Auditors need to be called to account, but can we rely on the watchdog?
The Department for Business, Energy and Industrial Strategy has announced the terms of reference for what will inevitably be known as the Kingman Review into the Financial Reporting Council. The FRC, which describes its mission as “to promote transparency and integrity in business”, regulates accountants, auditors and actuaries and operates the UK’S corporate governance system.
Full disclosure – this also includes oversight of fund managers in the exercise of their stewardship of investments, to identify if we are genuinely engaging with companies on governance issues or merely paying lip service. Venturing to opine on the FRC’S work is fraught with potential hazard for fund managers, but let us put that to one side.
Some commentators feel that this is symptomatic of a concern that the FRC’S remit is too wide, creating irreconcilable conflicts of interest. Establishing standards and overseeing their application may lead to situations where it is reluctant to criticise its own standards, if they are less than perfect.
For all the FRC’S brave words about challenging companies over concerns in their accounts, strong disciplinary action and promoting confidence in annual reports, I struggle to name half a dozen clear examples of regulatory intervention over company reporting. It may well take place behind closed doors, but if it is not highly visible, where is the censure to promote confidence in the system?
For Carillion’s auditors to specifically highlight as areas of potential misstatement recognition of contract revenue and the sheer quantum of goodwill on the balance sheet and yet still sign off the accounts perhaps needs no further comment.
For many years investors have been concerned that auditors persist in referring to the companies they audit as their clients, whereas it is actually the shareholders on whose behalf they work. We have all known the conflicts of interest posed by the big four accountancy firms, offering lossleading audits in exchange for lucrative consultancy work.
Where is the policing of this or the challenge by the FRC to shareholders that they actually need to countenance a material rise in audit fees in order to ensure a genuinely independent view?
What issues like the collapse of Carillion highlight is that investors can rarely gain external insights into the quality of audit work today. The conflicts of interest within the big four create the suspicion that many audited reports cannot provide the confidence the FRC wishes to provide – and the odd spectacular collapse can only support these suspicions. The International Forum of Independent Audit Regulators – of which the FRC is a member – recently published its sixth annual survey of the six largest audit firms globally. In a sample size of 918 audits, a remarkable 40pc had at least one “finding” – usefully defined as “a significant failure to satisfy the requirements of auditing standards”.
This does seem to confirm fears that investors are a long way from being able to place their trust in companies’ accounts. Increasingly we will be asking companies more questions about their auditors and on whose behalf they think they are working.
Audit committees who sign off one year’s accounts, then sign off a subsequent set involving a major exercise in “kitchen-sinking” by an incoming management team, can expect to face some questioning.
And it will be interesting to see how the Kingman Review does examine the FRC’S governance, when the suspicion of regulatory capture by former members of big four firms working at the FRC is quite high.
No one doubts the benefits of the FRC’S mission, promoting transparency and integrity in business, generating public trust and attracting investment. But all those under the FRC’S oversight – and the FRC themselves – have work to do to move closer to realising those goals.