FRC To Audit Firms : 'Do The Right Thing' In The Public Interest

The  Financial Reporting Council (FRC), the UK's accounting watchdog, has published its first report on audit culture. Based on a 'thematic review' on how audit firms identify and pay attention to challenges in their culture, it calls for "more extensive and transparent public reporting" by them. Encouraging investors and other stakeholders to consider the link between culture and audit quality, the regulator pushes back at the firms themselves, reminding them of the importance of 'doing the right thing.'

"There are many factors that influence the environment within which auditors make their decisions and act. Therefore, it is vitally important that firms create an audit culture where achieving high quality work is valued and rewarded, and which emphasises the importance of 'doing the right thing' in the public interest" said Melanie Hind, Executive Director of Audit and Actuarial Regulation at the FRC.

"We found that firms have taken steps to achieving this" she added. "However, more should be done by firms to successfully promote and embed their desired culture, so that audit quality can be consistently and sustainabley high" she said.

The FRC's thematic review was conducted over 2017 and the early months of this year. Last month the UK government launched its own independent review of the FRC led by Legal & General chairman Sir John Kingman, a former Treasury official. Due for completion by the end of 2018, it aims to assess the FRC’s governance, impact and powers, to help ensure it is fit for the future.

The Kingman review in turn follows the nomination of Andrew Tyrie as the new head of the Competition and Markets Authority (CMA). Now confirmed as Chair of the CMA, Mr Tyrie has made clear his intent to probe the four biggest accountancy firms, observing their work could sometimes appear to be “money for old rope”.

The FRC's focus on audit culture is the first such report in the UK. It follows other recent initiatives to toughen up accounting regulation including the increase in sanctions -  fines to £10 million or more for seriously poor audit work by a Big 4 firm and exclusion from the accounting profession for a minimum of 10 years for dishonesty. The watchdog says its new monitoring approach will see the FRC putting the firms under greater scrutiny over their practices and performance.

If firms have the right culture, an FRC spokesman suggests, it helps to demonstrate their independence, crucial to building confidence in their work. But the focus of this thematic review is across audit, on all the firms providing it in the UK (currently eight). Yet there is no allowance made for the possibility that merely being one of the Big Four and in that dominant position has an inevitable impact on culture, and therefore on attitude to audit.

All of the Big Four had contracts with Carillion plc (about which more in a minute) - they collectively earned £71m from work for Carillion plc in the past 10 years. In case you missed it, FRC CEO Stephen Haddrill gave an interview to the Financial Times in which a 'radical idea' was proposed, essentially a break-up of the Big Four.

I covered it here, in a Governance Watch : it seems as if the initial FT story to which I linked has been edited since, but I could be mistaken.

The FRC has come under mounting criticism recently from a broad range of stakeholders around seeming conflicts of interest as well as its approach to policing the audit market. At the parliamentary hearing into the collapse of the outsourcing company Carillion plc, Rachel Reeves MP, Chair of the Business, Energy and Industrial Strategy (BEIS) Committee, said: "Carillion's annual reports were worthless as a guide to the true financial health of the company. The fact that it was impossible to get a true sense of the assets, liabilities and cash generation of the business raises serious questions about Carillion's corporate governance."

"KPMG will have to explain why they signed-off on accounts which appear to have borne so little relation to reality" she said, and the FRC is currently investigating KPMG's audit of Carillion.

But it was late 2017 before the regulator admitted for the first time that it was too slow to investigate KPMG's audit of HBOS before the collapse of the lender in 2008, when KPMG was cleared of misconduct.

There's no doubt that the FRC is an embattled regulator today and that is a legacy of history that has taken a long time to arrive. This new emphasis on corporate culture extended to audit cannot be faulted on innovation in governance. But there appears to be no consideration yet of what 'true and fair' entails, in terms of numbers. Audit is surely all about the numbers - does culture radically change those ?

There are, also,  seemingly endemic problems in the world of UK business in terms of conflict of interest and corporate governance, covered here on Board Talk.

In its report the FRC mentions paying the Institute of Business Ethics (IBE) £19,000 for its focus groups conducted with audit firms for this review. Who is at the IBE and almost certainly involved? It's none other than an erstwhile FT colleague, Peter Montagnon, also ex-FRC.

None of this helps credibility, I am afraid. While 'nudging' people along to better behaviour may be vogue in official circles, there comes a point where they might ask who exactly is doing the nudging...and do they all go to the same dinner parties?

At January's parliamentary hearing into the collapse of Carillion plc, the FRC was accused by MPs of being "toothless" and "useless". It was a charge that its CEO Stephen Haddrill rejected, but agreed that the watchdog needed more enforcement powers, for which it has previously argued. It will now have to wait for the Kingman Review to learn its fate.

In terms of the dominance of the Big Four, the thematic review is interesting on case studies that are mentioned as positive reinforcement for good behaviour, such as at Grant Thornton UK- which has, of course, decided to exit the FTSE 350 audit market since the research was done. (Having listened to its first female CEO Sacha Romanovitch talk about values, purpose and employee engagement, I am guessing it was a dual commercial and corporate governance call).

Moving away from audit culture, the most interesting thing about this report for me, was section 3.8 page 33: Implications for stakeholders. Here it is: "We held an investor roundtable on audit culture. Investors commented on the tension between firms wanting to keep their audit clients happy, whilst at the same time needing to be professionally sceptical and willing to have difficult conversations. They suggested that audit tender documents needed to focus much more on how the auditor would challenge management on behalf of the shareholders."

"One investor commented that 'It was hard to envisage an audit tender document saying, ‘Hire us because we are the most awkward firm’, but that was the cultural change that needed to be achieved.'". Exactly.

I spoke to Andrew Meek, who has been at the FRC for 12 years in the oversight team as an inspections director, about this thematic review, and the difficulty of measuring 'audit culture.' "We would encourage the firms to frequently report what they are doing, and have the debate publicly - rather than privately" he said. "The audit committee, too, has a responsibility to assess the quality of an audit and we are encouraging them to ask questions around it" he pointed out.

So in fact, under the guise of a thematic review shining a spotlight on the audit firms, perhaps the FRC has opened a debate on where the responsibility lies in ensuring that the numbers are worth anything at all....it surely lies partly in a more collective responsibility for ensuring they are fit for purpose. Maybe it is called 'stewardship.'

Finally, the launch of this report brings to the fore the broader issue of the global challenge for audit, and the need for common standards across geographies and regulatory frameworks. The outcome of the Kingman Review and the deliberations from the CMA around the Big Four are going to be significant beyond these shores.

'Other regulators around the world are interested in what we are doing now (on audit culture and regulation) and will want a dialogue" said Mr Meek. Post-Brexit, that is likely to be very welcome.

As UK Business Secretary Greg Clark said when he announced the Kingman Review: "The UK has a strong reputation as a dependable place to do business but this needs to be continuously updated and it’s important to ensure all of our regulators continue to drive high standards."