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Missed shot at darts
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Watered-down audit reform is a missed opportunity

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The government’s proposals for audit reform are a cop-out, says Richard Murphy. The fundamental flaws will survive because audit itself is not reformed, and nor is the audit profession.

31st May 2022
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The government has, at long last, issued its proposals on how audit in the UK should be reformed. A first reading suggests that few, except the directors of the largest companies, will be pleased with the proposals made, many of which are much watered down from those included in the consultation paper published in February last year. 

Having read the 197-page document, published this morning, several things become clear. The first is that the fundamental flaws in auditing will survive the review. The audit report will still only address shareholders. This means that audit responsibility to the vast majority of the users of accounts of the public interest entities (PIEs) to which this proposal applies is denied, making a mockery of the whole concept of a PIE in the process.

Second, audit itself is not reformed, and nor is the audit profession. Instead the new regulator – ARGA – and “the market” are left to work out what corporate audit might mean in the future, clearly suggesting that the government intends to duck any difficult issues. The profession remains largely as it is with existing centres of power left intact as a result. This means that the market failure that audit represents is not addressed, on the basis of the obviously false assumption that the market can sort it out. Government ideology has clearly driven this, guaranteeing that the reforms will fail. 

Not fit for use

Third, the fundamental problem that has given rise to audit failure is that accounts based on International Financial Reporting Standards (IFRS) are not fit for use (based as they are on deeply subjective mark-to-market concepts that prioritise the balance sheet over the profit and loss account). They are open to abuse, spread income reporting over up to three statements so that no one can really appraise the performance of an entity during a period, and provide no real indication of value despite their balance-sheet focus. Not tackling this issue means that after this reform auditors will still be reporting on garbage, meaning that they will inevitably fail the public interest. The “garbage in, garbage out” principle of auditing remains firmly in place. 

Fourth, the environment is ignored. Instead we get a resilience statement. The only merit of this is that it requires that the PIE appraise the risk it faces in the short and medium term. The latter is a welcome addition with regard to financial sustainability and dividend policy but of no use at all when it comes to the longer-term risks inherent in climate-related issues, which auditors will still ignore as a result.

Hollowed-out firms

Fifth, the key reason for this review was to prevent audit failure. Research that my colleagues and I have undertaken has shown that excessive dividend payments, made out of unrealised reserves at a group level, are one of the biggest reasons for corporate failure. The excess payments create what we call hollowed-out firms. At least one-third of FTSE companies might meet this criteria. Despite our patiently pointing this issue out to the Department for Business, Energy and Industrial Strategy (BEIS) in writing and in meetings and despite us providing an explanation as to how the profits to permit payment of these dividends can be created, together with an explanation as to how group distributable profits could be estimated, the government has decided to only require disclosure of distributable profits at group parent company level. In the group accounts this disclosure will be recommended, but we can be sure that will be ignored. Audit failures will continue as a result precisely because, by ignoring the need to constrain excess dividend payments, the government is setting up companies to fail. 

Easing of thresholds

Sixth, the number of companies the reforms will apply to is reduced considerably by the easing of the thresholds for being a PIE. Fewer than half the anticipated companies will now be covered by the new regulation. The idea that the public are really going to get the information that they need or the protection that they deserve is, as a result, remote.

Seventh, that is because it is clear from the construction of the comments in this document that this consultation set out to listen to all the vested interests that have created the problem that we now have. So auditors and companies are heard most, and institutional investors next. Everyone else was brushed aside. As evidence, in the list of those submitting comments to the consultation every company is listed separately. Sixteen civil society groups and academics are treated as making a single submission, when Adam Leaver of Sheffield University Management School and I made four in all. This is to dismiss the public interest.

Eighth, the interests of directors are in contrast given priority. The proposed penalty regime on directors is relaxed, and move towards the Code on Corporate Governance, where sanctions are light. The demands for better internal control are substantially diluted. The status quo continues in other words.

Missed opportunity

In summary, this is a missed opportunity. Audit failure is evidence of market failure. The government is clearly not willing to embrace the idea that market failure is possible. As a result the need for regulation to protect people from market abuse is not recognised and auditing is left to reform itself, by and large. In a telling sentence on page 90 it is said that “The Government will leave the market – companies, directors, investors – to shape the development of an enhanced wider assurance services market in the coming years.” In other words, they have copped out. That's the most succinct summary of these reforms that I can offer.

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Replies (4)

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By Hugo Fair
31st May 2022 19:49

Pardon my naivety, but what does being an "economic justice campaigner" actually entail?
If I wanted to give it a bash, then what performance metrics would indicate my success or failure?

Back to the thread, as I said in response to Richard Hattersley's article on the same topic earlier today:
"The consultation responses had a common thread which could be summed up as the need to rock the boat (i.e. shake things up more than a bit) ... whereas the govt's proposals seem designed to minimise rocking the boat by applying compromise after compromise to (i.e. watering down) each area of change." Is anyone even remotely surprised at this lack of determination?

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Replying to Hugo Fair:
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By AndyC555
08th Jun 2022 16:04

"what performance metrics would indicate my success or failure?"

The number of grants you mange to blag from charities.

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By HLB
01st Jun 2022 09:57

Dice has been thrown. Big 4 audit firms can go past Go and collect £bn's in audit fees and miss the Go Straight to Jail square yet again.

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By TASG
01st Jun 2022 12:00

I expect a deafening silence as a response, but in concrete terms, using real life examples from any of numerous financial reporting failures that have occurred recently, could the author describe what actual issues are with the following abstract complains:-

a)"deeply subjective mark-to-market concepts" Are we still banging on about Enron? (and implicitly claiming Enron's financial statements were actually properly prepared in accordance with US GAAP? And even if so, why is US GAAP relevant to *UK* *auditing* standard?)

b) "prioritise the balance sheet over the profit and loss account". Is this about RBS and Northern Rock? ?(because if it was, accounting for credit risk expected losses has changed more than a decade ago) Genuinely don't understand.

c) "spread income reporting over up to three statements". What three statements? Are we proposing companies report using a trial balance? Who really has been affected by a SOCIE?

The real problem is much simpler. People commit fraud not because it is correct accounting - it is not correct accounting - but because they are financially motivated to do so.

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