2 Regulation, regulators and reporting

Accounting, reporting and auditing – not an exact science

Accounting and its rules are not an exact science. These two quotations epitomize the issue:1

• “How do you explain to an intelligent public that it is possible for two companies in the same industry to follow entirely different accounting principles and both get a true and fair audit report?” • “Every company in the country is fiddling its profits.”

This conundrum is referred to as the expectation gap. Identified by Porter in 19932 (and others), it refers to the gap between expectation and actual performance. This can be divided into deficient performance, deficient standards (together making a performance gap) and unreasonable expectations. Expectations, reasonable or otherwise, continually change. They only grow, not diminish. Auditors and standard setters consistently lag behind.

We know that accounting and the preparation of financial reports is like portraying dynamic n-dimensions into static two-dimensions – many interpretations and tricks are possible. Originally the financial reports consisted of:

1 The balance sheet, a snapshot of the business at a specific date; 2 An income statement or profit and loss account measured over a period of time and the cash flow statement;3 3 Various notes to these statements and accounting policies.

Not so now. It has been expanded with various additional reports and narrative reporting (sometimes referred to as the strategic report and

14 Regulation, regulators and reporting director’s report) and various non-financial information (NFI) and reports.

Flexibility and judgement – leads to misstatements?

There is flexibility and judgement. Rules can be written but to distil real-life transactions and events into a set of figures can never be exact – especially when some events are estimated such as how much of the money owed can actually be collected. There is the concept of what is material. Two companies with exactly the same performance and underlying reality might report very different results using the same set of basic accounting principles and standards.4 Differing estimates about the probabilities and events requiring exercise of ‘judgement’ will always cause this. What is still surprising to many observers is that the auditors will say that the two different sets of accounts can provide a true and fair view of the company.5 Note it is “[a] true and fair view”(as several commentators said to us):

There is no such thing as “the” true and fair view. There is always a range of views.

Materiality

You will find that the concept of materiality comes up in our case studies. According to Wikipedia,

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.6

Basically, if the amount being questioned is less than this numerical material amount, then the auditors can ignore that issue.

In the US, the Securities and Exchange Commission (SEC) defines what is material by using a numerical value. This is currently 5% of pretax profits, though this cannot be a hard and fast rule. If pre-tax profits are, say, £20 billion in one year, then fall back to £1 million the next year, and then return to £20 billion the year after, defining what is material as 5% of the £1 million figure is clearly misleading. So, the value of what may be material has to be assessed with regards to the overall nature of the company and its business, and also taking a longer-term view. Often the definition of a material value is included in the annual report under a section usually called ‘Materiality’.

Forward-looking statements

There is an increasing focus on NFI and a growing requirement to provide forward-looking information, including a forecast view of the business and the answers to additional ‘what if’ questions. ‘Going concern’ examines the survivability of the company over the next 12 months. ‘Viability’ looks forward several years. However, there is now interest in not just an opinion about the future but also numerical forecast numbers.

A recent survey by KPMG, the 2016 Survey of Business Reporting, reported that 25% of the companies included (270 companies across 16 countries) provide short-term forecasts in their annual reports.7

Not just an annual report

Reporting today has an annual report, various documents for the state and for tax computations, half-yearly reports and often quarterly reports (compulsory in the US). Added to that are the various presentations and information given to analysts and shareholders. These are usually found or mentioned on the company’s website under investor relations sections.

As well as giving an overview of the company, such websites will have key company announcements, news articles, press briefings and so on. There may be predictions by analysts or an average of the investment analysts forecasts or buy/sell recommendations (usually only if positive, though). Also, if necessary, any profit warnings are given. See Box 2.1.

Box 2.1 Additional information found typically under ‘investor relations’

For example, on BT’s website at www.btplc.com/

Sharesandperformance/Presentations/index.htm, you will find the following headings and information:

Results Watch webcasts and download press releases, slides, KPIs and transcripts. Latest consensus is also available.

Key company announcements

Regular ‘teach-in’ events Key company announcements such as BT

Pension Scheme agreements, the EE acquisition and BT sport rights auctions. In depth teach-in events on topics such as cost transformation, pension, regulation, network and technology.

Presentations from the lines of businesses Analyst presentations from around BT, with updates on products and strategy.

SRI events Presentations for socially responsible investors, including the purposeful business programme.

Capital market days Slides and videos from capital markets days.

Notes: Socially responsible investing (SRI), or social investment, also known as sustainable, socially conscious, ‘green’ or ethical investing, is any investment strategy which seeks to consider both financial return and social good to bring about a social change.

Purposeful business is less well known as a concept but according to BT it means “putting customers first; connecting people; working for the environment; supporting good causes; we’ve got big ambitions to be a more sustainable business”.

True and fair concept versus fair, balanced and understandable

We know that there may be many true and fair views of the financial statements from the identical underlying physical operations and transactions. The requirement to present a true and fair view in financial statements is enshrined in EU, UK and US law. The concept of true and fair is where directors must consider whether the financial statements that they approve are appropriate. The external auditors are legally obliged, under the Companies Act 2006, to state, when giving their opinion on a company’s financial statements, whether the accounts, in their opinion, give a true and fair view.

Since 2014, there is a requirement for an extended front half of the annual report with a greater narrative section. The new test is fair, balanced and understandable (FBU). Only the financial statements part of the annual report is independently assured by external auditors. Directors are obliged, under the UK Corporate Governance Code, to ensure that the entire report is FBU, but there is no obligation to obtain assurance over this – auditors do not have to carry out any additional work in this regard but must merely consider whether the non-financial part of the annual report is consistent with the knowledge they have gained in the course of the audit. Our evidence suggests that narrative sections often suffer from widespread lack of balance and tone, and sometimes misdirection.

Regulation, regulators and reporting 17

The increasing importance of the UK’s Financial Reporting Council (FRC)

The FRC has a role both as a standard setter and enforcer. Some think that this creates an inherent conflict of interest in that it is ‘marking its own work’. The FRC has introduced a number of changes, including the strategic report having a description of the business model, and a narrative section in the front half of UK reports. The FRC only has to prove breach of a rule on the part of the external auditors. However, the FRC’s regulatory powers do not extend to company executives who are not accountants. So, it has a somewhat asymmetric role in sanctions over misconduct or inappropriate behaviour as shown in Box 2.2.

Box 2.2 FRC’s Asymmetric Sanctions

FRC sanctions on external auditor

Persons Firm, engagement partner normally but could extend to other auditors or accountants on the audit (with recognized qualifications). Test Breach of FRC or regulatory rules. Sanctions for firm £10 million fine plus other actions. Sanctions for individual Fines and possible ban from working as an accountant.

FRC sanctions on company or organization

Persons with recognized qualification We will call this type of person a preparer accountant. A person without a recognized accounting qualification, if on the board, we will call a director-preparer. If not on the board, it is unlikely for any action to be taken other than for fraud by the Serious Fraud Office (SFO). Test Misconduct, which is a stricter test than breach of rule.

Sanctions for firm No sanction against firm. Passed to FCA or, for criminal fraud, the SFO.

Sanctions for individual Fines and bans from working as auditor or accountant.

So, in the case of a preparer accountant (a qualified accountant in the firm preparing the reports, usually a financial director or CFO), the FRC has to prove behaviour amounting to misconduct rather than breach of a rule. However, the FRC has no right to sanctions over other members of the board, e.g. director-preparers who are not qualified accountants. This is asymmetric as the FRC has much greater control over the auditors than the preparers.

Recent and possible initiatives from the FRC include:

Recent:

• Strong encouragement of ‘clear and concise’ reporting; • A new governance and stewardship code8 and usually periodic updates or guidance notes; • Expansion of this code to private companies;9 • New routine reports on materiality and auditing; often under the headings of guidance, policy or thematic review;10 • New fines and penalties (now up to £10 million, though this may be raised again); • Involvement in the senior appointments of the Big Six.

Possible (from reviews into the FRC):

• Possible break-up of the Big Four into split of separate audit-only and consultancy firms; • Stronger penalties and sanctions over management and the preparers of reports; • New audit rules. Now partly the responsibility of the Brydon Report.

The new ARGA which replaces the FRC and should have stronger powers and teeth. But not all the powers we wanted. The Kingman Review did water down some of ours and others more stringent requests.18

However, it has not all been plain sailing for the FRC. In 2017 it came under criticism for closing the investigation into Tesco and its auditor, PwC. The FRC said there was “not a realistic prospect”11 a tribunal would find PwC guilty of misconduct at Tesco. This is their standard language for saying they could not publicly fault PwC.

FRC: post-HBOS and Carillion In September 2017, the FRC cleared KPMG, the auditor of HBOS (Halifax and Bank of Scotland), of misconduct in relation to its work with the lender in 2007 and 2008. The FRC said the audit of HBOS’s 2007 results “did not fall significantly short of the standards reasonably to be expected” and that its assessment of the bank’s health in 2008 “was not unreasonable at the time”.17 The FRC’s decision prompted concern over accountability for the downfall of the bank (and in general all banks), which was forced into a rescue by Lloyds Banking Group in 2008.

Nicky Morgan, chair of the Parliament’s treasury Select Committee (SC), sent a letter arguing that accountants should be subject to tougher rules, more like those imposed on auditors “to protect the public interest”.18 FRC ex-chief executive Stephen Haddrill responded by saying that the ability of the FRC to investigate audits and bring auditors to book had been hampered by the prevailing UK law, which had set the bar of the misconduct test unattainably high. But with the EU Audit Regulation and Directive (ARD) implemented in 2016 and enshrined in UK law, the threshold had been lowered and the regulator would be able to make relevant enforcement. This also meant that more potentially deficient audits would be investigated, prosecuted and ultimately sanctioned. In so doing, fines were increased to in excess of £5 million and now to £10 million.

A £10 million fine was levied on PwC but reduced to £6.5 million on settlement, with a 15-year ban for one partner plus a fine of £325,000 for that individual. In 2017 there were two further large fines. PwC was fined £6 million, reduced to £5.1 million on settlement following an investigation into the 2011 accounts of RSM Tenon, which collapsed in 2013. One of PwC’s partners was fined £114,750 and PwC had to pay £500,000 in costs in 2017. This fine came after PwC was fined £5 million earlier in 2017 over its audit of Connaught in the period running up to the social housing group’s collapse in 2010. Bottom line, dismiss the numbers, but none of these sanctions were large enough to have much real effect and reports of them were confined to the specialist financial press or financial pages of the national press in the main. The ones that still stand out include the collapse of HBOS and the more recent 2018 cases; although, in our interviews, the impact seems to be much greater in terms of peer group pressures and status (i.e. promotions) within the audit firm.

The FRC has often been criticized for being too close to the Big Four. Of the 30 board and senior FRC positions identified in Accountancy in December 2017 (page 13), 15, or 50%, are from the Big Four (including one from Arthur Andersen, one of the Big Five firms before the Enron scandal), and two were from mid-level firms.

20 Regulation, regulators and reporting

It has also been criticized for being too slow and ineffective. The FRC admitted that it should have been faster to investigate why KPMG gave HBOS’s accounts the green light just seven months before the bank had to be rescued by Lloyds during the GFC. Instead, the FRC closed its investigation into the audit, saying it had found that KPMG’s work for HBOS “did not fall significantly short of the standards reasonably to be expected”, notwithstanding that criticisms have been made elsewhere that this was a biased board and the suspicion is that this may have been a biased decision. The FRC then admitted:

We should have adopted a more proactive approach to our early enquiry in relation to HBOS rather than a heavy reliance on other regulators.13

The FRC came under heavy criticism by the joint Select Committee (SC)12 and MPs for being slow and “far too passive” in its scrutiny of the financial practices of collapsed outsourcer Carillion. MPs on two highprofile parliamentary committees concluded in their report that they had “little faith in the ability of the FRC to complete important investigations in a timely manner”.14

The roles of the regulators

Box 2.3 lists the main regulatory bodies in the UK.

Box 2.3 Relevant watchdogs

FRC – Financial Reporting Council. Probably the best known of the watchdogs for annual reports, reporting and auditing.

It regulates auditors, accountants and actuaries, not directors (unless they are qualified accountants). Concerned with the listings of companies on the stock exchanges or equivalent and false market values and areas that might affect market capitalization and share value, corporate governance and reporting, including monitoring and reviewing the actions of the auditors. FCA – Financial Conduct Authority. Regulates listed companies and markets; more concerned with the conduct and actions of the board of directors.

PRA – Prudential Regulation Authority for banks and lenders. Pensions – The regulator for pensions and pension deficits. Equality and Human Rights Commission − Monitors gender pay gap data. BEIS − Department of Business. Monitors payments practices and directors’ conduct (rare). Insolvency Service − Currently takes around 1,200 directors to court and may get enhanced powers to pursue directors. SFO − Serious Fraud Office. Pursues fraud in corporate cases but criticized for taking too long (e.g. Tesco case) and having a low conviction rate. The latest example is Barclays Bank and their Qatari funding, the suspicion being that the deal may have been a round trip type of manoeuvre,15 but this was not proven; Barclays was found innocent. Information Commissioner’s Office − Data protection and privacy issues.16 Its ability to sanction or fine is impossibly small. Parliamentary Select Committees − These are not regulators but are becoming more prominent in a watchdog role as an external check.

There is some overlap in the role and remit of these regulatory bodies and we feel that the current set-up is unsatisfactory. Recent government pronouncements (discussed in detail later) as well as evidence from our interviews suggest that the government may not be satisfied with the performance of the FRC and other watchdogs due to their lengthy investigations and lack of action in high-profile cases.

Regulatory reviews

The review of the FRC by Sir John Kingman is officially titled the ‘Independent Review of the Financial Reporting Council’.17 Now released, it had two objectives:

• To ensure that the FRC structures, culture and processes; oversight, accountability and powers; and its impact, resources and capacity are as good as they can be. • To see the FRC standing as a beacon for the best in governance, transparency and independence.

The Kingman Review is limited to the FRC, with the aim of making the FRC the best in class for corporate governance and transparency.18

22 Regulation, regulators and reporting The review did not investigate policy or accounting standards or issues of competition. Competition, and particularly competition in the audit market, sits with the Competition and Markets Authority (CMA). The CMA update review paper was released on the 18 December 2018. The minister has asked the CMA to examine competition in the Big Fourdominated audit industry. This raised the possibility that the government would back major reforms to the Big Four. (See Volume 1, Disruption in the Audit Market.)

The Competition and Markets Authority (CAM) and Kingman report were published post-publication. Reactions to the CMA on the audit market and the Kingman report on the replacement of the FRC can be found in the online companion volume www.fin-rep.org.

The CMA’s report concentrates on a tightening grip and scrutiny of the audit committees (we think pie-in-the-sky), joint audits (costly and reduce audit quality, and who takes the blame in a dual audit). And bolstering the mid-tier challenger audit firms (takes decades). Finally peer review (may be the best of a poor bunch of remedies – but not sufficient). We strongly challenge and disagree with the CMA conclusions and remedies.

Websites and online material

Appendix 2.02.01 FRC Cases can be found at www.fin-rep.org. It lists and categorizes all FRC cases and may be routinely updated.

Notes

1 Jones, M. J., 2011, Creative Accounting, Fraud and International Accounting, University of Bristol, 2011 Paper given at the University of South Australia. Based on the book below. Available at: www.unisa.edu.au/Global/business/centres/cags/docs/ seminars/creative%20accounting%20and%20fraud(aus).pdf Accessed July 2018.

See also: Jones, M. J., 2010, Creative Accounting, Fraud and International

Accounting Scandals, John Wiley & Sons. Available at: www.wiley.com/en-gb/

Creative+Accounting%2C+Fraud+and+International+Accounting+Scandals-p9780470057650 Accessed July 2018. 2 Porter, B., 1993, ‘An Empirical Study of the Audit Expectation-Performance

Gap’, Accounting and Business Research, Volume 24, pp. 49–68. Available at (published online in 2012): www.tandfonline.com/doi/abs/10.1080/00014788.1993. 9729463 Accessed July 2018. 3 A cash flow statement is a statement showing the inflows and outflows of cash and cash equivalents over a period. Not to be confused with a flow of funds statement, which measures the changes in the financial position of the entity in different accounting years. 4 Even under current UK GAAP and full IFRS. Also applies to US GAAP.

5 Based on the stated assumptions, which can provide much leeway. 6 Wikipedia, Materiality (auditing). Available at: https://en.wikipedia.org/wiki/

Materiality_(auditing) Accessed July 2018. 7 See: KPMG, 2016, Room for Improvement: The KPMG Survey of Business Reporting, second edition, 28 April. Can be downloaded from (where there is also a link to KPMG’s Dynamic Risk Assessment system): https://home.kpmg.com/xx/en/ home/insights/2016/04/kpmg-survey-business-reporting-second-edition.html.

Available at: https://home.kpmg.com/xx/en/home/insights/2016/04/kpmgsurvey-business-reporting-second-edition.html Accessed July 2018. This may be published every year. The 2017 edition concerns corporate responsibility reporting: KPMG, The Road Ahead: KPMG Survey of Corporate

Responsibility Reporting 2017. This report can be downloaded from: https:// home.kpmg.com/xx/en/home/campaigns/2017/10/survey-of-corporateresponsibility-reporting-2017.html. Available at: https://home.kpmg.com/con tent/dam/kpmg/campaigns/csr/pdf/CSR_Reporting_2017.pdf Accessed July 2018. 8 Financial Reporting Council News, 2018, ‘A UK Corporate Governance Code

That Is Fit for the Future’, Financial Reporting Council, 16 July. Available at: www. frc.org.uk/news/july-2018/a-uk-corporate-governance-code-that-is-fit-for-the

Accessed July 2018. This page leads to a number of relevant documents:

‘The UK Corporate Governance Code, July 2018’. Available at: www.frc.org. uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UKCorporate-Governance-Code-FINAL.pdf

‘Revised UK Corporate Governance Code 2018 Highlights’. Available at: www. frc.org.uk/getattachment/524d4f4b-62df-4c76-926a-66e223ca0893/2018UK-Corporate-Governance-Code-highlights.pdf

‘Guidance on Board Effectiveness, July 2018’. Available at: www.frc.org.uk/ document-library/corporate-governance/2018/guidance-on-board-effective nessThis link does not open a page, but just downloads this report. 9 See the consultation document: ‘The Wates Corporate Governance Principles for

Large Private Companies’, Financial Reporting Council, 13 June 2018. Available at: www.frc.org.uk/consultation-list/2018/consultation-the-wates-corporate-gover nance-princ. To download this report: www.frc.org.uk/getattachment/48653f8692c3-4cd6-8465-da4b7cac0034/;.aspx Accessed July 2018. 10 For example, Financial Reporting Council, 2017, ‘Audit Quality Thematic

Review: Materiality’, Financial Reporting Council, December. Available at: www. frc.org.uk/getattachment/4713123b-919c-4ed6-a7a4-869aa9a668f4/Audit-

Quality-Thematic-Review-Materiality-(December-2017).pdf Accessed

April 2018; and Financial Reporting Council, 2018, ‘Audit Culture Thematic

Review: Firms’ Activities to Establish, Promote and Embed a Culture That Is

Committed to Delivering Consistently High Quality Audits’, Financial Reporting

Council, May. Available at: www.frc.org.uk/getattachment/2f8d6070-e41b-45769905-4aeb7df8dd7e/Audit-Culture-Thematic-Review.pdf Accessed July 2018 11 Financial Reporting Council News, 2017, Closure of investigation into the conduct of members and a member firm as auditors of Tesco plc, Financial Reporting Council, 5 June 2017. Available at: https://www.frc.org.uk/news/june-2017/ closure-of-investigation-into-the-conduct-of-membe Accessed July 2017.

12 Dunkley, E., Marriage, M., Martin, K., ‘KPMG cleared over audit of HBOS before collapse: Regulator finds assessment of market conditions not ‘unreasonable’ at time’, Financial Times, 19 September 2017. Available at: https://www. ft.com/content/34fa0fdc-9d13-11e7-9a86-4d5a475ba4c5 Accessed July 2018. 13 Jones, H., 2017, ‘UK Watchdog Says Was Too Slow to Probe HBOS Audit’, Reuters, 30 November. Available at: www.reuters.com/article/us-lloyds-accounts-hbos/ uk-watchdog-says-was-too-slow-to-probe-hbos-audit-idUSKBN1DU10Z

Accessed December 2017. 14 House of Commons, Business, Energy and Industrial Strategy and Work and Pensions Committees. Carillion. Second Joint Report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017–19. HC 769. Published on 16 May 2018 by authority of the House of Commons. Relevant paragraphs or page numbers in the main report are noted in text. Available at: https://publications.parliament.uk/pa/cm201719/cmselect/ cmworpen/769/769.pdf Accessed July 2018. 15 Barclays Bank was found innocent. However, the suspicion might have been that

Qatar invested equity in the bank in exchange for roughly an equivalent amount in loans so the net transaction was zero. But this would have helped Barclays’s equity ratio, thereby the bank avoided being taken over by the state. 16 Facebook may be fined £500,000 by the privacy regulator after the social network giant failed to prevent key user data from falling into the hands of a political consultancy that helped get President Donald Trump elected. The UK’s Information Commissioner’s Office is threatening the company with the maximum penalty allowed. The tech giant is accused of not properly protecting user data and not sharing how people’s data was harvested by others. £500,000 to Facebook is something less than a pin prick. Now, £500 million might have been a more substantial pin prick. See also: Bodoni, S., 2018, ‘Facebook Faces U.K.

Fine over Cambridge Analytica Inquiry’, Bloomberg, 10 July. Available at: www. bloomberg.com/news/articles/2018-07-10/facebook-faces-u-k-privacy-fineover-cambridge-analytica-probe Accessed July 2018. 17 Kingman Review, 2018, ‘Independent Review of the Financial Reporting

Council’, Review Secretariat Which Is Hosted by the Department for Business, Energy, and Industrial Strategy, 6 June. Available at: https://assets.publishing.service.gov. uk/government/uploads/system/uploads/attachment_data/file/717492/Inde pendent_Review_of_the_FRC_-_Call_for_Evidence_-_FINAL.pdf Accessed

July 2018. 18 In April 2018, the government launched an independent review of the FRC, the regulator for auditors, accountants and actuaries. The review will be led by Sir

John Kingman, who has extensive private and public sector experience. He will be supported by an advisory board. The root and branch review, due for completion by the end of 2018, will assess the FRC’s governance, impact and powers to help ensure it is fit for the future.