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« Compliance Alert: New UK law criminalizes corporate apathy toward tax evasion | Main | Navy commander guilty of obstructing Fat Leonard investigation »
Wednesday
Aug162017

Rahul Rose: Has the UK audit regulator been captured by those it regulates?

In the prior post, I described the lackluster approach to enforcement that has characterized the Financial Reporting Council. What's the cause? A large part of the explanation lies in the regulator’s closeness to those that it is supposed to be holding to account.

A number of the FRC’s senior positions as well as the tribunal judges that decide cases are former employees of KPMG, EY, Deloitte or PwC, the Big 4 firms that dominate the audit industry.

Indeed, four of the FRC’s board members previously worked at Big 4 firms. Another member, Mark Armour sits on the audit committee of UK-based retailer Tesco, which in April this year entered into a deferred prosecution agreement with the Serious Fraud Office over allegations of accounting misconduct.

The FRC’s chairman Sir Win Bischoff formerly chaired Lloyds Banking Group, which took over UK-based bank HBOS in January 2009 during the financial crisis, while the regulator’s director of corporate governance, Paul George, worked at KPMG for nearly 15 years.

The concentration of former Big 4 accountants and industry figures at the FRC has led to allegations of regulatory capture. However, the regulator’s shortcomings go deeper than this. It is also under-resourced.

According to the FRC’s 2016 annual report, the enforcement division only has only 24 employees. The regulator often has to outsource investigations. In comparison, the UK Financial Conduct Authority has over 650 full-time staff in its enforcement and market oversight division.

The FRC’s investigatory powers have also traditionally been limited. Until recently the regulator was able to compel information only from accountancy firms, However, as of June 2016, the FRC has also been able to compel third parties to provide information, including by interview.

To date no investigation has been completed using these new powers, so it remains to be seen whether they will result in an uptick in FRC enforcement.

When presented with criticisms by Corruption Watch, the FRC said it has a “robust conflict of interest policy” in place, and that its enforcement division was appropriately resourced to carry out proper and timely investigations. It added that it delegates the majority of its enforcement activity to professional accountancy bodies, such as the Institute of Chartered Accountants in England and Wales, not because of a lack of funds, but because this is required by the law.

However, investigations are not the only part of the FRC’s enforcement regime that have come under criticism. The sanctions imposed the FRC -- and in particular its financial penalties -- are tiny compared to the revenue of the Big 4 firms and the remuneration of individual partners at these firm.

Between 2009 and 2012, the average fine that the FRC imposed on an individual was just £9,000 ($11,640). Things have got better in recent years, but only marginally. In 2016, the average fine imposed on a partner from a Big 4 firm was only 16 percent of the mean profit per UK-based partner at such a firm. In the same year, the mean fine levied on a Big 4 audit firm was only 0.12 percent of the average UK revenue of the Big 4, and an even smaller proportion of global turnover.

The fines that the FRC levies on accountancy firms are also often small compared to the fees that firms charge their clients. For example, between 2000 and 2005, Deloitte only faced a £3 million ($3.88 million) fine despite earning £30.7 million ($39.7 million) from audit and consultancy fees from the carmaker MG Rover Group (which collapsed in 2005 with nearly £1.4 billion ($1.81 billion) in debts despite receiving a clean bill of health).

Fortunately the FRC has recognized that there may be problems with its sanctions regime. The regulator has launched an independent review, led by a former Court of Appeal judge, of its current guidance and policies for imposing sanctions.

The review is focusing on, among other things, the question of whether the FRC’s fines are too low. A glance at the statistics would suggest that the answer to this question is “yes” -- the FRC needs to increase the size of its financial penalties if they are to have a real deterrent effect. At the current level, fines are simply the cost of doing business for major audit firms.

Aside from increasing the size of its financial penalties, Corruption Watch also hopes that the FRC will introduce changes to separate itself more clearly from the firms that it regulates. This may require the FRC to employ fewer people from Big 4 audit firms, especially in senior positions.

The regulator also needs to take a more proactive approach to pursuing possible misconduct. At present, the terms of reference for its investigations are too narrow, inquiries often take too long, and in some instances, as in the case of Ian Foxley discussed in the prior post, the FRC fails to respond to whistleblowers at all.

Investing more resources in its enforcement division is a necessary first step for the FRC to take a more active and robust role in investigating possible misconduct.

In a July 2016 report, the Treasury Select Committee described the FRC’s reluctance to properly scrutinize KPMG’s auditing of HBOS for its role in the 2008 financial crisis as “inexplicable” and “unacceptable.” The committee has also said that it “likely” wanted to review the work and regulatory approach of the FRC in more detail.

Corruption Watch hopes that Nicky Morgan, the Treasury Select Committee’s new chair who was elected in July, continues the project started by her predecessor and carries out a full review of the FRC.  

_____

Rahul Rose is a senior researcher for Corruption Watch, a London-based NGO that undertakes cross-border investigations into grand corruption and pushes for effective enforcement of UK anti-corruption legislation. He can be contacted here.

Reader Comments (2)

Rahul Rose is right to raise these issues, but I would add two points. First, there is a danger of confusing accounting firms' earnings from audits, etc with their profits from these net of costs. And second, there are broader issues of the impacts of penalties additional to the penalties themselves: about which we know relatively little. Effectiveness is more important than symbolism.
August 19, 2017 | Unregistered CommenterMichael Levi
Looking forward to reading a rebuttal piece from some highly placed accountants, that would, I expect, point a similarly skeptical / accusing finger at the legal profession,the business community and the political class. All have a role in enabling misconduct. All are either part of the solution, or, part of the problem. Thankfully we have the FCPA blog, as the mainstream media cannot possibly discuss the issues, or present a platform for discussion/debate the way this forum does.
August 20, 2017 | Unregistered Commenterlameslave 13

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