Restoring Trust, After It’s Long Been Lost

Failings

The Government BEIS Department have published a white paper entitled “Restoring trust in audit and corporate governance”. It’s an acknowledgement that the trust of investors in directors who manage the companies they invest in has long ago been lost. And the trust in auditors that the accounts issued by companies are accurate and give a fair view of a company’s financial position has also been lost.

There are few stock market investors who have not been affected by one or more scandals or downright frauds in the UK in recent years. However diligent you are researching companies and checking their accounts, you are unlikely to have avoided them all. Examples such as Autonomy, BHS, Carillion, Conviviality, Patisserie Valerie and numerous small AIM companies give you the impression that the business world is full of shysters while auditors are unable to catch them out. The near collapse of the Royal Bank of Scotland and other banks in 2008 was symptomatic of the malaise that had crept into the accounts of companies which has still to be rectified.

Indeed in the first chapter of my book “Business Perspective Investing” I said accounts don’t matter because they cannot be relied upon. I suggested other aspects of a business that should be examined to pick successful investments and went through them in some detail in the rest of the book. But would it not be better if we could trust company directors and auditors?

The failures of the existing accounting standards and corporate governance, and enforcement thereof, has been recognised in previous Government reviews. For example the Kingman Review in December 2018 made a number of proposals to reform the Financial Reporting Council (FRC) and for a replacement body to be named the Audit, Reporting and Governance Authority (ARGA) with wider powers (see: https://www.sharesoc.org/blog/accounting-and-audit/frc-revolution-to-fix-audit-and-accounting-problems/). The fact that it has taken 3 years to move one step further tells you about the glacial pace of reform.

Proposals

The Government has accepted most of the recommendations in past reviews of this area. They plan to tighten up the accountability of company directors and propose “new reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning, designed to sharpen directors’ accountability in these key management areas within the largest companies”.

The audit profession, who have been one of the barriers to change, comes under attack with these comments: “Central to achieving [reform] is the proposed creation of a new, stand-alone audit profession, underpinned by a common purpose and principles – including a clear public interest focus – and with a reach across all forms of corporate reporting, not just the financial statements. Alongside this the Government is proposing new regulatory measures to increase competition and reduce the potential for conflicts of interest, by providing new opportunities for challenger audit firms and new requirements for audit firms to separate their audit and non-audit practices”.

The Government proposes new legislation to put the new ARGA body on a statutory basis with stronger powers to be financed by a new statutory levy. You may not believe it but the FRC is financed by a voluntary levy and has limited powers over finance directors (none at all if they are not members of a professional body).

There is a new focus on the “internal controls” in a business and proposals to ensure they are adequate. A lack of internal controls is often the reason why fraud goes undetected. These proposals are similar to the Sarbanes-Oxley regulations introduced in the USA.

For investors, a big change that might have an impact is: “Companies (the parent company in the case of a group) should disclose the total amount of reserves that are distributable, or – if this is not possible – disclose the “known” distributable reserve, which must be greater than any proposed dividend; in the case of a group, the parent company should provide an estimate of distributable reserves across the group; and directors should state that any proposed dividend is within known distributable reserves and that payment of the dividend will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years”.

There are of course existing rules that should prevent dividends being paid out of capital, which incidentally was one of the common reasons for collapse of companies in Victorian times – the ability to continue paying dividends gave a false sense of all being well to investors. But clearly the current regulations are ineffective. The BEIS report actually says “high profile examples of companies paying out significant dividends shortly before profit warnings and, in some cases, insolvency, have raised questions about its robustness and the extent to which the dividend and capital maintenance rules are being respected and enforced”.

There is also the problem of big bonuses being paid to directors when they should have known the financial position of their company was precarious. This is tackled by new proposed rules to “strengthen malus and clawback provisions within executive directors’ remuneration arrangements”.

There are proposals to reduce the dominance of the “big four” accounting firms and introduce more competition which is seen by some as the reason for the poor quality of many audits. But it is not clear that the proposals will have a major impact.

Conclusion

In conclusion, there are many detailed proposals in the 226 page report, which is now open to public consultation. I may make more comments later, but overall I would support the main proposals as a step forward. I just wish the Government would get on with the proposed changes before investors lose the will to live.

White Paper: https://www.gov.uk/government/publications/restoring-trust-in-audit-and-corporate-governance

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )