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Quality of audit

There has been much recent comment on the quality of audit. This includes suggestions that the Big Four accountants should be broken up, all FT-SE 100 companies should be jointly audited with a non-Big Four company and that auditors should be banned from doing consultancy work with clients they audit.

Certainly, the Financial Reporting Council (FRC) has been getting more strident with record fines for accounting firms, both Big Four firms and smaller fry.

FRC has suddenly grown teeth, but it is too late. On 11 March 2019, the government announced that FRC is to be abolished and replaced by a new Auditing, Reporting and Governance Authority (ARGA). FRC chairman Stephen Haddrill will stand down with chairman Sir Win Bischoff and deputy chairman Huey Evans. ARGA will have new and stronger powers than FRC.

In some ways, ARGA is simply a continuation of a process that has gone on for more than a century.

In cases no more recent than Lothian Chemical Co Ltd v Rogers [1926], the court has said that accounts must comply with “ordinary principles of commercial accounting”. (The case concerned whether conversion of plant was capital expenditure. It is.) Arguably there are similar cases going back to the 19th century.

At that time, there were no accounting standards as such. The ordinary principles of commercial accounting were determined by reference to an authoritative text book or by calling on a respected accountant.

The first attempts at written standards were “recommendations” produced by the Institute of Chartered Accountants in England and Wales (ICAEW) and published in The Accountant (of which I later became an assistant editor). These were issued until 1969 and were not fully repealed until 1989.

These were superseded by Statements of Standard Accounting Practice (SSAPs) drafted by the Accounting Standards Committee (ASC) from 1970 and issued by the participating accounting bodies.

In 1990, ASC was replaced by the tougher still Accounting Standards Board (ASB) which had statutory backing and issued Financial Reporting Standards (FRSs) under its own authority.

In 2012, ASB was itself replaced by the Financial Reporting Council (FRC) which replaced all extant standards. This body is itself now to be replaced.

A full account of the development of accounting standards can be found on the Tax Training Ltd website from here.

Where auditing goes wrong

The criticism of auditing derives not so much from an expectation gap as an expectation ocean. What account users and what auditors provide are so far apart as to be invisible to each other. The introduction of ARGA is not likely to change this.

There are two main problems.

First, the statutory audit of a company is only concerned with two matters:

  • are the accounts true and fair
  • do they comply with the Companies Act.

The audit does not say that the company is operating fairly or even legally. It does not say that the directors are competent or honest. There are now some laws and procedures to address these shortcomings but the audit is not part of them.

Second, the audit is not addressed to the right people. The auditors are generally appointed by the shareholders to whom they are answerable. The answerability to members (usually shareholders) is set out in Companies Act 2006 s495.

The function of the auditors is to report to members on how far the directors have exercised proper stewardship of the company.

But they don’t do it!

Anyone reading company audit reports quickly realises that they all seem to read the same. This is because all that the members receive is text copied verbatim from an auditing standard.

The real evidence found from the audit is contained in a “letter of weakness” sent from the auditor to the directors — the very people the auditor should be checking on behalf of the shareholders. This is like detectives investigating crimes and passing on the details to the criminals and not the prosecuting authorities. In such a scenario, it is hardly surprising that audits are seen as not fit for purpose.

Replacing FRC with ARGA will not solve this problem. There is little point in replacing a weak tiger with a strong tiger if it is not allowed near its prey.

For audits to gain public trust, two things must happen.

First, the scope of the statutory audit must be widened to include whether the company is trading efficiently, honestly and legally.

Second, and more important, all contents in a letter of weakness must be made known to shareholders and other users of accounts.

Robert Leach FCA FCCA
May 2019.

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