REFORMING THE AUDITING INDUSTRY - visar.csustan.edu

1 REFORMING THE AUDITING INDUSTRY . Prem Sikka Colin Haslam Christine Cooper James Haslam John Christensen Deepa Govindarajan Driver Tom Hadden Paddy Ireland Martin Parker Gordon Pearson Ann Pettifor Sol Picciotto Jeroen Veldman Hugh Willmott * REFORMING THE AUDITING INDUSTRY . This review was commissioned by the Shadow Chancellor of the Exchequer, John McDonnell MP, and conducted independently by Professor Prem Sikka and others. The contents of this document form a submission to Labour's policy making process; they do not constitute Labour Party policy nor should the inclusion of conclusions and recommendations be taken to signify Labour Party endorsement for them. This report is promoted by John McDonnell MP, Shadow Chancellor of the Exchequer at House of Commons, Westminster, London SW1A 0AA. *We are grateful to partners and staff of the big four accounting firms, mid-tier accounting firms, Group A firms, small firms, regulators, individual investors, institutional investors, corporate executives, pension scheme trustees, pension scheme members and ordinary citizens for sharing their thoughts with us.

2 The Authors; Published: December 2018. Contents Chapter Topic Page List of Acronyms 2. Executive Summary 3. 1. There's No Business Like Accounting Business 9. 2. The Accounting INDUSTRY 19. 3. Auditors Must Act Exclusively As Auditors 35. 4. Big Four Become The Big Three? 51. 5. Statutory Auditor For The Financial Sector 59. 6. Expanding The Supply Of AUDITING Services 75. 7. An Independent Body For Appointment Of 85. Financial Auditors 8. Audit Market And Competition 85. 9. Corrosive Organisational Culture 102. 10. REFORMING Auditor Liability 116. 11. Accounting for AUDITING Firms 128. 12. Regulatory Structures 137. 13. Conclusions 165. The Investigating Team 169. 1. LIST OF ACRONYMS. Accounting Standards Board (ASB). Association of Chartered Certified Accountants (ACCA). Association of International Accountants (AIA). Audit Inspection Unit (AIU). Bank of Credit and Commerce International (BCCI). Bank of England (BoE). Chartered Accountants Ireland (CAI).

3 Chartered Institute of Management Accountants (CIMA). Chartered Institute of Public Finance and Accountancy (CIPFA). Consultative Committee of Accountancy Bodies (CCAB). Competition Commission (CC). Competition and Markets Authority (CMA). Department for Business, Energy & Industrial Strategy (BEIS). Department for Trade and INDUSTRY (DTI). Federal Deposit Insurance Corporation (FDIC). Financial Conduct Authority (FCA). Financial Reporting Council (FRC). Generally accepted accounting principles (GAAP). Institute of Chartered Accountants in England and Wales (ICAEW). Institute of Chartered Accountants of Scotland (ICAS). International Accounting Standards Board (IASB). International AUDITING and Assurance Standards Board (IAASB). International Federation of Accountants (IFAC). International Financial Reporting Standards (IFRS). Limited Liability Partnerships (LLPs). National Audit Office (NAO). PricewaterhouseCoopers (PwC). Public Interest Entities (PIEs).

4 Public Sector Audit Appointments Limited (PSAA). Prudential Regulation Authority (PRA). Recognised Professional Bodies (RPBs). Recognised Qualifying Bodies (RQBs). Recognised Supervisory Bodies (RSBs). Republic of Ireland (ROI). Securities Exchange Commission (SEC). Statement of Recommended Practice (SORP). 2. EXECUTIVE SUMMARY. Accountants belonging to select few accountancy trade associations enjoy the state guaranteed market of external AUDITING . Yet audits have been used as a stall for selling other services. Auditors have been unable to deliver independent and robust audits and the AUDITING INDUSTRY is in disarray, dysfunctional and stumbles from one crisis to another. AUDITING firms are mired in conflict of interests and have shown willingness to bend the rules at almost any cost to increase their profits. A steady parade of scandals has followed and auditors' silence has been a major factor in loss of people's pensions, jobs, savings and investments.

5 Supply chain creditors and tax authorities have been forced to write-off billions of pounds at Carillion, BHS and elsewhere. The 2007-08 banking crash showed that banks crashed within days of receiving a clean bill of health from auditors. It did not encourage the INDUSTRY to examine its practices and reforms were organised off the agenda. The regulators are captured by the AUDITING INDUSTRY and poor quality of audit work is the inevitable outcome. They have failed to check predatory practices, improve audit quality, mount speedy and thorough investigations of audit failures, apply effective sanctions against auditors delivering poor audits, or develop any schema for public accountability of the AUDITING firms. The UK AUDITING INDUSTRY is dominated by the big four firms who are routinely implicated in scandals and seem incapable of delivering high quality audits. The AUDITING INDUSTRY lacks basic market pressure points. There is lack of competition and choice, especially at the top-end of the market.

6 In competitive markets those producing shoddy goods/services and deriding customers for expecting higher quality are pushed out of business. They can face mega lawsuits. But despite monumental failures, AUDITING firms stay in business because the audit market is guaranteed by the state and regulators do nothing. Auditors enjoy too many liability concessions. Anyone selling automobiles, food or medicines has to ensure that the product is fit for purpose and will not injure current or future consumers, but such considerations are absent from the audit INDUSTRY . People have few, if any, rights against negligent auditors. The INDUSTRY sets its own AUDITING standards or benchmarks which are often the lowest common denominator. A mechanical checklist mentality dominates within the firms to the detriment of audit quality. A culture of profit maximisation has resulted in inadequate time budgets, irregular AUDITING practices, offshoring (or outsourcing) of audit work and reliance upon work performed by staff not under the direct control of the firms.

7 Firms have a history of non-cooperation with regulators. The reforms of the AUDITING INDUSTRY have been grudging, minimalist and ineffective and often on the terms specified by the big four accounting firms. Reforms are needed to give backbone to auditors by ensuring that they concentrate on audits only. The distraction of non- AUDITING services needs to be removed and auditors must act exclusively as auditors. Auditors of large companies need to be freed from fee dependency on company directors and therefore need to be appointed and remunerated by an independent body. In order to reduce market domination and reduce turbulence resulting from the demise of a large supplier, joint audits for large companies need to be mandatory. For the last fifty years, the audit firms have been unable to deliver effective audits of financial enterprises. Society has paid dearly for 3. such failures and cannot afford any further banking crashes. Therefore, an independent statutory body needs to perform audits of banks, building societies and insurance companies.

8 For far too long, the setting of accounting standards has been left to organisations under the control of big firms and corporations, and the end result has been a poverty of accounting practices as shown by banks, Carillion and other cases. Accounting standards affect the distribution of income, wealth, wages, dividends and risks only parliament has the democratic mandate to oversee such matters. All accounting standards/principles need to be set by parliament. The same applies to auditor duties and AUDITING standards. Parliament shall legislate on the principles and the Companies Commission, a newly created independent regulator, can then fill-in the details. There shall be no statutory regulatory powers for the Financial Reporting Council or any of the accountancy trade associations. The following is an overview of the reforms proposed by this report. Details are in the text that follows: Auditors Must Act Exclusively as Auditors 1 Statutory Auditors of large companies and other entities must act exclusively as auditors.

9 2 The audit business of accounting firms must be legally separate from everything else, with no cross holdings. 3 Auditors and their associates cannot sell any non- AUDITING services, with the exception of delivering statutory returns, to audit clients. 4 It will be a criminal offence for statutory auditors of large companies and any entities related to them to offer or perform non- AUDITING services for audit clients. 5 Members of the audit team cannot join the staff of the audit client for five years after ceasing to be a member of the audit team. A Statutory Auditor for the Financial Sector 6 The state can become the fifth largest supplier of audit services. 7 A statutory state-backed body must be created to conduct real time audits of banks, building societies, credit unions, insurers and major investment firms. 8 The statutory auditor will work closely with the financial sector regulators. 9 The financial sector regulators shall have unhindered access to the files of the statutory auditor.

10 4. Expand Supply of AUDITING Services 10 Remove all restrictions on the ownership of AUDITING firms in order to attract new entrants, capital, competition and choice and create pressures for improvement in audit quality. 11 Joint audits must be made mandatory for large companies, as defined by the Companies Act 2006. Independent Body for Appointment and Remuneration of Auditors 12 An independent body to be created to appoint and remunerate auditors for all non-financial sector large companies, as defined by the Companies Act 2006. 13 Big four firm share of the audits of FTSE 350 companies must be capped at 50% of that market. Audit Market and Competition 14 Large companies must be required to change audit firms, partners and entire audit staff at least once every five years. 15 Audit firm rotation must be accompanied by a ten year cooling-off period the outgoing firm cannot return for another ten years. 16 Audit tenders should be publicly available 17 The winning audit tender, in its original form, shall be filed at Companies House.