“ACCOUNTANCY” – APRIL 2018 – EMILE WOOLF

“TACKLING THE SOURCE OF THE MALAISE”

Deserved it may be, but the massive reputational battering of Big 4 brands does nothing for the profession’s standing. Since those firms appear to be quite capable of bearing the financial consequences of their errors – indeed, their own financial strength exceeds that of many clients – the remedy must lie elsewhere.

Consider the textbook distinction between limited companies and partnerships. The former have always required a statutory audit as protection for creditors since, by definition, their members’ liability is limited to the amount of share capital they have agreed to subscribe.

In partnerships (a form of business combination recognised for over 500 years), partners ultimately face joint and several (collective and individual) liability for the whole of the partnership’s debts. Misjudgements (or worse) of other partners could ultimately culminate in personal bankruptcies.

Imagine, under that regime, the level of care and diligence that existing partners must have exercised before admitting newcomers to their ranks – aware that a successful claim against the firm could result in all partners, regardless of actual involvement, being liable to the full extent of their personal wealth!

When I entered the profession, “trust” and “integrity” were not just words.

 

Enter the “Wild West”

Then, in 1991, Texas (where else!) introduced the oxymoronic concept of a “limited liability partnership” (LLP), which became so popular that most states eventually passed LLP legislation. Then Jersey (where else!) followed with legislation that allowed audit firms to register as LLPs, and they campaigned vigorously for UK law to follow suit. The Limited Liability Partnership Act 2000 duly came into force in 2001.

Newly liberated LLP partners foresaw a level of expansion and profitability previously undreamed of. Even those guardians of professional probity, the accountancy bodies that had always prohibited incorporation of member firms, succumbed to the law’s new permissiveness.

Gone were the virtuous self-policing incentives. Care and respect for partner colleagues gave way to commercial exploitation of oligopolic power by Big-4 firms, each with thousands of “partners” who have never even met each other. In the ensuing commercial melee even basic rules against conflicts, such as undertaking consulting work for audit clients, were conveniently glossed over.

Acres of accounting clutter

 

Between 2008 and 2010, in the EU alone, 182 banks had to be given liquidity or debt guarantees by their governments – just to survive. Not one of them received a qualified audit report prior to the crisis that engulfed half the world. Yet their accounts were laden with acres of accounting clutter that complied with every standard but added no more value than the worthless audit opinions attached to them.

 

A causal link

Connecting the dots, we have (i) a legal framework that effectively protects “partners” against personal liability; (ii) aggressive commercialisation of audit work; and (iii) blatant lapses in audit quality, evidenced by caseloads of palpably defective financial reports of public companies carrying unqualified audit opinions.

A box-ticker’s charter

 

The most egregious of these lapses arise from the idiotically self-fulfilling “presumption” that financial statements, just because they have been prepared in accordance with accounting standards, give “fair” presentation. If ever there was a judgement-free, “box-ticker’s charter”, this is it!

Those standards! Beneath the morass of today’s financial reporting rules core principles have been submerged: prudence; revenue and cost recognition; valuation of intangibles; loss provisioning; lower of cost and market value; prohibition of “netting-off” on contracts. If these pillars of accounting sanity had been diligently applied, would the accounts of Carillion, passed by KPMG two months before it issued a major profit warning, have escaped “going concern” alarms in its audit report?

What’s to be done?

The response that used to be trotted out: “It’s not the purpose of an audit to detect fraud”. Now it’s: “The function of an audit is to check the figures. We’re not crystal ball gazers”. Anything, except the very role that’s been staring them in the face for years!

We can’t turn the clock back. Any meaningful reform must begin where we are. For starters: (i) pin responsibility where it belongs – on individuals – reinstating a meaningful measure of personal liability; and (ii) unequivocally ban all non-audit work for audit clients.

If that means fewer auditors, who are the losers?

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