UK audit reforms fail to address the real problem behind scandals

The writer is professor of business and public policy at the University of Oxford’s Blavatnik School of Government

Corporate auditing is in crisis, as the public wonders how the Big Four key players missed major accounting scandals such as Carillion and Wirecard. And this betrays a wider crisis of public trust in business itself: does the economy work for the people or is it the other way around?

The UK government announced a bold set of proposals aimed at restoring public trust in audits and markets on Thursday. The newly appointed business secretary, Kwasi Kwarteng, is following up on a series of public reviews from 2018 and 2019 that seemingly gathered dust last year, as the government appeared distracted by Brexit and the pandemic.

Alas, it has not been worth the wait. The proposals focus almost entirely on fixing “rules”, not rebuilding “norms”. The key idea seems to be that new regulations and regulators will succeed where old ones failed. But the trouble is not badly designed rules; it is that, whatever the rules, we lack a systematic culture in audit firms and corporate boardrooms to challenge chicanery when it presents itself.

True, the accounting standards that enabled Carillion to avoid goodwill write-offs and instead pay out dividends are flawed, in that they give managers unverifiable discretion over accounts. We should fix them. But the standards do not impede auditors and independent directors in questioning management’s reporting judgments.

In the case of Carillion, the imputed claim behind management’s decision to avoid goodwill charge-offs was that it would somehow take lossmaking government contracts and turn them profitable. The company had little record of doing so, and the “externals” should have raised this inconvenient truth. We do not need new regulations to make that happen: we need more common sense and integrity.

Some of the government’s proposals on bonus clawbacks and stricter director liability will be quite useful to that end. But others, such as forcing client companies to use smaller audit firms to second-guess the Big Four — Deloitte, EY, KPMG and PwC — are misplaced.

The approach hearkens to the government playing favourites in the marketplace, akin to the nanny state saying each time you spend at Tesco you must also buy something at the corner shop. If the smaller audit firms do not have to sweat to compete in the big league, they will underinvest in quality. This will make the UK less entrepreneurial and markets less safe for investors, contrary to the stated intentions of the proposals.

As part of its wholesale reforms, the government is replacing one regulator — the Financial Reporting Council, which has been seen as too close to the audit firms — with another, prospectively named the Audit, Reporting and Governance Authority. To address the perceived failures of the FRC, the government is endowing ARGA with more powers, including that to bypass judicial review in some cases.

This move, alarming in itself for disregarding the “separation of powers” principle at the heart of good government, misses the point. The problem with the FRC is not that it has too little power: the problem is that its power is seen to be captured by close ties to the audit industry. Giving the new regulator still more powers does not address the issue of regulatory capture.

To the end of setting corporations on a more virtuous path, the government has decided to weave into its proposals new requirements to hold companies to account on the UK’s 2050 climate agenda. Among these is the idea that certain companies should produce “resilience” statements on their carbon sustainability.

What we see of (voluntary) corporate statements to this effect is highly variable with much puffery, suggesting that the economy is still experimenting with meaningful forms of such accounting. So, by mandating such a nascent reporting practice, the government risks institutionalising mediocrity or worse.

Restoring people’s confidence in auditing and business does not entail evermore regulation. After all, people these days have little faith in government, too. The public will have more confidence in business when business once again delivers prosperity equitably.

These reforms introduce regulatory costs to the economy at a time when Britain is perilously uncompetitive and alone in the world. And regulations tend to benefit the regulated, as smart players with misaligned incentives can always find ways around rules. What needs to be done is more difficult: fix the culture in auditing and boardrooms to challenge unseemly corporate practices as they happen.