FRC Revolution to Fix Audit and Accounting Problems

A major announcement that will impact investors was made yesterday by the Government. You may not have noticed it in the midst of political turmoil, but it’s worth studying.

The Kingman review of the Financial Reporting Council (FRC) was published last December. It was a quite damning criticism of many aspects of the current regulatory regime that had resulted in so many audit failures and poor-quality financial reporting. See my previous blog post on this subject here: https://roliscon.blog/2018/12/18/all-change-in-the-audit-world/

There are few experienced investors who have not suffered from audit failures in the last few years. Accounts need to be accurate, reliable and trustworthy but they have been far from that in the last few years. It is now proposed that the FRC, which regulates the audit world and sets accounting and corporate governance standards, be scrapped and replaced by a new body to be called the Audit, Reporting and Governance Authority – ARGA as it will no doubt be abbreviated to. ARGA will have stronger powers, a new mandate and new leadership.

There is a public consultation on the proposed new body and supporting legislation which can be obtained from here: https://tinyurl.com/y55a376d . Anyone with an interest in improving auditing, and preventing company failures such as those at Patisserie or Carillion and major banks in 2008 should respond. But there are so many changes proposed that the document may take time to digest. I pick out some of the more important ones below:

A new Chairman and Deputy Chairman are being recruited to head ARGA so there will be change at the top. Let us hope they manage to change the culture of the FRC even if many of the FRC’s staff move into the new body. It needs to be more than a change of name.

The ARGA will have clear statutory powers with a clear purpose and objectives, supported by a “remit letter” from the Government. One objective will be “to protect the interests of users of financial information and the wider public interest…” which is a positive statement and replaces the unclear historic accumulation of limited powers by the FRC.

The new board responsible for the ARGA will be smaller, more diverse and less representative of “stakeholder” interests. Let us hope that this means less dominated by major audit firms and the audit profession.

The Audit Firm Monitoring Approach will be put on a statutory basis and with enhanced skills and seniority in the team. There are also proposals to improve the Audit Quality Review system which sound promising although such reviews only affect large companies. There will also be expansion of Corporate Reporting Review activity focused on higher risk companies and the new regulator will have the power to change accounts without going to Court.

The “audit expectation gap” where, for example, investors expect auditors to detect false accounting or even fraud whereas auditors don’t perceive that as part of their job will be reviewed. There is indeed a problem with the failure of auditors to challenge the information they receive from management and the latter’s forecasts and interpretation. Let us hope that is a meaningful independent review that results in some changes.

A new “pre-clearance” system will be introduced to enable companies and their auditors to obtain approval for “novel and contentious matters in accounts in advance of their publication”. This may assist auditors to “pass the buck” to someone else if they have doubts about how to present the financial figures.

More transparency in the new body is encouraged on such matters as disclosure of undertakings from concluded cases and it will become subject to the Freedom of Information Act. There will also be more publication of information on complaints and improved handling of them. Such changes are to be encouraged to stop the current secrecy under which the FRC operates which frustrates investors.

The oversight of the accountancy profession is proposed to be improved although the details are unclear and it may require primary legislation. The wording suggests that audit firms may escape substantial change.

The prevention of corporate failure is to be tackled by developing a market intelligence system to identify emerging risks in companies. This will enable a change from a purely historic analysis of corporate failures which is rather like shutting the stable door after the horse has bolted to a more proactive, future-looking approach. Auditors may also be required to warn of concerns about viability.

The AARG will be able to commission a “skilled person review” where concerns are raised about a company. Details of how this will operate are to be determined, but this appears to be a useful step forward. The cost would be charged to the companies where it is invoked.

The Government accepts that there is merit in improving internal company controls by something along the lines of the US Sarbanes-Oxley regime. They will explore options in this area and do a consultation on it in due course. This is a welcome move and I covered the benefit of such a change in a previous blog post: https://tinyurl.com/yxmx9gzg

It is proposed to improve “viability” (i.e. “going concern”) statements and the FRC has been tasked with taking that on immediately. Such statements are certainly ineffective at present and could be improved in several ways, e.g. to avoid the “all or nothing” approach at present. Such questions are not simple black and white issues in most cases.

It is proposed to replace the existing, and most peculiar, voluntary funding arrangement of the FRC with a new statutory levy for the ARGA. This is surely welcomed as money is the key to improving many of the regulatory functions. It is clear that the FRC is under-resourced in terms of the numbers and skills of staff.

In summary, most of the recommendations in the Kingman review are being taken forward.

Comment: These long-overdue reforms are certainly welcomed and the Government does seem to be applying some urgency to them, although with a log-jam in Parliament at present it may take time to get some of the needed statutory law changes in place. But cultural changes in organisations are never easy. Old bad habits in the FRC may persist, while it remains to be seen whether adequate funding will be put in place for the ARGA. There is also a lot of detail yet to be worked out. Let us hope it is a case of welcome to ARGA and not AARGH when we learn the details.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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FRC Review of Auditing Standards – They’re Looking At The Wrong Things

The Financial Report Council (FRC) have recently published a “Post Implementation Review: 2016 Ethical and Auditing Standards”. It concentrates on the changes made in 2016 to improve the independence of auditors but will that solve the lack of trust in financial accounts and audits thereof? I doubt it.

This is what I said in response to some of their questions (answers in red):

  1. Do the current ethical and auditing standards drive the auditor to deliver work that meets the expectations of users within the current scope of an audit? If there are expectations that are not being addressed, please state those along with your proposals as to how they can be addressed. The expectations of users are still not being met because simply introducing ethical rules to be followed by auditors does not tackle the basic problem that many audits do not identify false or misleading financial accounts.
  2. Are there further steps that the FRC should consider as part of this review to ensure the delivery of high-quality audit? If so, please state what they are and why. The FRC needs to spend effort to identify why fraudulent accounts can still be produced by companies and not be identified as such by auditors. In other words, they need to look at what rules or procedures could be put in place to identify such failings as false balance sheets (e.g. reported cash not being available or undisclosed overdrafts as in Globo and Patisserie), incorrect revenue recognition (Quindell et al), excessive risks being taken and poor internal controls (Conviviality, banks in 2008, etc), and other aspects of companies that cause them to fail.
  3. Do you believe the current restrictions on non-audit services are sufficient to address threats to independence, objectivity, integrity and audit quality, and address stakeholder expectations? If not, please explain why, by providing examples where audit quality has been compromised as a result of non-audit services being provided by the auditor. They do very little to affect the objectivity, integrity and audit quality or to address stakeholder expectations.
  4. Is the work required of an auditor on an entity’s compliance with laws and regulations, and those procedures to identify irregularity, including fraud, sufficient to meet the needs and legitimate expectations of users? If not, what additional work would you require and why? A lot more work would be required to identify fraud and meet the expectations of users of financial statements. What that work might be can only come out of an examination of past audit failings.
  5. Should the FRC take further steps to increase the value of extended auditor reporting to users of financial statements? If you agree, what material would you like to see included in auditor’s reports? It’s not a case of more extended auditor reporting being required – more information will just cloud the picture. We just need to have more confidence in the accounts as reported.
  6. to assess whether management’s use of the going concern basis of accounting as required by IFRS or UK GAAP is appropriate. How could auditors make their assessment of greater value to users of financial statements? Please set out what steps you believe should be required to better underpin confidence in audit and audited financial statements. The “going concern” requirement is clearly inadequate as so many companies pass the current standard and yet go into administration or have to be bailed out before the next year end. There should not be a single “black/white” comment on the financial health of a company, but a range of reported measures. One problem at present is that both auditors and companies are desperate to avoid “qualified” accounts with the undesirable consequence that minor issues (which might point to major problems) are not reported.

There was a very interesting letter in today’s Financial Times on this subject. It was from Rodger Hughes of The Family Building Society. He said that the key driver of audit quality is the ability and attitude of audit partners and managers, but he suggested that increased compliance regulations and more auditor insecurity might have made matters worse. He concludes by saying “What is lacking and urgently needed is an authoritative study of audit failures and the underlying causes”. I wholeheartedly agree with that comment as it seems the FRC has been focussed on other than the key issues.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Improving Auditing – It’s Certainly Time

Readers don’t need to be reminded that many of the most damaging events for investors in public companies in recent years have arisen because of the failures of auditors to identify misleading accounts, if not downright fraud in some cases. The Kingman review of the FRC and the views of the Competition and Markets Authority (CMA) suggest that there is a widely recognised problem in the quality of work done by auditors and the regulation of the profession.

I have mentioned previously a report entitled “Reforming the Audit Industry” commissioned by the Labour Party which has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al (see https://tinyurl.com/yb68pfr5 ) is particularly good on the subject of how auditors have ducked any liability for their failings over the last 50 years – see Chapter 10.

If we want auditors to do a good job, then they need to be made accountable to both the companies who commission them and to investors who rely on the accounts that are published. That includes both audit firms and individual audit partners and managers. But we now have a situation where auditors have ducked both obligations by forming into Limited Liability Partnerships (LLPs), by writing contracts with their clients that exclude liability and by legal judgements such as that in the Caparo case. The aforementioned document spells out how this came about and is well worth reading. It shows how the FCA, FRC, and the Government have avoided their responsibility for ensuring that auditors are properly accountable with the result that one might expect – in essence shoddy work by auditors. One can only conclude that audit firms and accountants have had too much influence over the regulation of the audit profession. Or as the report puts it “the accounting cartel sets the rules”.

As the report says, “current liability laws do not exert sufficient pressure on auditors to be diligent or even exercise reasonable care and skill. In this environment, some audit partners cannot even be bothered to spend enough time on the job, or supervise audit staff”. It mentions that the PwC audit partner spent just two hours on the final audit of BHS and its parent company; while the Audit Senior Manager recorded only seven hours and was not involved in the final stages of the BHS audit. And at Quindell, auditors KPMG failed to obtain reasonable assurance that the financial statements as a whole were free from material misstatement, failed to obtain sufficient appropriate audit evidence and failed to exercise sufficient professional scepticism.

The reforms recommended in the report are:

  • Auditors must owe a ‘duty of care’ to individual stakeholders who have a reasonable justification for placing reliance upon auditors.
  • The incidence of liability must act as a pressure point for improvement of audit quality. Individuals and society must be empowered to seek redress from negligent auditors
  • There must be personal liability for audit failures upon partners responsible for audits.
  • Where a partner of the audit firm acts negligently, fraudulently or has colluded in the perpetration of fraud and material irregularities, civil and criminal liability must fall upon the partner of partners concerned and upon the firm jointly and severally.
  • Class lawsuits must be permitted to empower stakeholders as many stakeholders are not always in a position to seek redress from negligent auditors.
  • In the event of negligent and fraudulent practices, audit fees for the relevant years shall be returned to the audited entity.

These appear to be eminently sensible proposals to this writer.

The report covers the issue of lack of competition in the audit market as was covered by the CMA and their proposals are similar. Also covered are the failings of the FRC – lack of urgency, investigations abandoned and puny sanctions after audit failures. An example of the latter is that the fines imposed as a proportion of a firm’s global audit fees after major failings is a miniscule 0.016% on average. In other words, audit firms have no great incentive to avoid mistakes.

The concluding paragraph in the report says this: “History shows that much of the change in the world of accounting and auditing has been introduced in the teeth-of-opposition from accountancy trade associations and accounting firms. The same approach must be taken in order to make audit work for, and be accountable to, the many, and not the privileged few. Otherwise, there will be more avoidable scandals resulting in loss of pension rights, jobs, businesses, savings, investments and tax revenues, social instability and ultimately loss of faith in the ability of institutions of democracy to connect with the plight of the innocent bystanders”.

I hope everyone in the Government who has responsibility for company regulation reads this report. It is certainly time to make major changes in the audit profession.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Lehman Collapse, Labour’s Employment Plans, Audit Reform Ideas and Oxford Biomedica

There was a highly amusing article in today’s FT by their journalist John Gapper explaining how he caused the financial crisis in 2008 by encouraging Hank Paulson, US Treasury Secretary, to resist the temptation to rescue Lehman Brothers. So now we know the culprit. Even more amusing was the report on the previous day that the administrators (PWC) of the UK subsidiary of Lehman expect to be left with a surplus of £5 billion. All the creditors are being paid in full.

Why did Lehman UK go bust then? They simply ran out of cash, i.e. they were cash flow insolvent at the time and could not settle payments of £3bn due on the day after their US parent collapsed. Just like Northern Rock where the assets were always more than the liabilities as also has been subsequently proven to be the case.

Perhaps it’s less amusing to some of the creditors of Lehman UK because many sold their claims at very large discounts to third parties rather than wait. Those that held on have been paid not just their debts but interest as well. So the moral is “don’t panic”.

Lehman’s administration is in some ways similar to the recent Beaufort case. Both done under special administration rules and requiring court hearings to sort out the mess. PWC were administrators for both and for Lehman’s are likely to collect fees of £1billion while employing 500 staff on the project. It may yet take another 10 ten years to finally wind up. Extraordinary events and extraordinary sums of money involved.

An editorial in the FT today supported reform of employment legislation as advocated by Labour’s John McDonnell recently. He proposed tackling the insecurity of the gig economy by giving normal employment rights to workers. I must say I agree with the FT editor and Mr McDonnell in that I consider that workers do have some rights that should be protected and the pendulum has swung too far towards a laissez-faire environment. This plays into the hands of socialists and those who wish to cause social unrest. Even the Archbishop of Canterbury suggested the gig economy was a “reincarnation of an ancient evil” and that it meant many companies don’t pay a living wage so employees rely on state welfare payments. A flexible workforce may give the country and some companies a competitive advantage but it takes away the security and dignity of employment if taken to extremes. The Conservative Government needs to tackle this problem if they wish to be certain of getting re-elected. If you have views on this debate, please add your comments to this blog.

Mr McDonnell also promoted the idea of paying a proportion of a company’s profits to employees – effectively giving them a share in the dividends paid out. That may be more controversial, particularly among shareholders. But I do not see that is daft either so long as it is not taken to extremes. After all some companies have done that already. For example I believe Boots the Chemists paid staff a bonus out of profits even when a public company.

Another revolutionary idea came from audit firm Grant Thornton. They suggest audit contracts should be awarded by a public body rather than by companies. This they propose would improve audit standards and potentially break the hold of the big four audit firms. I can see a few practical problems with this. What happens if companies don’t judge the quality of the work adequate. Could they veto reappointment for next year? Will companies be happy to pay the fees when they have no control over them. I don’t think nationalisation of the audit profession is a good idea in essence and there are better solutions to the recent audit problems that we have seen. But one Grant Thornton suggestion is worth taking up – namely that auditors should not be able to bid for advisory or consultancy work at the same company to which they provide audit services.

Oxford Biomedica (OXB) issued their interim results this morning (I hold the stock). They made a profit of £11.9 million on an EBITDA basis. OXB are in the gene/cell therapy market. What interests me is that there are some companies in that market, at the real cutting edge of biotechnology with revolutionary treatments for many diseases, that are suddenly making money or are about to do so. That’s often after years of losses. Horizon Discovery (HZD) which I also hold is another example. Investors Chronicle recently did a survey of similar such companies if you wish to research these businesses. It is clear that the long-hailed potential of cell and gene therapy is finally coming to fruition. I look forward with anticipation to having all my defective genes fixed but I suspect there will be other priorities in the short term particularly as the treatments can be enormously expensive at present.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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