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Audit reform: Too little, too late

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The Financial Reporting Council is rearranging the audit deckchairs again, says Richard Murphy.

14th Apr 2022
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The Financial Reporting Council (FRC) has published a new Audit Firm Governance Code. This fits into its new three-year plan, which itself clearly exists only because the government has so obviously failed to deliver on its audit reform programme. At the same time, the FRC has decided it will now be the registrar for all the auditors of public interest entities (PIEs) so that they are all under its supposed control. 

Unfortunately, like those proposed reforms, this new code will do nothing to deliver the change required with regard to the accounting, reporting and auditing of PIEs in the UK. Having the FRC in sole charge of these auditors simply increases the chance that auditing will continue to fail to meet user needs, which the FRC very obviously does not understand.

Built-in failure

The FRC’s assumption is that if only the regulation of audit firms was improved, with the right incentives being created for them to deliver relevant and reliable audit reports as a result, then all will be well in the world of auditing. Nothing could be further from the truth. Bringing the governance structures of UK auditing firms closer to those required by the UK Corporate Governance Code by requiring the separation of roles at the top of these firms and boosting the role of their non-executive directors will, in my opinion, change not a single audit outcome in the UK. There are three reasons for saying so, but one over-arching one.

First of all, failure is built into this new code from the outset because it is, like its predecessor, written for the benefit of the wrong people. As the code says: 

The code is intended to benefit stakeholders with an interest in the reliable performance of high-quality audit, including: 

  • investors and shareholders in PIEs; 
  • audited entities, particularly PIEs, and their partners, employees, suppliers and customers; 
  • company directors, particularly audit committee members, with responsibilities for the appointment of auditors and the effectiveness of audit; and 
  • regulators.

The trouble with this definition is that it ignores the fact that the accounts of almost all PIEs are prepared in accordance with International Financial Reporting Standards (IFRS). The IFRS Foundation, which issues these, has quite specifically said that the general purpose financial statements that they want produced using their standards are only designed for the so-called primary users of that data. They define these primary users to be existing and potential investors, lenders and other creditors of the entity, and then solely with regard to their decision making that relates to providing resources to it. In other words, most of the users the FRC refers to have uses for data that are not designed to be met by IFRS accounts, while other users, such as journalists, local authorities, civil society, tax authorities and academics are simply ignored. You cannot base good governance on confusion of this sort. 

Second, the reform does not actually change the process of auditing, but merely changes the governance that surrounds it. This is bound to fail because the problem with so-called audit failure is not that auditors can’t spot audit problems. The issue is that accounting rules permit failing companies to present accounts that make them look like going concerns when they are not.

Not true and fair

Then, because International Auditing and Assurance Standards Board (IAASB) standards demand it, audit firms are required to sign these misleading accounts off as true and fair when they are not. That is because compliance with the demands of an accounting framework is now all that is deemed to be necessary for a true and fair view to be shown by a set of accounts, however deficient those standards might be. 

As an example, companies with massive deficits on cumulative reserves on their consolidated balance sheets (which might indicate real causes for audit qualification regarding the relevance of the going concern basis) are nonetheless, under rules issued by ICAEW, permitted to continue to pay dividends out of group parent companies that refuse to recognise the required write down in asset values of subsidiaries that those losses appear to demand. Auditors are told if these rules are followed the accounts are true and fair.

Then when the hollowed-out company fails (which is exactly what happened in the case of Carillion) the auditors are sued. Unless and until the FRC overrules this inappropriate definition of “true and fair” nothing in their new governance code will change audit outcomes or prevent audit failures. 

Third, there is the farce that this reform is happening while the accounting and auditing professions are setting up new accounting standards that will prevent auditors expressing opinions on climate-related issues by keeping provisions for these issues out of audited accounts. That is not an indication of good governance, but is instead an indication of a failure to accept responsibility for the delivery of audited reporting on the biggest issue accounting – and the human race as a whole – faces. This governance code does not reflect that fact.

Another sticking plaster

So what is the over-arching failure that this governance code ignores? It is that, as it stands, the financial statements of PIEs are deliberately designed to ensure that they do not meet the public need. Until the FRC demands accounting standards that deliver relevant reliable, comparable and comprehensible data for all the users of financial statements, without exception, nothing it can do will resolve this, and audits will fail because they are designed to do so. This new governance code and audit registration arrangements do not address these issues, and so are just another sticking plaster to cover the FRC’s continuing failure to act in the public interest.

Replies (3)

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By Nigel Hughes
14th Apr 2022 13:55

Richard - I couldn't agree more. Never mind, when ARGA takes over, all will be well (I think not)
Let's just hope someone will listen to you.

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By DJKL
19th Apr 2022 16:32

"Third, there is the farce that this reform is happening while the accounting and auditing professions are setting up new accounting standards that will prevent auditors expressing opinions on climate-related issues by keeping provisions for these issues out of audited accounts. That is not an indication of good governance, but is instead an indication of a failure to accept responsibility for the delivery of audited reporting on the biggest issue accounting – and the human race as a whole – faces. This governance code does not reflect that fact."

Should current auditors actually be expected to comment on climate related issues, are auditors the correct parties to so comment, I am not sure their upbringing makes them appropriate?

Just because they are already auditors regarding financial statements does not, imho, equip them to comment on climate related issues, mitigation and measurement.

I think such reporting might have more rigour if approached by those from the Geographical Sciences who are possibly more equipped to address the concepts and ideas from an informed viewpoint rather than tagged on as a bit part of the audit.

Perhaps universities like St Andrews that offer a bespoke course in Sustainable Development (my daughter holds an MA SD from same) might be persuaded to offer it say combined with an extra year or two covering carbon etc auditing.

https://www.st-andrews.ac.uk/subjects/sustainable-development/

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By TASG
26th Apr 2022 13:26

Impairments of subsidiaries are a big issue for auditors. I see no evidence that the accounting standards are the issue - the problem is that they aren't followed by companies and auditors.

In the absence on any concrete examples of how general purpose user model of IFRS makes the work of tax authorities or journalists unduly onerous, I cannot see what the issue is.

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