Among the many casualties of the Financial Crisis of 2007-09, one of the more notable was the reputation of much of the financial services industry. Bankers, asset managers, credit ratings agencies, even regulators were found wanting, and public confidence in their competence and even probity was as a result much diminished.
One sector of the financial services industry, though, seemed to escape largely unscathed. The accountancy profession, and more specifically auditing, seemed to avoid much of the blame and criticism levelled at the rest of the financial sector. While in the aftermath of the crisis bankers became the pariahs of the financial industry, and the banking industry was (and for many people still is) a byword for greed and mendacity, accountants and auditors suffered nothing like such a diminution in their public standing.
This is on the surface somewhat surprising, because the failures of auditors in the Crisis were as large as anyone’s. Auditors are meant to understand what is going on inside companies, and have a duty to make their concerns public if they suspect a company is heading into financial trouble. Yet it is a singular feature of almost all the high-profile corporate bankruptcies that arose in the Crisis that in the period before a company declared itself in trouble, the auditors issued a clean bill of health and signally failed to raise any alarms.
No auditors raised any concerns before the collapse of Bear Stearns, Lehman or AIG (some of the high profile US casualties of the Financial Crisis) or in the UK before the failures of RBS, HBoS or Northern Rock. All of these companies were declared sound by their auditors until one day … they weren’t. And yet their auditors escaped any criticism for this lack of forewarning. One has to go back to the failure of Enron in the early 2000s to find an example of a corporate failure resulting in adverse consequences for their auditors, as the firm of Arthur Andersen disintegrated under accusations of complicity in the frauds that led to Enron’s demise.
However, in the UK at least this charmed life for auditors may be about to change. The bankruptcy of major UK companies such as BHS (2016) and Carillion (2018), and significant profit warnings out of the blue for many others, especially in the retail sector, has brought the question of “what were the auditors doing?” to the fore, though it was the rather smaller though higher profile collapse of Patisserie Valerie that really caught the public eye and moved the question of the role of auditing from the business section of the newspapers to the front pages.
And the UK authorities have responded, with first the Kingman Report on the workings of the Financial Reporting Council last December, and then the commissioning in February of a Review, headed by Sir Donald Brydon, which is expected to report by the end of the year. And not to be outdone, the House of Commons held a Select Committee hearing in March on the wider question of audit failings, and the press has kept the matter in the public eye since then. All of these have been critical of the big accountancy firms and have raised legitimate concerns about how the industry operates.
But is this criticism justified? Are accountants complicit in the failure of management at these and other companies, or the victims of events which they cannot control and often have deliberately hidden from them?
Here one must distinguish between the great majority of companies and company audits, where the companies are relatively small and simple and the audit task relatively straightforward, and the numerically very much smaller (even if in a financial sense much larger) issue of accounts for publicly listed companies.
In the former, there is seldom much controversy or dispute about what the “true and fair record” of past financial events should be, and there is no suggestion that for such companies, the UK’s many smaller accountancy firms are failing in their duty to provide them. But larger and more complex audits involve an increasing amount of judgment – there may not be one simple and correct “answer” – and here the role of the auditor is less financial scorer of what has happened and more arbiter of how to present it.
This is not in itself to criticise large companies or their auditors. The accounts of services-based (and even more so, technology-based) companies are inherently less absolute, because so much of the balance sheet relies on management assessment of the value of financial positions and intellectual property. The accounts of complex companies are more open to different presentation than those of unitary ones because of the need to account for intra-company activity, which is often not conducted at arm’s length or with real pricing. And the accounts of global companies have to allow for the treatment of finances across national borders, where different accounting and tax regimes many treat events in different ways.
All three of these increase the element of judgment in the construction of accounts for large public companies. But whenever there is significant scope for professional judgment, there is also the opportunity for the auditors to be open to pressure from management to exercise that judgment in one direction rather than another.
This matters because of the way the accountancy profession interacts with major companies. Firstly, although the auditors are in theory appointed by and answerable to shareholders, in practice they are appointed by, paid by and importantly have their reappointment controlled by management. In addition, the annual audit is often neither as interesting work, professionally speaking, nor as well-paid as the much more lucrative consultancy business that accountancy firms offer their clients.
As a result, for the Big 4 accountancy firms and the major companies they service the annual audit exercise is in itself largely something to be completed with minimum aggravation and minimum risk of upsetting or annoying management, and more significantly a “loss-leader” to provide the gateway to the provision of other services.
It is not very surprising then that audits of listed companies often seem to bear more signs of how management would like them presented, rather than what shareholders really ought to know. Particularly where, as is now the norm for listed companies, management’s own remuneration depends to a large extent on their company’s annual results and share price.
But the consequence is that modern corporate accounts risk suffering from a variation of Goodhart’s Law. The standard phrasing of this law, named after the economist Professor Charles Goodhart, is that “when a measure becomes a target, it ceases to be a good measure”. And this sums up the position for the accounts of listed companies fairly closely: corporate accounts have moved from being a measure of how well a company is doing to a target for management to attain for remuneration purposes, and in the process they risk losing much of the information content they used to have.
Ironically, the biggest losers from this may in the end be management themselves, who find that the accounts of their company move from being a window through which they can see what the company is doing, to merely a mirror in which they only see what they themselves have been doing in arranging the books.
We think this may be behind some of the major collapses in public companies recently – big profit warnings, collapses of balance sheets and so on. In many of these cases, management seem to have been almost as surprised as everyone else when the true state of the companies they are responsible for has been revealed (Patisserie Valerie is a prime example). It is if they have overlaid the base accounts with so many judgment calls that they themselves have lost track of the true position.
The heart of the problem is that accountants of major corporations are producing accounts that are used by the general public (shareholders, potential investors, the stock exchange, the tax authorities), but paid for by and to a very large extent overseen by management. And as a result, the profession is open to the risk that either it does not try hard enough to prevent management “finessing” the accounts or, worse, it enables and encourages them to do so. As the old saying has it, “He who pays the piper calls the tune”.
This is exactly the nexus that destroyed the integrity of the credit rating agencies, whose verdicts on the financial health of borrowers were used by investors but paid for by management.
How to address this? We offer a radical solution, which is that for any listed company, the auditors should be appointed by the stock exchange they are listed on not the management.
This has a basis in the reality that the consumers of the accounts are, by and large, the investors in their stock and the general public more widely, and resolves the auditors’ conflict between management’s interests and shareholders’. It would encourage honest accounts because the auditors would want to be reappointed by the (independent) stock exchange. And lastly it would leave open the whole field of consultancy – which is where accountants derive most of their revenue – for the big accountancy firms to engage with companies in independent and unconflicted relationships divorced from the auditing role.
Lest this idea seems extreme, reflect across to bank supervision, another form of running an independent eye over a financial company’s books. Nobody in their right mind would suggest that the supervisors of a bank should be appointed by and responsible to the bank’s own management!
Since the turn of the Millennium, a constant theme has been the loss of respect and reputation for the established elite. MPs, the BBC, the press generally, the police, the economics profession and so on have to varying degrees lost the public’s respect. The financial sector suffered an almost complete loss of public trust, which it is still more than 10 years later struggling to rebuild.
If the Big 4 accountancy firms do not want to follow down this sorry path of being seen by the public as self-centred, overpaid and with dubious morals, they need to watch the outcome of the current debate in parliament, the press and other public forums very closely.