Auditor Regulation and the dozy watchdogs

The Government has published a public consultation on Auditor Regulation. This is a discussion document in response to the requirements of a new European Directive on Audit, and your responses are invited. It’s available here: https://www.gov.uk/government/consultations/auditor-regulation-effects-of-the-eu-and-wider-reforms although those who do not have a professional interest in the subject may find it heavy going. But it’s worth repeating the first paragraph which is:

“Effective financial reporting underpins the development of the best businesses – those that others are willing to invest in and to do business with. It informs decisions that are made, for example, by shareholders, directors, investors and suppliers. Audit is an essential safeguard to provide independent assurance that the financial reporting of businesses properly reflects their circumstances”.

Yes auditing is important as the investors and directors of Tesco are no doubt keenly aware. The Financial Reporting Council (FRC) have now confirmed that they will be investigating the audits of Tesco by PwC for the last three years. They are also investigating PwCs role at Barclays where many billions of client funds were not segregated as legally required.

The Economist published a very good article under the title “The Dozy Watchdogs”on December 13th (available on the web). It covers the past history of audit failures and shows how common they are. For example the recent failure of Banksia in Spain that had to be nationalised only a few months after an IPO. Enron and Worldcom in the USA (Enron caused the failure of large audit firm Arthur Anderson), or Polly Peck in the UK. Or consider the recent banking crisis where audit firms consistently passed the UK banks that failed as “going concerns” months before they collapsed (Northern Rock, Royal Bank of Scotland, Bradford & Bingley, Lehmans come to mind), although some people blame that on the accounting standards in use rather than the audit firms.

The Economist article does tackle some of the big issues and possible causes of audit problems. Namely that the company being audited selects the audit firm and pays them. In addition they often have a very long standing contracts with the audit firm, and the latter might also have considerable other consultancy business from the company which might prejudice their willingness to report failings or challenge management.

It is also very difficult to make auditors accountable for mistakes. Unlimited liability of audit partners no longer generally applies as audit forms have set up Limited Liability Partnerships (LLPs). In addition, auditors only have a contract with the company they audit and not with shareholders so they are no longer accountable to shareholders. That is certainly so in the UK due to the Caparo legal judgement and even in the USA it’s not easy to make them accountable.

ShareSoc has covered these problems in our Policy Manifesto (available from our web site) which says this: “In essence the legal system which acts as the framework for companies has been watered down in the interests of company directors and their professional advisors over the last 50 years, to the detriment of shareholders interests“; and “The legal framework for companies should be changed to improve accountability. Directors and auditors should have a duty to, and be legally accountable to shareholders. The legal concept of ‘fraud against shareholders’ should be introduced in a new law to cover such matters as issuing false or misleading information to the market or the prejudicing of minority shareholders, and provide a basis for legal actions. And the legal system should be reformed so that shareholders can pursue grievances at reasonable cost. In addition the penalties for fraud should be increased.”

Are we going to see any substantial changes from the EU Directive or from the Government consultation? It seems very unlikely as the changes proposed are quite minor. They are unlikely to prevent future major audit failures as have happened in the past. The Economist suggested it was time for “some serious reforms”, and this writer cannot but agree.

But if any ShareSoc member has a particular interest in audit matters and would be interested in writing a response to the aforementioned public consultation, please let me know. Response are required by the 19th February.

This is undoubtedly my last blog post of the year so I wish all my readers a prosperous New Year. The next one is likely to be on what our followers would like to see ShareSoc do in the New Year. Perhaps campaigning for audit reform might be in there.

Roger Lawson

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