External Auditing of Companies: Deficiencies

Lord Sikka Excerpts

Monday 14th October 2024 Lords Chamber

Asked by

[Lord Sikka]

To ask His Majesty’s Government what plans they have to address any external auditing deficiencies highlighted by the collapse of BHS, Carillion, Patisserie Valerie, and London Capital and Finance.

[Lord Sikka (Lab)]

My Lords, I am honoured to open this debate and flag some of the issues, which I hope the Government will address. Ever since the collapse of BHS in 2016 and Carillion in 2018, the previous Government promised a Bill, but none materialised. This year, the King’s Speech promised an audit reform and corporate governance Bill. Naturally, I look forward to it. I have a particular interest in that Bill, not only as an accountant with 56 years’ experience but as an adviser to the Work and Pensions Committee for its investigation into the collapse of BHS and Carillion.

I understand that much of the Government’s attention is focused on transformation of the Financial Reporting Council into a statutory audit, reporting and governance authority, or ARGA—a very awkward name. This was recommended in Sir John Kingman’s 2018 report. Those reforms are welcome but they will not be sufficient.

In addition to ARGA, the audit industry will have four other regulators: the accountancy trade associations. None has the required independence from its members and all are outside the remit of freedom of information laws. A fragmented system would inevitably result in waste, duplication and obfuscation. Will the Minister ensure that accountancy trade associations are not allowed to act as regulators, for the reasons I specified?

The Kingman report was concerned about independence, but ARGA will remain dominated by large corporations and big accounting firms, which fund accounting and auditing standard setting and provide key personnel to the bodies. Despite Brexit, the UK has abandoned its powers to set accounting and auditing standards relevant to the local environment. Instead, it adopts international accounting and auditing standards. These are primarily crafted by big corporations and accounting firms at both international and UK level. This makes for poor financial reports, audits and public accountability. Good luck to anyone trying to figure out the UK profits of Google, Microsoft, Starbucks, Apple or other global corporations. Water companies routinely inflate investment and distributable reserves by capitalising interest and repair and maintenance payments. It is all permitted by the accounting rules and no auditor has ever objected to it. Profit shifting is a major tool for avoiding tax, but group accounts provide zero information about intragroup transactions, so it is hard to see how the Chancellor will clamp down on tax abuse by companies. I look forward to hearing from the Minister how the Government will address regulatory capture and reform accounting practices.

I will raise questions about the conduct of audits, because major firms are unable or unwilling to deliver robust and honest audits. While penalties for negligent directors need to be strengthened, that should not deflect attention away from the failures of auditors. Annual audit quality reports from the FRC show that many firms do not even meet the feather duster auditing standards applied in the UK.

There are fundamental fault lines. In contemporary society, we come across numerous types of audits on a daily basis. For example, at airports, our passports are audited by immigration officers acting as auditors. In no case is the auditee allowed to hire, remunerate or fire the immigration officer or appoint him or her as an adviser, yet that is the starting point for company financial audits. Will the Minister explain why that situation persists?

Some may argue that audit committees consisting of non-executive directors should have a greater role in liaising with external auditors, but audit committees at BHS and Carillion were not effective. I saw that at first hand. Almost all major corporations mired in scandals had audit committees and non-executive directors. None rocked the boat.

It is hard to think of any financial scandal highlighted by auditors. At BHS, PricewaterhouseCoopers’s audit partner backdated the audit report to appease Philip Green and other directors. At Carillion, KPMG never objected to imprudent accounting policies relating to accounting for good will. The company also capitalised interest payments to inflate its balance sheet. At Patisserie Valerie, auditors did not even check the bank reconciliation; they just continued to dish out the usual clean audit bill of health. Naturally, they were not going to bite the hand that feeds them.

Research by Professor Adam Leaver at Sheffield University looked at 250 listed companies that collapsed between 2010 and 2022. Despite publicly available evidence, only about 25% carried a “going concern” audit qualification. The Nelsonian auditors were rewarded handsomely.

Does the Minister agree that the appointment and remuneration of auditors at large companies by an independent body will give them some backbone? Will he insist that the auditors must act exclusively as auditors, meaning that no other business must be done by audit firms?

There is an urgent need for transparency about the delivery of audits. This would enable stakeholders to make assessments of the quality of audit and ask focused, timely questions. Currently, we get a glimpse of audit problems only after scandals; if by hook or crook a company survives, poor auditing practices remain buried.

At BHS, a PwC audit partner was budgeted by the firm to spend just two hours on the audit, and 31 hours on consultancy. For all practical purposes, the audit team was led by a person with only one year’s post-qualification experience. Unsurprisingly, the audits were shambolic.

The auditor appointment usually begins with a kind of beauty parade. Firms submit a tender and then make presentations to companies. I have sat through some of those. The most common phrase in these tenders is something like, “We have a reputation for constructive accounting solutions, and will help you to present your financial statements in the best possible way”. I wonder how many banks that crashed were told that. Auditors remained silent at those companies.

Audit tenders are not made publicly available because the firms say they are secret, even though their senior personnel know all about the contents. The same people migrate to other firms and take the knowledge with them; so rivals know what the firm’s policies are, but the stakeholders are denied that information. Audit tenders must be made publicly available.

Section 493 of the Companies Act 2006, requires disclosure of the “terms of audit appointment”, but Governments have failed to enact that section. I hope that the Minister will tell us when this section will be enacted.

To prevent firms assigning inadequate time budgets and audit teams to audits, there must be disclosure of the composition of the audit team, grade of staff and time used. Such disclosures are already made by insolvency practitioners, so it is hard to see what objections auditors could have. The disclosures would have prevented PwC from assigning just two hours to a partner to conduct the audit of BHS.

There need to be disclosures of the key questions that auditors ask and the replies received from directors. Such information is included in what are called management representations. All this information should be publicly available and can be filed at Companies House when the annual accounts are filed.

For far too long, audits and audit firms have escaped transparency. That silences stakeholders and leads to poor audits and accountability. I hope that the Government will address these failures.