Why the FRC’s ethical standard fails to restore public trust

Ethics is far more than an incidental feature of the auditing framework. It is actually its very essence. In virtually every instance of audit failure that finds its way into the public domain, whether it concerns undetected management fraud, money laundering, accounting manipulations, bogus claims, insider trading, you name it, we find that the cause of such failure is rarely technical incompetence.
It is rather the all-consuming moral haze in which first principles of independent sceptical assessment have been sidelined in favour of commercial expediency.

The latest round of audit quality inspections (AQI) highlights the egregious failure of firms to abide by the Financial Reporting Council’s revised ethical standard, with almost a quarter of all inspections resulting in failure.

fines and penalties ineffective

The question of AQI effectiveness brings in the issue of punishment for failure. To date, examples appear to relate to high profile breaches already in the public domain, often involving past and present litigation, civil and criminal. The fines and penalties are clearly ineffective because everything carries on much as before, as if those swingeing imposts have already been costed in, as an unavoidable overhead.

Try this instead: a complete ban on the firm accepting any new public company audits until the stock exchange authorities are satisfied that audit partners and managers have undergone a sufficiently robust (and humiliating) training in what audits are really about.

Ambiguous exceptions

Nor does the FRC help itself by imposing a standard that is itself riddled with subjectively determined exceptions. This applies particularly to the rules prohibiting non-audit work for audit clients. Too many of the rules designed to avoid conflicts of interest have counterpart exceptions that, in effect, invite conflict.

For example, provision by the external auditor of internal auditing services is prohibited if it is “reasonably foreseeable” that the audit firm “would place significant reliance” on that work. There is an additional “safeguard”: the internal audit work must be undertaken by partners and staff who have no involvement in the audit engagement.

indigestible piece of fudge

Where does that indigestible piece of fudge leave you? “Reasonably foreseeable”? To, or by, whom? What is “significant reliance”? If it is known that the work is not going to be relied on, why perform it at all? And using different people in the same firm to plan and perform it? That’s a ploy, not a “safeguard”.

Then there are information technology services. These are not permitted if they are “important to any significant part of the accounting system”, whatever that may mean. And valuations? Not permitted unless they have “no material effect” on the financial statements. Auditors have been debating the meaning of “material” since the dawn of accountancy, and here we find it in a proscriptive rulebook binding the whole profession.

Tax services? Not permitted if the engagement partner has reasonable doubt on “whether the related accounting treatment involved is based on well-established interpretations or is appropriate”.

No basis for judging quality

These mealy-mouthed strictures provide no objective basis for judging audit quality and the FRC does itself no favours by persisting with this sorry patchwork of conflicting terminology. As I argued in last month’s column, this impenetrable nonsense cannot restore the trust in audited financial statements that years of flagrant commercialism have lost.

Only a complete ban on the undertaking of non-audit work by auditors of public interest entities could achieve this now. I mean all non-audit work – not only for audit clients.

“Don’t upset the client!”

As they stand, the rules on ethics fail to mask their subservience to a different rule – one that lies at the root of all conflict: “No matter what, don’t upset the client”! Under such a prescription, free scope for sober and disinterested scrutiny is reduced to limits, subtly imposed.

If, alternatively, public company auditors are licensed only to audit, the commercial pressures to acquire and retain non-audit consultancy work will disappear. Audit firms will be smaller, but more focused on the most important public service of all: protecting the investments and savings of millions of people and entities whose shares and bonds are a key component of the capital bedrock of the nation’s future economic growth.