Audit – is a change in the law the answer?

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When the London and General Bank went bust in the 1890s, its auditors were sued for negligence by the bank’s liquidators. They had been persuaded by the directors not to issue a qualified report, despite the under-capitalised and almost insolvent bank’s proposal to pay a grossly imprudent dividend.

Forward to 2019, when the House of Commons Business, Energy and Industrial Strategy (BEIS) Committee’s report into the failings following the collapse of Carillion stated that ‘year after year’ the company paid dividends to investors, despite its debts and pension deficits. Auditors are still in the spotlight over these corporate failings, such as BHS, Carillion and the financial irregularities at Tesco.

We are often told how the standard of accounting and auditing has improved. Certainly their complexity has, with the 20th century producing nine Companies Acts and the creation latterly of national and international accounting and auditing standards. But ‘standards’ may not be the same thing as ‘standard’ in terms of the standard of quality – hence the need for reviews that have been or are being carried out by the BEIS, the Competition and Markets Authority and Sir Donald Brydon.

An obvious suggestion of what to do would be to change the law. The consolidated Companies Act 2006 did a good job of making life easier for owner-managed businesses, but there is a tendency to pass the buck over to the accounting profession when the going gets tough:

  • The concepts of ‘true and fair view’ or ‘prudence’ have never been defined in legislation, but rely on ‘conventional wisdom’;
  • ‘Realised profits and losses’ are those which are ‘treated as realised in accordance with principles generally accepted at the time when the accounts are prepared’ – a pretty big buck to pass.

Governments can’t themselves change professional standards, although the BEIS committee recommends that they should lead international efforts to improve them.

So other than legislative changes, what can be done? The following have been suggested in the various reports to date:

  • replace the Financial Reporting Council with the Audit, Reporting and Governance Authority, which it is hoped will have stronger regulatory powers;
  • auditors being appointed by the regulator rather than directors and shareholders;
  • whole or partial separation of audit and non-audit functions within accounting firms;
  • the largest companies audited by joint auditors;
  • a shorter period of compulsory rotation of audits than the current 20 years;
  • scope of the audit being extended to the whole annual report;
  • a clearer distinction between distributable and non-distributable reserves;
  • a ‘solvency test’ applied to dividends.

The question remains: would applying any of the above make a difference? Fifty years ago audit reports were six lines long. Today they stretch to over a page, yet there is no indication that this has had an impact on audit quality.

The implication when signing an audit report must be that although the engagement partner has delegated the detailed work, they were aware of all issues that arose during it, and that they were involved with both planning and review. They also need to ensure that their team have fully understood the nature of the business and the pressures and the motivations of its management. If auditors can’t honestly say that, they need a business climate where they have no fear of the consequences of issuing a modified report or at least an emphasis of matter.

The key thing to remember is that auditing is a ‘people business’, and to achieve change, people have to change.

This article was written by David Duvall MA FCA, and was originally published in full in Accountancy Daily.

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