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Audit Separation: Has the FRC wimped out?

Philip Fisher takes a critical look at the Financial Reporting Council's proposals for audit separation.

8th Jul 2020
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In the eyes of the world, the audit industry has been rife with scandal for ages.

It seems as if barely a week goes by without the announcement of another corporate disaster that begs questions about auditing competence, most recently Wirecard.

Auditors appear unable to do the basics right, constantly failing to identify and take action until it is too late, by which time companies have either gone under or lost millions (billions in the case of Wirecard).

As a result of avoidable failures, pension funds, small investors, creditors and soon to be former employees suffer irreparable damage, while you wonder why banks and the Treasury accept the significant losses that they incur. Surely our profession owes stakeholders a better service?

The FRC is supposed to ensure that this kind of thing doesn’t happen but has frequently been unable or unwilling to take necessary action.

Action at last

Now, at last, there have been some firm proposals for action. Admittedly, the status quo can continue for four more years before full implementation and we will just have to pray that there are not too many disasters in the interim.

The plan is worthy. “The objectives of operational separation, which is world leading, are to ensure that audit practices are focused above all on delivery of high-quality audits in the public interest, and do not rely on persistent cross subsidy from the rest of the firm.” That world leading might be regarded as an unfortunate phrase, given its farcical use by government ministers in the last few weeks, generally attached to embarrassing failures.

The two primary objectives are:

  • Objective 1: Improve audit quality by ensuring that people in the audit practice are focused above all on delivery of high-quality audits in the public interest.
  • Objective 2: Improve audit market resilience by ensuring that no material, structural cross-subsidy persists between the audit practice and the rest of the firm.

With all due respect, Objective 1 should have been a given for the last century or three, not a 21st century goal.

Equally worryingly for this writer, one of the desired outcomes is, “The total amount of profits distributed to the partners in the audit practice should not persistently exceed the contribution to profits of the audit practice.”

As an accountant, it is hard to understand why the total amount of profits distributed to partners in the audit practice would ever exceed the contributions of that practice.

It also seems strange that, having found a solution and decided to implement it, the FRC is exempting everyone bar four firms. The scandals have been spread more widely over the years and it is hard to see why audit separation should not extend across the profession.

Subsconscious perceptions

The other question that some may have is whether the problem of sub-standard auditing is purely down to influence. It might be a bold assertion but some might wonder whether the fact that they constantly get away with it has changed the perceptions of some auditors, possibly subconsciously.

Back in the old days, accountants had joint and several liability: if their colleagues screwed up, they could lose their houses. That certainly concentrated the mind and made us very much aware of colleagues’ shortcomings.

Many of the problems around sloppy auditing are also connected to loss-leading audit fees. First, as the FRC has identified these make firms beholden to clients, who are then expected to buy big when it comes to consultancy.

In addition, auditors are tempted to cut corners in order to reduce perceived losses expressed as under-recoveries, which finance partners are wont to attack. The best way to achieve this is to do a lousy job. It would have been good to see a more coherent strategy to get over these hurdles too.

You also have to wonder whether the FRC’s analysis and proposals are on the right lines and go far enough. A partial separation, with close connections seems to be pussy-footing around.

If they really believe that the problem lies in undue influence, the more obvious solutions are either to legislate to put auditors into completely separate corporate structures from consultants with no overlap or, if they really want to take away any chance of influence, nationalise the whole sector.

Replies (6)

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By jon_griffey
08th Jul 2020 18:04

Blindingly obvious elephant in room:

Directors are responsible for appointing auditors and agreeing and paying their fees. Auditors are therefore never going to be independent.

Until that conflict is resolved, everything else is just window dressing.

Thanks (1)
Replying to jon_griffey:
By cbarling
10th Jul 2020 09:48

This is so true, Jon.

Having sat on financial services audit committees for the last 10 years or so, it is totally different dealing with the auditors versus the regulator.

While it is very painful dealing with regulators who often leave a lot to be desired, they definitely aren't in our pockets. I wouldn't go so far as to say the auditors are, but the whole tone is very different. The reason for that is that ultimately the executive directors have a big influence in appointing or firing them, despite that not being the official position.

Thanks (1)
By Paul Crowley
09th Jul 2020 18:04

And pretty much closed shop.

Time for audit on quoteds to be completely seperated from ALL other services by same firm

Thanks (0)
By Brend201
10th Jul 2020 10:33

"As an accountant, it is hard to understand why the total amount of profits distributed to partners in the audit practice would ever exceed the contributions of that practice."

But a practice is typically more than just an auditing practice: many firms include taxation, corporate finance, insolvency etc. I heard the expression once that "we are an ice cream and umbrellas business - we do well when it is sunny and we do well when it rains". The firm where I worked at the time had gone through difficult times when its tax consultancy, corporate finance and audit had all been hard hit by the financial crisis but they picked up a lot of insolvency work which kept the business and partnership intact. I wasn't a partner but there was an implication that the distributions took account of the swings and roundabouts. Was that a bad thing?

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By paddy55
10th Jul 2020 12:56

"Objective 1: Improve audit quality by ensuring that people in the audit practice are focused above all on delivery of high-quality audits in the public interest."
If auditors are to deliver services in the public interest, then they should be paid by the public directly.
Nobody is independent of the paymaster. He who pays the piper calls the tune.

Thanks (1)
By geoffmw1
10th Jul 2020 15:57

I go back to the 1950s and 1960s as a manager in a large medium sized practice. The work included audit, accountancy, company secretarial, reporting accountants and some tax.
It is in my opinion impossible to separate audit from other professional accountancy.

Thanks (0)