It has descended into predictable farce. Every time a corporate reporting clanger is dropped and auditors of a public company are mired in yet another scandal, the Financial Reporting Council responds by undertaking to investigate the accounts and audit of the plc in question.

The FRC is fighting a rear-guard action. It is constantly taking pains to reform its own structures on independence and reporting, and is recruiting more top people. It continuously upgrades its expectations of audit firms regarding experience; skills; attributes; leadership; governance; models; risk management; audit quality. You name it, and they are looking for it!

Breaking up the Big 4?

But they are looking in the wrong direction. Everything FRC tries is of questionable effectiveness: mandatory audit rotation; ever-greater fines and penalties; recruiting more monitors; reputational shredding; even threatening to break up the Big-4.

Its updated guidance, effective 1 June, addresses the question of sanctions for misconduct by guilty audit firms and individuals, possibly resulting in fines of up to £10 million, ten-year bans for individuals and greater use of non-financial penalties. Whether this will make any appreciable difference to audit quality remains to be seen, but don’t hold your breath.

I believe that delivery of decent audits will elude them until the nettle of fundamental reform is grasped.

The scourge of limited liability

Personal responsibility has been eroded since limited liability partnerships replaced the traditional partnership structure, under which every partner risked unlimited personal liability for the financial consequences of the actions of every other partner.

Partners of untested integrity

The LLP structure has spawned a multitude of “partners” of untested integrity, scarcely known to each other, and has replaced the virtuous self-regulatory incentives of real partnerships with corrupting incentives to look the other way.

But the genie is out of the bottle and we can’t put it back.

Without LLP protection firms would simply switch to limited company status – after all, they would sooner take to the hills than practise without limited liability in today’s climate! They would not be prepared to take it on trust that a partner, somewhere, will not succumb to the temptation of approving accounts that include the odd fiction.

Potential reform lies with the Limited Partnerships Act 1907. This allows partnerships to have some members (referred to as “limited partners”) with limited liability. The key is that the limited partners are prohibited from taking part in the management of the partnership. If they stray into the firm’s management they automatically lose their right to limited liability.

Profit-sharing arrangements could easily be adjusted to reflect the re-apportionment of risks and rewards, and partners could focus on what they do best.

Cordoning off high risk audit work from other areas

But whatever happens, firms must be rigorously split (physically and financially) so as to cordon off high-risk audit work from equally lucrative areas such as pre-share issue due diligence, consultancy, legal and tax advisory work, and interpreting accounting standards.

Allowing the audit to be negotiated as a showcase deal for the offer of other services must end immediately.

Treacherous accounting rules

Yet even these reforms will be of little avail while the world of corporate reporting is stuck with accounting rules (IFRS) that are not only wrong, but whose complexity has taken off on a flight of unintelligible verbosity, utterly incomprehensible to ordinary investors. If you don’t believe me, try reading the rules on recognizing revenue from contracts – then you will perfectly understand how the deeply flawed governance of Carillion facilitated the inclusion of half-a-billion pounds of reverse-factored bank debt in “other creditors”, while also treating it as positive cash flow – all with KPMG’s benign blessing.

Why stop there? How about more than 90 per cent of “intangible assets”, nearly £1.7 billion, being “goodwill”? Did anyone actually believe that this accounting device had value? But because these accounting fictions followed compliance with half-baked, impenetrable standards, they were presumed to achieve “fair presentation” – according to the perverse logic of IAS1.

Spineless imprimatur

As long as auditors are expected to give their spineless imprimatur to reports mired in the distortions of mark-to-market mythology and “expected” loss models, how can they possibly redeem their sullied reputation for going with the flow and simply following the money?

Emile Woolf

Emile Woolf

Emile Woolf is a Renegade Inc. correspondent.

Over 45 years, he has been a teacher, lecturer, best-selling author of professional texts, practising accountant, forensic expert witness and, throughout this period, one of the profession’s most widely read columnists and magazine journalists.

Emile's subject range includes the wider spectrum of economics, taxation and any related developments that have a financial dimension, always seeking to identify the principle that lies behind the dilemma.

Website: http://www.emilewoolfwrites.co.uk/
Emile Woolf

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