Investors’ Audit Gap 

Investors rarely engage on improving the audit function, but this sorely needs to change, say stewardship proponents.  

The massive financial and social costs of high-profile accounting scandals are well documented. The infamous collapse of US energy firm Enron in 2001 cost shareholders US$74 billion, saw 20,600 staff lose their jobs, along with the 20,000 employees working at its accountant Arthur Andersen, after prosecutors indicted the entire company and put it out of business. 

But despite the constant déjà vu of accounting scandals since, few investors actively engage on the issue. This puzzles Paul Lee, Head of Stewardship and Sustainable Investment Strategy at UK-based investment consultant Redington, who says accounting standards are fundamental to the information flows that come to investors.  

“The number of investors is vanishingly small. I could probably name every single one of the individuals that’s engaged in a couple of decades and that’s shocking frankly,” Lee tells ESG Investor, noting that without trust in the numbers that companies are reporting, investing in them “just becomes gambling”.  

“You’ve got this huge disconnect between these major issues that absolutely influence how the markets work, how confidence works, and investors are just not engaging with it at all,” he says, adding that the audit is designed as a “service for shareholders”, providing reassurance on the financials which form the basis on which investment decisions are made. 

Lee’s strong views on the subject come from his time serving on the secretariat of the UK’s 2019 Brydon Review which concluded that audit must become more informative, with higher expectations placed on auditors and company directors to restore trust in the function and prevent unnecessary corporate collapses.  

Along with investor reticence on the subject of audit quality, the UK government has been unengaged too. It’s been heavily criticised for delaying action on the 64 recommendations from the Brydon Review made four years ago. The Head of the Institute of Chartered Accountants in England & Wales (ICAEW) reportedly warned this month that continued delays could see foreign investors lose confidence in Britain as a trustworthy destination to allocate funds.  

In contrast, the country’s Financial Reporting Council (FRC) is already implementing some of the Brydon Review recommendations that do not need legislation, as well as recommendations from the Competition and Markets Authority (CMA) report on competition in the audit market and the Kingman Review on the FRC.  

This includes a minimum standard for audit committees, recommended by the CMA, which the FRC is currently consulting on. Railpen, one of the country’s largest pension fund, has responded to this particular consultation because of the importance it places on audit committees, says Caroline Escott, its Senior Investment Manager. 

“The audit committee is the primary mechanism by which shareholders can engage with the audit process and with the auditor,” Escott says. “It is in shareholders’ best interests that policy and guidance are set in a way that incentivises audit committees to hit a certain level of behaviour to exercise the appropriate scrutiny of their auditors, to encourage audit committees to engage with their shareholder base as well and help them take a robust approach to tendering and so on – that’s why we contributed to this.” 

Voting policy “red flags” 

Railpen is one of the few companies that has actively engaged on audit quality for a couple of decades, with UK stewardship stalwarts such as Frank Curtiss and Deborah Gilshan driving activity on the issue.  

Before Escott joined in 2020, Railpen had a longstanding voting policy on audit rotation where it votes against the reappointment of an auditor if the tenure is longer than 15 years – “where we feel an auditor tends to lose the ability to be independent,” she explains.   

After she joined, alongside team member Michael Marshall, Head of Sustainable Ownership at Railpen, it tightened up the policy further to cover audit remuneration to ensure audit costs are not cut at the expense of quality.  

“We would much rather have a slightly more expensive audit, and not cut corners,” she says. “We care more about the auditor being able to put the appropriate number of well qualified resources to work on the company’s reports and accounts than we care about cutting the odd £100,000.” 

Escott says there have been a number of instances where there was a reduction in audit fees by “quite a significant proportion” and there was no clear rationale for it, or it was in combination with a rotation of the auditor and Railpen couldn’t get a satisfactory answer for the lowering of fees. “That is a red flag for us,” she says.  

Railpen also refreshed its exclusion process for companies where it deems forward-looking governance risk to be unmanageable to include auditor tenure as one of the variables in its methodology for assessing it.  

“It particularly looks at some of those companies in the US where they had the same auditor for 50 or 100 years and what can we sense from the audit report and what it says about the potential nature of the report and accounts, and whether or not they really present a true and fair view of the financial health of a company.”  

It also has a policy to vote against auditors that are signing off on accounts that it feels do not adequately incorporate climate risks. UK-based asset manager Sarasin & Partners has a similar policy. 

Engaging on audit 

On why very few investors engage on any aspect of auditing, Escott says: “Audit like many corporate governance issues is seen as pretty dry. There are also many investors who quite rightly feel they don’t have the technical expertise to be able to really get to grips with the nature of the audit process and to have the understanding required to ask the right questions of audit committees.”  

She says the Brydon review, which she describes as “excellent”, will help challenge this.  

One recommendation from the Brydon review, says Lee, is that an Audit and Assurance Policy, where companies show how they are assuring the integrity of reporting, including, but not limited to financial statements and handling risk, should be opened for investor input.  

“It was intended to be a hook for investor dialogue with companies on these important issues and perhaps is an opportunity to highlight a lack of engagement from investors where that was the case.”  

While the wait for audit reform continues, Rupert Krefting, Head of Corporate Finance & Stewardship at asset manager M&G, who chairs the UK Investment Association’s Corporate Reporting and Audit Group, says it would like to do more on audit quality, but it lacks the tools.  

He points to the FRC which scores auditors on quality but the company associated with the score isn’t named. “I don’t know what to do with that information. Until we know where the good audits are I’m not sure what we can do?”  

In a statement, the FRC says it does acknowledge the importance of transparency and accountability of its work but says the Companies Act prevents it sharing information related to the private affairs of individuals and businesses without their consent, which includes information obtained during its Audit Quality Reviews. A proposal to release individual inspection reports was dropped after it failed to garner support during the consultation period, even from investor representatives, adds the FRC.     

Krefting, a former auditor, also says it could help investors if “the management letter” written by the auditor to the board, at the end of the audit process, outlining things to improve and strengths, was made public.  

“We don’t get to see that. What we get is quite an anodyne audit report,” he says. “We’ve talked to audit partners in the past and they say you can tell a lot about the language we use in the audit report – but that’s quite difficult to do.  

“We’ve got a large number of companies we invest in and we can’t pour over each report and start doing a sort of Times crossword puzzle trying to work out what they are actually saying. It’s like code. So, we don’t know which ones are risky and which aren’t.”  

ESG assurance 

Across the pond, US public pension giant California Public Employees Retirement System (CalPERS) is another rare example of an investor who regularly engages on the audit function. It feeds into consultations on updates to the Sarbanes-Oxley Act (SOX) that in 2002 established sweeping auditing and financial regulation for public companies.  

James Andrus, Interim Managing Investment Director, Board Governance & Sustainability at CalPERS, sits on the Investor Advisory Group of the Public Company Accounting Oversight Board established under SOX by the US Congress to oversee the audits of public companies.  

The other investors who sit on this group alongside academics and lawyers are New York City Board of Education Retirement System, Luther King Capital Management, Elliott Investment Management, Colorado Public Employees’ Retirement Association and Bersot Capital Management LLC. Investor bodies including the CFA Institute and the Council of Institutional Investors are also members.  

In an email interview, CalPERS’ Investment Office team says it learned an important lesson during the 2001 financial crisis, and as a universal owner it is actively working to prevent similar mistakes in the future. “Auditors play a key part in our financial system. They are the only ones that get an early look under the hood at a company’s finances. As a universal owner, we are concerned with the systems underpinning our financial markets.” 

The Investment Office team adds that the next frontier for auditing is getting more robust assurance for material ESG related information. Work on this is already under way with the International Auditing and Assurance Standards Board (IAASB) consulting on an overarching standard for assurance on sustainability reporting to be released next year.  



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