Re:Balance -- Jim Peterson

UK Audit Reform: Carson Block Comes Up Short

Since the collapse of Carillion in January 2108, there is no remaining dispute on the desirability of extensive re-engineering of Big Audit –- the model by which assurance is provided on the financial information issued by the world’s large public companies.

That said, the discussion was not advanced by short seller Carson Block, who in the Financial Times for May 20 re-played the too-familiar proposition that “the audit industry is failing to protect investors and employees from malfeasance.”

Right message. As for the messenger … not so. The reasoning is deficient, to be explained shortly, but first recognize the anomaly of criticism from someone with deep self-interest in preserving the current model.

Leave for others the impassioned views on the legitimacy –- indeed, the morality –- of short selling. Rather, Block’s arguing for accounting and audit reform is like a whisky salesman arguing for prohibition. The success and very business model of his hedge fund Muddy Waters Capital depend on the ability to dig out and exploit the undiscovered misbehaviours that lurk in the dark niches of corporate reporting.

From his reputation-building attack on Sino-Forest in 2011, down through NMC in 2019 and GSX and Luckin Coffee in 2020 –- all could have been non-events, in the capital markets and for Block himself, if only detected and mitigated on a timely basis, under a model not beset with systemic dysfunctionality.

Nor is there anything new here. Short sellers and their brethren have long been active in the gaps and inadequacies in Big Audit. My own first experience with the world of white-collar financial criminality goes back to 1973, and the Ponzi scheme at Los Angeles-based Equity Funding, exposed by renegade analyst Raymond Dirks rather than by dual auditors Haskins & Sells and Seidman & Seidman.

Beneficial for investors and the entire market structure as would be timely prevention of the malfeasance that inheres in a system populated by those ready to exploit its weaknesses, achievement of real improvement would come at the cost to Block of the very feedstock for his success –- even as that virtuous environment is nearly impossible to imagine in a world where public expectations are of “zero defects” in the operation of a complex system designed and run by fallible human beings. 

Passing the question of Block’s credibility as a critic, his views have these flaws:

First, it is incorrect that “material accountability” for lapses in audit quality is enabled by the “ringfencing of liability.” The market facts are to the contrary.

True, a “worst case” civil or regulatory outcome in, for example, Wirecard in Germany, or NMC, Carillion or Patisserie Valerie in the UK, would be fatal to the financial viability of the local firm of a global network. From there, however, cross-border or global network-level liability becomes irrelevant. The fragility of the global networks was demonstrated in 2002, with the unwillingness of the ex-US firms of Arthur Andersen to support its US firm under the liability of Enron –- thus not a consequence but a major contributing cause of its disintegration.  

Second, Block rings again the long-heard theme that consulting services are “the most insidious way that the audit firms abuse public trust,” advancing the notion that auditors are exploited to “whitewash” business problems.

Which is simply not so -- recent examples to the contrary being the revelations at Wirecard and Adler in Germany, where auditor activity beyond their statutory remits figured prominently. Moreover, the case for broadened rather than narrowed auditor competencies and services, laid out in Sir Donald Brydon’s comprehensive if regrettably side-lined report of December 2019, is now at the forefront of the energized public calls for expanded reporting and assurance in the Environmental, Social and Governance space. 

Least appealing in his whinging is Block’s failure to offer constructive suggestions. The evolution to an achievable and sustainable Big Audit model, assuming resolution of all the necessary challenges, will not sprout and blossom if watered by the crocodile tears of those whose interests are served by the preservation of the status quo.   

Nor, it must be said in conclusion and agreement with Block’s opening shot at the official “failure actually to do anything” on audit reform, is there any credible explanation for the Boris Johnson government’s silence, now running from the March 2021 launch of its fully-informed consultation, other than the bare state of its empty tool kit.   

For that, it is well past time to acknowledge that “operational separation” of the Big Four audit practices is no more than an exercise in optics and appearances, while the forced reduction of their dominant market share of FTSE 350 audits is a “solution” thoroughly discredited as unrealistic and unachievable.

Instead, necessary fundamental changes will require re-visiting of basic principles so long embedded in the model that practitioners and participants can scarcely imagine alternatives –- regarding scope and permissible range of audit practice, extension and diversity of auditor competencies, evolved financial and governance structures for assurance providers, and re-casting of the regimes of regulatory oversight and legal liability.   

 

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Audit Reform in the UK? The Queen’s Silence Says It All

As reported in London, there were two notable absences when the Queen’s Speech was delivered on May 10, in the effulgent pomp and circumstance of the State Opening of Parliament.

Missing was the Queen herself, claiming “episodic mobility problems” –- a prudent choice, for a monarch of 96 years and in official harness since her coronation back in 1953.

Second was any mention of legislation on the parlous state of Big Audit –- the model by which assurance is provided on the financial information of large public companies –- a franchise dominated by the tetrapoly of Deloitte, EY, KPMG and PwC.  

The Queen’s substitute was Prince Charles, the longest-serving heir apparent in British history – for which, no criticism. A legislative body with 800 years of history can survive being read to by the senior member of the House of Windsor’s second team.

Less credible is that the energy for audit reform in the UK has run steadily downhill since the January 2018 collapse of the massive contracting and project supervising enterprise Carillion. The immobility of the Boris Johnson government is faced by Kwasi Kwarteng, secretary of the Business, Energy and Industrial Strategy department –- himself frozen in silence on Big Audit since his public mention in January 2021, the first month of his tenure.

The absentee BEIS secretary’s disinterest would be consistent with years of official attitude, in the face of a roster of reports and criticisms: Sir John Kingman’s final report of December 18, 2018, which characterized the UK’s audit regulator --  the Financial Reporting Council -- as ramshackle and shambolic; the Competition & Markets Authority’s Update Paper, finalized on April 28, 2019; the Parliamentary BEIS committee’s report, “The Future of Audit,” of April 2, 2019; and Sir Donald Brydon’s December 2019 report, on his “Independent Review Into the Quality and Effectiveness of Audit.”

With that fulsome body of material in full view, the BEIS department launched its consultation, “Restoring Trust in Audit and Corporate Governance,” in March 2021; with its prompt closure that July, there has been dead silence since.

Political concerns are said to dominate, as the government’s concerns and priorities lie elsewhere. Audit reform is characterized as “boring” by contrast to “wedge issues” designed to “go down well with voters.”

That’s as may be, although it is no less plausible that reality has intruded and that Whitehall may actually realize that its kit is empty of tools.

That is, in the entirety of the proposals floated by the various critics, there are only two with possible direct effect on the business model and performance of the handful of firms that dominate Big Audit.

The first is “operational separation,” by which the Big Four firms have agreed with the FRC to identify distinct leadership, governance, and performance metrics for their audit practices. That insubstantial undertaking was from the start never more than an exercise in optics, as the firms were already running their businesses that way, indeed with considerable public disclosure.

The second was the critics’ notion that both audit quality and large-company auditor selection would somehow benefit if the Big Four were forced to yield up a material portion of their dominant share of the FTSE 350 audit market. The barriers to such a fancied “solution” have been comprehensively laid out, centering on the lack of both appetite and resources on the part of the unfortunately-labelled mid-tier “challenger firms.”

Laid beside the official paralysis, it matters that while evolution in Big Audit is not possible without the participation of all the players -- issuers, auditors, providers of capital, standard setters, regulators and the legal systems and agencies of law enforcement -- each of those has its own vested interest in resisting change, preserving and maintaining a status quo that is viewed as working tolerably well. 

In that context, an observer would be justifiably anxious that any official policy action could deliver unintended consequences all too familiar from earlier efforts –- the hasty passage of the Sarbanes/Oxley law in the US in 2002, the UK’s mandating of auditor re-tender in 2012, and the EU’s parallel imposition of mandatory rotation in 2014.

Not only should the interested parties look to limit official action to the “do no harm” variety, they would well recognize that while the official policy of inaction is in effect, no affirmative harm is being inflicted.

In other words, for those judging the government’s passivity to be fraught, it would be wise to consider the approach of Napoleon Bonaparte in his Austerlitz campaign: “Never interfere with an enemy when he is making a mistake.”

 

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