Open Season on Auditors?

I attended a joint ShareSoc/UKSA meeting hosted by PwC yesterday. There was a lively debate as one might expect on the problems of the audit profession where there have been just too many issues with listed company accounts in recent years. The latest is an investigation announced by the FRC into the audit of Conviviality but there have been lots of other problem cases in both large and small companies – Carillion, Interserve, BHS, BT, Rolls-Royce, Mitie, RSM Tenon, Connaught, Autonomy, Quindell, Globo and Blancco Technology are just a few not to mention those in the financial crisis a few years back such as HBOS, RBS, Northern Rock et al. There are simply too many such examples but whenever I go to meetings run by auditors or the FRC I get the distinct impression of complacency. They all think they are doing a great job and the bad apples are exceptions. Yesterdays event was no different.

Reading the London Evening Standard on my way home, there was an article on this topic written by Jim Armitage which was headlined “It’s open season on auditors as others dodge the bullet”. He blamed the incompetent management at Conviviality for the company becoming bust but did the audit report at that company highlight the risks being taken?

Even if it did it seems unlikely from comments from the audience at the PwC meeting that anyone would have noticed them. Only a minority of investors read the audit report part of the annual report because most of it consists of boiler plate text following by the comment “nothing to report”. Indeed it was very clear that auditors will do everything possible to avoid a “qualified” report as that might damage the company and its share price. The result is that a “qualified” report is a rare beast indeed.

There are two ways to improve performance of anyone: the carrot or the stick. Perhaps auditors should be paid more so they can put more time and effort into their audits but company boards might be reluctant to do that. There were a few suggestions raised in the meeting on how to improve matters. One was having auditors appointed by a shareholder committee rather than by the board of directors. But I suspect that would only help if such a committee had the power to approve expenditure of the company’s money. Certainly one problem at present is that auditors are selected to a large degree on price rather than quality.

Another suggestion was to have an independent audit committee (i.e. not made up of board directors), rather like a supervisory board which is used in some European countries. But that would surely add complexity and cost that only the largest companies could justify.

The stick approach would mean more penalties for auditors when they make mistakes. The Financial Reporting Council (FRC) could be tougher and impose higher penalties although they probably need more resources budget-wise to enable them to do that. But one advantageous change would be to reverse the Caparo legal judgement and make auditors liable to shareholders. At present it’s much too difficult for investors to sue auditors while companies rarely want to do so.

As regards the FRC, the Government have recently announced a review of the role of the FRC to be chaired by Sir John Kingman – see https://www.gov.uk/government/news/government-launches-review-of-audit-regulator

Sir John is looking for evidence so if you have some, please send it to him. I will probably be submitting something and ShareSoc/UKSA are likely to do so also. But if you have evidence of individual cases where auditors have fallen down on the job and the FRC have not been helpful then please submit it. The FRC also has responsibility for Corporate Governance so you may like to comment on that also. There may be hope of some change from this review – at least the advisory committee is not full of auditors and accountants.

One idea proposed in the PwC event to help auditors was for a mechanism to enable shareholders to suggest to auditors what they should be looking at in the accounts of a company. That might assist but from my experience of once doing this on a company, it had no impact on a clean audit report – the company subsequently went into administration.

There were some interesting comments on the general quality of accounts with one speaker suggesting that the failure to depreciate goodwill was distorting balance sheets and it was now obvious that investors ignored the statutory accounts and paid attention to the “adjusted” figures for profit or other non-statutory measures. Should not the auditors be auditing the latter and commenting on them? Perhaps we should have alternative measures as part of the statutory accounts?

In conclusion the PwC event was undoubtedly useful as it highlighted many of the current problems and also covered the technological future of auditing (the tools PwC now uses in its audits were covered). One can see that technology might embed the status quo of the four large audit firms as smaller organisations might not have the resources to develop their own equivalent software products.

The more one considers the accounts of companies and the audit profession in the modern world, the more one comes to realise that substantial reform is required.

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

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Audit Quality and the Caparo Judgement

There was a very good letter from Guy Jubb and Mark Solomon on the subject of the Caparo legal judgement in the Financial Times yesterday (6/2/2018). It was headlined “It is time the curse of Caparo was broken”. Here is some of what it said:

….the joint inquiry into Carillion by the parliamentary Work and Pensions Committee, and Business, Energy and Industrial Strategy Committee, must examine closely the little-known consequences of the Caparo judgment (Caparo Industries plc v Dickman [1990] 2 AC 605), which, in summary, ruled that auditors do not owe a duty of care to any one shareholder but rather to the body of shareholders as a whole, represented by the board of directors. The court decided that it would not be fair to visit what was viewed as indeterminate liability to investors for purely financial loss upon auditors and their firms. This all means that, as a practical matter, the auditors of listed companies are, in the normal course, immunised from the risk of being sued by investors for audit failure. It just never happens.”

The Caparo judgement overturned the previously assumed responsibility of auditors to the shareholders of a company and the general public to ensure that the accounts of a company could be depended upon. The judgement seemed to rely on the fact that shareholders have no contractual relationship with the auditors but only with the company who appoints them.

This judgement made it exceedingly difficult for shareholders to pursue auditors, and although there are possible “derivative” actions there are other obstacles that have been introduced over the years that reduce the potential liability of auditors. One is that they are now mostly not simple partnerships with the partners being individually and personally liable, but Limited Liability Partnerships. Secondly auditors write their contracts with companies and these now limit the scope of liability substantially – they frequently exclude liability for omissions that one would expect auditors to identify.

With the declining quality of audits, and the lack of competition between the big four audit firms, it is surely time to revisit the whole legal framework under which auditors operate. With companies often more interested in reducing audit costs than ensuring the accounts can be relied upon, one can see why and how the standard has been reduced over the years.

It’s not just Carillion that has shown how dubious are current audit standards but the problems in the banking crisis faced by RBS and HBOS were a direct result of lax audit reports. It also extends to numerous smaller companies – indeed too many to mention.

How to fix these problems? These are my suggestions:

  1. Auditors should have a statutory responsibility to the owners (i.e. the shareholders) in a company.
  2. Auditors should personally be liable for failings and not be able to hide behind LLP structures.
  3. Contracts between auditors and companies should be based on “model” contracts as laid down by the Financial Conduct Authority or the Financial Reporting Council, and drawn up based on the advice of investors.

I shall write to my Member of Parliament on this subject as this is something the Government needs to take in hand. I suggest readers do the same. How do you contact your M.P.? Simply go here for contact information: https://www.parliament.uk/mps-lords-and-offices/mps/

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

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