Too close for comfort: the incestuous ties that bind auditors and watchdogs

Stephen Haddrill has the look of a man with the weight of the world on his shoulders. At his most recent public appearances, the 62-year-old boss of Britain’s accounting watchdog appeared tired and grey.

It is no surprise, given that the Financial Reporting Council has recently faced the most intense criticism of its 28-year history. There are questions over how long Mr Haddrill, who has run the regulator for the past decade, will remain in his job.

Pressure has mounted following the collapse in January of one of Britain’s largest construction companies, Carillion.

This triggered heavy criticism of Carillion’s auditor, KPMG, which gave the group’s accounts a clean bill of health just nine months before it unravelled.

It also fuelled calls from academics, politicians and investors for a break-up of the audit market over concerns that the industry is too beholden to the clients whose numbers it vets.

In the eyes of its critics, the FRC is part of the wider problem. Observers highlight the regulator’s close ties to the firms it supervises, its plodding approach to investigations and its record of levying what are seen as Mickey Mouse fines.

The watchdog is now facing the possibility of its own demise after the UK government commissioned an independent review of its competence led by former civil servant Sir John Kingman. Mr Haddrill, who earned nearly £500,000 last year, making him one of Britain’s best-paid public officials, is clinging on.

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The FRC is hardly the first accounting body to face a crisis of public confidence. Since the second world war, the US has had no fewer than three standard setting bodies: the Committee on Accounting Procedure (1939-59); the Accounting Principles Board (1959-73) and the present Financial Accounting Standards Board (FASB).

Each of FASB’s predecessors met their demise in part over concerns about their lack of independence from private interests.

Karthik Ramanna, professor of business and public policy at Oxford university’s Blavatnik School of Government, thinks accounting bodies face a special set of challenges. “These are highly technical areas that concern issues with low political salience,” he said. “They depend on deep experiential knowledge from practitioners and are prone to powerful and concentrated commercial interests. It is a model that is almost perfectly designed for regulatory capture.”

This charge certainly tops the sheet for those challenging Britain’s FRC. Long criticised for its “light touch” when monitoring the Big Four audit firms, which include EY, PwC and Deloitte, the watchdog has come under fire over its investigation into the failure of HBOS, one of Britain’s largest banks.

KPMG gave the institution’s accounts a clean bill of health in February 2008, eight months before HBOS collapsed and had to be rescued with a £20bn taxpayer-funded bailout. Yet the FRC then took eight years, and a great deal of political prodding, before it even launched an investigation.

Its verdict last September cleared KPMG of misconduct after deciding that the HBOS audit did not fall “significantly short” of the standards to be expected.

It later emerged that the regulator had raised the bar for proving misconduct in 2013. Instead of “falling short of standards”, firms had to fall “significantly short”. Paul George, a former KPMG partner, was executive director in charge of conduct at the regulator when the wording was changed.

The verdict troubled observers, who fear that vested interests played a role in the outcome.

These conflicts are not unique to Britain. Financial Times analysis of seven authorities involved in the audit market underlines their reliance on current and former Big Four staff.

Take the European Financial Reporting Advisory Group, which advises the European Commission on accountancy rules. Nearly half of its 17 board members are current or former Big Four, as are nine of the 16 individuals on its technical working group.

At the PCAOB, the US accounting regulator, two of its five board members are ex-Big Four. Four of the seven advisers to those board members are also alumni. South Africa’s accounting watchdog, which has similarly come under heavy scrutiny this year following high profile accounting scandals, has four former or current Big Four staffers on its board of seven.

Few question that the world’s top accountants should have some input into the rules they apply; the question is where the balance should be struck.

Erik Gordon, professor at the university of Michigan, describes the dilemma: “The overlap creates regulatory capture danger but excluding people from the Big Four would deprive regulatory bodies of many of the most expert and experienced people in the field,” he said. “There is no easy way out.”

So how captured are the regulators? One perceived index of undue influence is the relatively low fines they levy on their industry. (These are important because investors have historically been loath to punish auditors for sloppy or inadequate work by removing their contract).

The PCAOB is one of the toughest accounting watchdogs globally, having secured an $8m settlement from Deloitte Brazil in 2016. The FRC issued its own record penalty of £6.5m in June against PwC. The largest fines ever handed out by the Dutch, German and South African accounting watchdogs total €2.2m, €50,000 and R200,000 respectively.

These pale in comparison to the penalties issued to banks and other financial services companies. In 2010, the US Securities and Exchange Commission issued a record $550m fine against Goldman Sachs, while the UK’s Financial Conduct Authority meted out a record £284m penalty in 2015.

Some doubt whether such penalties really drive behaviour. As one investor points out, these are largely paid by insurers anyway, and even a tripled or quadrupled fine would be little more than a flea bite to any of the Big Four.

As with banking, the suspicion is that individual sanctions may be more important. The FRC’s recent decision to effectively ban Steve Denison, the PwC auditor who signed off the accounts of BHS shortly before the retailer went into insolvency, for 15 years is regarded as much more of a nuclear sanction.

“If a partner faces a lengthy or lifetime ban from the industry, that cuts into their lifetime earnings,” says Tim Bush, head of governance at the shareholder advisory group, Pirc. “It’s a much more serious sanction.”

The FRC only removed one other auditor apart from Mr Denison in the past three years. Others seem more muscular. The PCAOB, which carries out inspections globally, has barred or suspended 114 individuals since the start of 2015.

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The bigger question is whether industry regulators can be structured better, in ways that minimise the possibility of regulatory capture.

When the FASB was erected out of the ashes of the APB in 1973, several innovations were introduced to underpin its independence.

Membership became a full-time commitment; you could not serve while also working for someone else. The FASB was supported by full-time research staff, limiting the necessity of using accounting firms as an informational crutch.

The FRC or its successor could lengthen the ‘cooling off’ period that is required before alumni from the largest accounting firms can join its panels. Similar restrictions could also apply to departing FRC staff to ease ‘revolving door’ concerns.

And the watchdog crucially needs more resources. It received just £32m of funding in 2016/2017, compared to £566m for the FCA and £254m for the Prudential Regulation Authority.

Money is not just an issue for the British either. The PCAOB has 783 staff and an anticipated 2018 budget of $260m, against $1.6bn for the SEC in support of 4,543 employees.

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Unsurprisingly, Mr Haddrill has rebutted accusations that the FRC is “toothless” or “useless” — charges levelled at him by MPs earlier this year. “I think as an audit regulator we are among the most robust in the world,” he told the FT in March.

The Kingman review may not result in a complete dismantling, and could lead to the FRC being given greater powers and resources. But the review is expected to prompt a leadership change at the top.

Critics of the audit market have noted that Sir John himself is not conflict-free. The Legal & General chairman worked with the FRC in his former role at the Treasury.

A colleague of his at L&G, Mark Zinkula, sits on the FRC’s board. Sir John is under pressure to prove his independence. That may prove dangerous for Mr Haddrill.

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