reviews, so we address ourselves here just to that document and its own proposals, which we summarise below:

  • Public Interest Entities (PIEs)
    • Broaden definition to include large private companies
  • Directors’ accountability for internal controls, capital maintenance
    • Require directors’ statements about effectiveness of controls and adequacy of resources
  • Additions to corporate reporting
    • Introduce resilience statement and audit and assurance policy
  • Increased regulator role in reporting
    • ARGA empowered to direct changes in reports and remit extended to the whole of the report
  • Directors’ wrongful behaviour
    • Stronger malus and clawback provisions and powers for ARGA to pursue
  • Auditors
    • Create new corporate auditing profession with new overarching principles
  • Audit committee role
    • ARGA to set additional tasks for audit committees and facilitate shareholder engagement re audit matters
  • Competition in the audit market
    • Regulator-managed shared audit and operational separation of audit and non-audit work with powers for ARGA to monitor the market and act against individual firms
  • Audit quality reviews
    • Regulator, rather than professional bodies, to approve audits of PIEs
  • Replacing the FRC
    • ARGA as a strengthened regulator with more powers, including supervision of accountants and actuaries

Taking its proposals in turn, our comments are as follows:

  • PIEs
    • Including more companies as worthy of closer inspection is surely irrelevant if the auditors follow our three point guidance above in relation to ALL their audits
  • Directors’ accountability
    • Why does this need spelling out? It is part of the directors’ responsibilities under the Companies Act, and the auditors’ job to check and report
  • Additions to corporate reporting
    • If the directors are doing their job, it shouldn’t be necessary to introduce what will inevitably become another piece of boilerplate; if they aren’t, the audit should make this clear
  • Increased regulator role
    • If the FRC has proved to be weak and ineffective, the issue is whether that it requires new management or extra powers. The consensus appears to be the latter, but setting up a new, more powerful body closer to government raises new issues, not least any unintended consequences, and the adequacy of future resourcing
  • Directors’ wrongful behaviour
    • Arguably justified as the bonus culture has been blamed for all manner of corporate and societal ills
  • Auditors
    • Setting up what amounts to a new profession is a huge step, smacking of naivete. It would lead to a much reduced supply of professionals who would likely have a significantly restricted view of business and limited experience, with a diminished career path and poorer remuneration. Not the recipe for a talented body
  • Audit committee role
    • This comes back to the potential conflict resulting from the new regulatory body taking powers from the current supervisory bodies; why would ARGA, as a statutory body be more effective than a professional body with the power to expel members?
  • Competition in the audit market
    • The nature of any market is that the more successful players become dominant, and imagining that the Big Four can be transformed into a Big 6, 7, 8 etc by the means of managed shared audits seems naïve. There is a gulf between the top four and the rest, just as there was between the top 7 – 8 and the rest, thirty years ago. Amalgamation is what created the top four, and domination in the audit market will have to be managed in the same, problematical, way as in any other industry
  • Audit quality review
    • See comments above about the new regulatory role of ARGA
  • Replacing the FRC
    • See comments above about the new regulatory role of ARGA

The White Paper includes Governance in its title, but doesn’t address corporate governance in any meaningful sense, and seems to think that problems of inadequate audit can be solved by setting up a new regulator.

It reminds one of the words attributed to the Roman, Gaius Petronius in the first century AD:

We trained hard – but every time we were beginning to form up into teams, we would be reorganised. I was to learn later in life that we tend to meet any new situation by reorganising, and a wonderful method it can be for creating the illusion of progress while producing confusion, inefficiency and demoralisation”.

Role of audit

We have argued that compliance-based regulation is missing most of the point and is both ineffective and descending into disrepute, in the opinion of company boards, shareholders and the general public. The same argument applies to the focus on how a board conducts itself and related compliance with rules about board behaviour.

And rather than simply alluding to corporate governance in the course of defining the broad responsibilities of the new regulator, ARGA, our proposal would be to augment the auditor’s role in corporate governance by establishing a new approach using something like our proprietary ACG secure stakeholder communication system, which would link the auditors to the individual companies’ internal secure stakeholder communication systems, which, in turn, would be linked to their key stakeholders. Such an arrangement would provide the auditor with private access to key data on stakeholder views, outside their clients’ internal reporting systems, enabling it to monitor the critical elements of corporate governance performance both for the boards direction of the company and for individual directors own performance.

A similar use of the system linking key stakeholder groups to this continuous information access and distribution would eliminate large parts of the voluminous annual reports, which are getting bigger and bigger as the years go by.

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