Auditing and Corporate Governance: Government reforms will achieve little

By Prem Sikka

The UK is in danger of drowning in corporate sleaze. Too many are engaged in rip-offs, frauds and fiddles.

The evidence is all around us. The finance industry has mis-sold numerous financial products relating to pensions, endowment mortgages, precipice bonds, split capital investment trusts, payment protection insurance, mini-bonds and much more. It has rigged interest and foreign exchange rates. The UK is a global hub for money laundering, tax avoidance and illicit financial flows.

There are scandals galore. BHS, Carillion, Thomas Cook, Patisserie Valerie, London Capital and Finance, Redcentric, Quindell, Autonomy Corporation, Blackmore Bond, Woodford Equity Income fund and alleged frauds at HBoS and RBS are just the tip of an expanding iceberg. Greensill Capital and Liberty Steel are the latest additions.

The UK has an ineffective regulatory architecture of around 700 regulators and all too often it does the bidding of the industry rather than protect people from malpractices. On 10th March 2021, I gave the House of Lords examples of organisations which admit to being engaged in “criminal conduct” but have been shielded from retribution by UK Ministers and regulators.

Corporate sleaze has enriched some but robbed millions of jobs, savings, investments and pensions. It is against the above background that the government has published its consultation paper titled “Restoring trust in audit and corporate governance” with the aim of “improving the UK’s audit, corporate reporting and corporate governance systems”. However, it is unlikely to achieve its aims.

Failures of Corporate Governance

The UK has a shareholder-centric model of corporate governance, but shareholders of listed companies rarely take a long-term interest in invigilating companies, directors or auditors. They are focused on short-term returns and none objected to directors of Carillion massaging financial statements or borrowing loads of cash to pay dividends. BHS was the plaything of the Green family. Shareholder control at these companies and elsewhere did not check management excesses, but the government is pushing the same failed policies.

 The consultation paper says “Shareholders, as the owners of companies, have a vital role to play in the corporate governance framework”. This makes no sense. There is no legal or economic theory to show that shareholders own companies.

Under the Companies Act 2006, shareholders have controlling rights but “ownership” is something totally different. Employees, pension schemes, consumers, supply chain creditors, local communities and taxpayers have a long-term interest in the wellbeing of companies and have borne the brunt of all scandals. But the government does not grant them any role in corporate governance by empowering them to elect directors and auditors.

The consultation paper expresses some concern about undeserved executive remuneration, especially when unexpected corporate collapses draw attention to failures and negligence. So the government hints at some regulatory action to clawback some portion of executive remuneration.

The difficulty is that the UK has no central enforcer of company law. Executive contracts are not publicly available and annual financial reports rarely provide good information and conceal things such as payment of school fees; the use of private jets, yachts, cars, chauffeurs, club membership fees and other perks.

Shareholders have rarely rejected executive remuneration packages as they are more concerned about their own short-term returns. The government is not seeking to empower employees or consumers to vote on executive pay. Its choice is “to consult on changes to the UK Corporate Governance Code to include provisions which recommend that certain minimum clawback conditions or ‘trigger points’ are included in directors’ remuneration arrangements”.

This will achieve little, especially as compliance with the Code is voluntary. It does not empower stakeholders and cannot be enforced by courts because the Code is not part company law.

Audit Failures

Numerous scandals have shown that external auditors, the private police force of capitalism, are in bed with corporate directors, the very people that they are supposed to be invigilating. The Financial Reporting Council, the auditing and accounting regulator, has stated that more than 80% of the audits in its sample needed “improvements required” or “significant improvements required”.

Most of these are carried out by the big four accounting firms – PricewaterhouseCoopers (PwC), Deloitte, KPMG and Ernst & Young. A large part of the consultation paper is focused upon external auditors, but the proposed reforms are more likely to appease big accounting firms rather than deal with audit failures.

The big four accounting firms audit 97% of FTSE 350 companies and there is little choice at the top-end. This enables the firms to collect monopoly rents. At the same time, there is the danger that the collapse of a big audit firm could cause considerable market turbulence. So in the interest of market resilience the government could break-up the big audit firms, but that is not on the agenda.

It could advocate joint audits which could enable medium-sized and big firms to jointly perform audits. This would enable medium-size firms to get a toe-hold in the big company audit market, but the government does not do that either. Instead, it calls for “managed shared audit requirement for UK-registered FTSE 350 companies”. The result of this will compromise the independence of the junior firm even though it will sign the audit report as an equal and share liability as an equal.

Neoliberals are all too fond of talking about increasing the number of suppliers to promote competition and drive down prices and improve quality, but such talk is absent in the government’s consultation paper. Currently, accounting firms can enter almost any market, but others can’t enter the audit market as there are statutory barriers to entry.

No one says that only pilots can run an airline business, chefs run food business or pharmacists run drug companies, but the law requires that only organisations under the control of auditors can deliver audits. The government has no plan to remove barriers. So the supply of audits won’t increase and accounting firms would continue to collect monopoly rents.

We live in an audit society and come across numerous varieties of audits, such as audits by VAT inspectors and passport checks at airport and ports by immigration officers. In no case is the auditee able to hire and remunerate the auditor, and the auditor is not permitted to act as an adviser to the auditee.

Yet that is the basis of company audits. Auditors are dependent upon companies for their appointment and fees and will not bite the hand that feeds them. Fee dependency is worsened as auditors are permitted to sell consultancy services to audit clients and audit the resulting transactions. BHS paid its auditors PwC £355,000 in audit fees and £3,303,000 in consultancy fees.

Fee dependency buys auditor acquiescence and PwC partners backdated the audit report for good measure too. Public Sector Audit Appointments, an independent body, appoints and remunerates auditors of local councils and public bodies, but the government is content to let companies and their directors appoint and remunerate auditors.

There needs to be a complete ban on the sale of any consultancy services by auditors to any audit client. The best way of achieving that is to have firms whose sole business is to conduct audits, but big audit firms do not like that and the government is not pushing for it either.

At best, we may end-up with an organisational split of the big auditing firms i.e. a firm with two divisions under common control; one arm selling audits and the other selling consultancy to the same client. So auditors would continue to be mired in conflict of interests. There is no likelihood that the arm auditing financial statements would find fault with internal controls installed by the consultancy arm of the same firm.

There is a regular parade of audit failures. The main reason is the absence of strong pressure points to improve quality, and poor public accountability. The producers of potato crisps and toffees have to ensure that their product is safe and they owe a ‘duty of care’ to current and potential consumers. However, that does not apply to auditors. At best, they owe a ‘duty of care’ to the company and not to individual stakeholders injured by their negligence.

Successful litigation against negligent auditors is rare. Therefore, threat of liability laws does not act as a pressure point for improvement of audit quality. Rather than reforms, the government hints that more liability concessions may be showered upon auditors. Of course, any gifts for auditors will need to be handed to producers of other goods and services too and will weaken consumer protections.

There is little public information about the audit process and most of it comes to attention from scandals. For example, at BHS, the PwC audit partner spent two hours on audit and thirty-one hours on consultancy. The audit team was under the day-to-day control of a person with only one-year’s post-qualification experience and the audit team mix was poor. Unsurprisingly, many of the basic audit tasks were not carried out. All this was acceptable to internal norms of the firm.

Corrosive organisational culture can be addressed by forcing auditors to publish their time budget, composition of the audit teams, time spent by each grade of labour, a list of key questions and replies secured and a list of recent regulatory action against the firm. However, none of this is on the government’s agenda.

Albert Einstein is accredited with saying that “Insanity is doing the same thing over and over again and expecting different results.” So it is with the government’s proposed reforms. They are located in the failed paradigm of a shareholder-centric model of corporate governance, the appeasement of big accounting firms and neglect of democratisation of corporations, and will achieve little.

Lord Prem Sikka is Emeritus Professor of Accounting, University of Essex. Twitter: https://twitter.com/premnsikka

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