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Crashing Down

11 April 2019 by John Stittle

Crashing Down

There has been many auditing, reporting and governance reviews – but will they be any more effective this time around?

Just what is happening to the state of corporate reporting and auditing in the UK? Recent company collapses have highlighted the industrial scale of failures in accounting, auditing and by their regulator. Politicians, the government and other stakeholders are questioning why the quality of accounting and auditing is not of the standard they rightly expect. In addition, the Financial Reporting Council, the sector’s primary regulator, has over the last decade or so, given the widespread impression of being a sleepy, lack-lustre and not too effective supervisor and enforcer. And for good measure, it is claimed the FRC has been too close to the accounting industry it is supposed to regulate. At the end of last year, two major reviews highlighted that the accounting and audit sector – and the FRC – are in need of a major overhaul. But will these reviews really lead to any substantive improvement?    

Previous Scandals

Around three decades ago, the collapse of a series of well-known UK companies was testimony to poor and inadequate standards in accounting, auditing and often highlighted failures in effective governance too. Companies such as BCCI, Queens Moat, Polly Peck, Barings and Mirror Group Newspapers have now become a shameful monument to the abysmal inadequate regulation at that era. Subsequent reforms to auditing and accounting procedures and processes including the establishment of the over-arching FRC have notably failed to deliver the expected outcomes and benefits.

Indeed, just a decade ago, the banking crisis illustrated that the UK standards of accounting and audit regulation still needed further reform. Governance in banks and financial institutions showed that more changes were urgently needed. The Parliamentary Commission into Banking in 2013 was scathing:  ‘auditors and accounting standards have a duty to ensure the provision of accurate information to shareholders and others about companies’ financial positions. They fell down in that duty….audited accounts conspicuously failed accurately to inform their users about the financial condition of banks.’ 

But surely lessons have now been learnt from this banking turmoil over a decade ago. Unfortunately, it seems to a substantial degree, there often remains an on-going dereliction of duty from auditors and inertia from accountants to learn from past errors; yet still the FRC has been lethargic to intervene.

More recently, the low quality of all players in this accounting and audit sector has been reflected by well publicised corporate collapses of companies such as Carillion, BHS, and now, Patisserie Valerie; and there have been other accounting issues involving major listed companies such as Tesco and BT.

The patience of politicians is almost exhausted. Frank Field, chair of the Parliamentary Works and Pension Committee, who headed the inquiry into Carillion‘s collapse couldn’t have been more damning in his criticism of KPMG, auditors to this outsourcing company. KPMG were accused of ‘egregious wrong doing at every stop on this gravy train.’ Accusations were also made about many aspects of the audit – including suggestions that documents that may have been back-dated. Rachel Reeves, chair of the Business Committee, was even more critical than Field.  Indeed, she argued that the audit market had experienced ‘a complete breakdown in trust among the public and investors in the integrity of company accounts.’ 

The government had to act. The government’s attempt to clean up the audit industry and the sector regulator is two pronged. Firstly, the Business Secretary, Greg Clark appointed Sir John Kingman, chairman of Legal and General to carry out ‘a root and branch review’ of the FRC, the overall accounting and audit regulator. Secondly, the Competition and Markets Authority would investigate the working of the audit market.

Kingman Review

Kingman was concerned about the FRC’s ‘clearly deficient’ powers and its failure to be more effective ‘in shaping the debate on major issues’. The FRC’s own periodic Corporate Reporting Review of companies was also regarded as too limited in scale and scope. Kingman’s response to addressing to the FRC’s weaknesses was not only serious but also devastatingly blunt. The current FRC was: a ‘ramshackle house, cobbled together with all sorts of extensions over time [that]…leaks and creaks [and]…built on weak foundations’.

Kingman was clear - the FRC should be abolished and replaced by a new regulator and renamed the Audit, Reporting and Governance Authority (ARGA). The FRC currently operates under a mixture of statutory functions, some delegated powers and voluntary agreements. But the new ARGA will be an independent regulator with its own clear statutory powers and objectives. Part of its key strategic objective will be to “protect the interests of users of financial information and the wider public interest by setting high standards of statutory audit, corporate reporting and corporate governance’.

But it’s all very well calling for the FRC to be scrapped in favour of a new and more powerful regulator – but will these changes actually work in practice and just why has it taken so long to introduce them? Meanwhile, pending the statutory establishment of the ARGA, the FRC now remains little more than a zombie regulator.

Competition and Markets Authority 

The CMA consultation paper also published last December identified ‘serious concerns’ in the audit sector and proposed legislative changes to improve the quality of audit services for ‘the benefit of savers and investors.’  The CMA found ‘too much evidence’ of companies selecting auditors which have the ‘best cultural fit or chemistry’ - rather than auditors who offered the ‘toughest scrutiny’ of accounts. In addition, the CMA pointed out that the Big Four auditing firms audited 97% of the FTSE350 companies. As such the choice of auditor is too limited. Other concerns expressed were that auditors were diluting their focus on quality control issues because at least 75% of their revenue derives from non-audit services such as consulting, taxation advice and investigative work.

However, many companies, analysts and politicians will be disappointed with the outcome of some CMA proposals. After calls for the break up the ‘Big Four’ audit firms to encourage more competition, the CMA failed to deliver. The review claims the international reach and expertise of the ‘Big Four’ would make a break- up ‘protracted and complex.’ As a result, the CMA now only currently calls for the audit and non-audit business ‘to be split into operating entities’. These changes would then require separate management, accounting and remuneration structures. However, this recommendation will now have reduced impact after KPMG has already decided to cease offering some forms of consultancy services to their audit clients; and both EY and PwC will be voluntarily implementing a similar policy soon.

On a more practical note, the CMA wants ‘close scrutiny’ of the appointment of auditors and in ensuring ‘auditors are held to account.’  The CMA states a company’s management should also be independent enough to select the ‘most challenging audit firm’ rather than the cheapest.’

More controversially, to improve competition and reduce conflict, the CMA states that the audits of FTSE350 companies should be conducted by at least two firms – of which one firm would be outside of the ‘Big Four’. Such a change to joint auditors may mean more planning, higher audit costs and increased audit risks resulting from division of work and responsibilities. 

Looking Ahead

And if these two reviews are not enough, Business Secretary, Greg Clark has now established yet another review by Donald Brydon, outgoing chairman of the London Stock Exchange. The Brydon review will build upon both Kingman and the CMA reports and will now ‘consider audits as a product and what the future, standards and requirements should be for audits in the future’.

Overall, it is all very well to keep establishing committees hoping to address these auditing and reporting problems. But perhaps the government and regulators should also turn their attention to other directions too. Many of current accounting and auditing problems stem both directly and indirectly from the increasingly complex, (and sometimes) convoluted, IFRS. But that’s another story and will undoubtedly require the creation of yet another review at some stage. 

John Stittle is senior lecturer at University of Essex

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