The ESG Interview: Holding Auditors to Account

Tim Bush, Head of Governance and Financial Analysis at PIRC, explains why asset owners should scrutinise audit relationships more closely.

If you thought this year’s AGM season was going to be dominated by shareholder resolutions on climate policy and employee equity during the Covid-19 pandemic, think again. PIRC, the UK-based independent shareholder advisory consultancy, is keeping governance firmly on the agenda too.

For the 2021 AGM season, and very possibly beyond, PIRC is advising shareholders of large UK firms to vote against the reappointment of any auditor which does not accept responsibility for detecting fraud by company management during the audit process.

PIRC’s uncompromising stance follows last August’s decision by the UK Court of Appeal to throw out an attempt by Grant Thornton, the UK’s sixth-largest accounting firm, to overturn a record £22.6 million damages claim by former AIM-listed client AssetCo, which leased engines and other equipment to the London Fire Brigade.

“The mantra of the auditors is that fraud is the responsibility of management. But the Grant Thornton case shows that when management are fraudulent, the responsibility for detecting the fraud was the auditor. The auditor is the backstop,” says Tim Bush, Head of Governance and Financial Analysis at PIRC.

Open and shut case?

The ruling confirmed a judgement handed down in 2019 which identified serious failings and “flagrant breaches of duty” by Grant Thornton when auditing AssetCo’s financial statements for the years ending March 2009 and 2010.

The auditor had failed to notice that the company’s management had overstated assets and cashflows, which inflated its balance sheet and allowed directors to pay out dividends while AssetCo was in reality trading at a loss. Directors had also conducted fraudulent transactions and forged documents to cover their tracks.

Despite this widespread, systematic financial mismanagement, Grant Thornton gave AssetCo a clean bill of health as a going concern. The ruling held the auditor accountable for the payment of the illegal dividends, following its failure to detect the fraud, and for subsequent misinvestments, by AssetCo.

When the firm’s insolvency was finally revealed, its share price slumped to 2p from 60p, leaving investors nursing substantial losses. The Financial Reporting Council (FRC) fined Grant Thornton £2.3 million and gave the partner responsible a three-year ban.

Grant Thornton’s argument that the auditor should not be held responsible for fraud or imprudence by management was rejected in the courts, potentially giving rise to future legal action against auditors from clients, in the event of losses resulting from decisions made after an inadequate audit.

The implications appeared to be clear. Under UK law, auditors need to take seriously their responsibilities for detecting fraud by management, necessitating a shift in the somewhat cosy relationship of recent decades, which had seen audit firms enjoy long-term tenure and routinely earn large fees from follow-on work for their consulting arms.

“There’s an analogy with the European Super League. The whole point was that your investment in a European Super League was safe because there’s no relegation. Auditors have been in that position for years,” Bush comments.

Mind the expectations gap

But instead of prompting auditors to accept defeat, the Court of Appeal decision was merely a prelude to a new chapter.

The next month, September 2020, the International Auditing and Assurance Standards Board (IAASB) launched a consultation on its standards relating to fraud and going concern, with a view to potentially expanding auditor responsibilities. The global standards-setter’s discussion paper asked for feedback on suggestions for closing the gap between user expectations and what professionals claim the financial statement audit is designed to deliver, summarised as being “useful to users”.

Responding to the consultation, which ended in February, PIRC rejected the concept of an ‘expectation gap’ and called for the exercise to be abandoned on grounds of its “incorrect”  premise. Further, it gave notice that firms failing to repudiate the expectation gap would be opposed in upcoming shareholder votes.

“Auditors just need to do what they’re supposed to do. They don’t actually need any new duties,” notes Bush.

The auditors under threat include Grant Thornton, PwC and EY, but not Deloitte, BDO and Mazars. In their responses to the IAASB consultation, the three did not endorse the expectation gap concept, acknowledging that expectations depended on the law of the local jurisdiction. Some also flagged the problems arising from international accounting standards, which allow over-statement of assets to a degree that can obscure its status as a going concern, similar in effect to fraud .

Never knowingly oversold

While auditors may wish to adhere solely to the international principle that audits must be useful to users, PIRC asserted the primacy of the law of the UK – and several other jurisdictions –  on the question of auditors’ duties in respect of fraud, citing not only the Grant Thornton ruling, but also a 2019 ‘Future of Audit’ report by the House of Commons Business Energy and Industrial Strategy (BEIS) committee.

“It’s the law that’s paramount, not the standards,” says Bush, pointing out also that common accounting practice on unrealised profits also runs counter to basic laws of economics.

In the 2019 report, MPs gave short shrift to the idea of a misunderstanding by the public. “We do not accept the attempts of auditors – particularly the Big Four and Grant Thornton – to underplay the role or scope of audit, nor to implicitly blame the public for failing to understand the purpose of audit. Rather, the firms should focus on the poor quality of their audits, and on how they are falling short of what audits are for within the current framework,” it said.

Fraudulent reporting by directors, they added, is almost always material. “The detection of material fraud is, and must continue to be, a priority within an audit. Audits must state how they have investigated potential fraud, including by directors,” MPs noted. “The delivery gap is far wider than the expectation gap and that is what must be fixed as soon as possible.”

Long-overdue reforms

The MPs’ conclusions also reflected a wider malaise in the audit industry. The report called on the UK Competition and Markets Authority (CMA) to effect full legal separation of audit and non-audit services, criticised companies’ audit committees for favouring ‘cultural fit’ over professional scepticism when selecting auditors and dismissed the FRC as a “weak and ineffective regulator”.

Later in 2019, an independent review into audit quality and effectiveness, conducted by former London Stock Exchange chairman Sir Donald Brydon, came to similar conclusions, making 64 recommendations to the UK government, primarily aimed at separation of the audit and accounting industries. Reports on the FRC and by the CMA made for similarly uncomfortable reading for auditors.

These myriad criticisms are now driving change. In March, the UK government launched a consultation designed to “rebuilt trust” in audit and corporate governance, aiming to end a series of high-profile financial mismanagement scandals, including Carillion, BHS and Patisserie Valerie, among others.

The BEIS Department’s consultation endorses the separation of the audit profession, increases the responsibilities and accountability to shareholders of auditors and directors, expands the scope of the audit to include non-financial information, including ESG risks, and introduces a more powerful regulator, the Audit, Reporting and Governing Authority (ARGA).

Governance on the ballot

Typically, the reappointment of the auditor takes up little time or attention at an AGM, often being nodded through as a matter of course. But this approach undervalues the critical role of audit to investor’s relationship with, and understanding of, the investee firm.  After all, the auditor is the investor’s guarantee that the figures are correct.

“Investors don’t always appreciate that, if the audit is wrong, the investment may be worth less than it appears,” says Bush.

PIRC’s advice to shareholders includes voting at today’s (April 28) NatWest Group AGM held at the bank’s Edinburgh headquarters. Not only has PIRC advised against reappointing EY as auditors, but it also opposes a proposed rights issue. According to Bush, the firm will be scrutinising board proposals on remuneration and share-buy backs throughout the season, both of which are likely to be a priority for investors and directors as companies plot their recovery from the economic impacts of the pandemic.

Along with questions around the role of audit, PIRC’s focus on a wider range of issues serve to remind investors that governance remain fundamental to shareholder value, in parallel with growing and urgent concerns over economic and social factors. Investor efforts to flag concerns of audit quality have contributed to the momentum for change in the recent past and will continue to play an important role.

Acting antagonistically

When considering the proper role of audit in the investor’s oversight of companies, Bush looks both forward and back.

To further underline the weight of evidence supporting PIRC’s stance on audit, he points to a 1990 House of Lords ruling in the case of Caparo Industries v Dickman, which references the auditor’s duty to provide shareholders with an independent report on the reliability of the company’s accounts. “No doubt [the auditor] is acting antagonistically to the directors in the sense that he is appointed by the shareholders to be a check upon them,” the judgement noted.

“Case law recognises the auditor’s role as inherently antagonistic. This is the antithesis of an auditor who takes on consultancy work,” he says.

The importance of audit quality is only going to grow for investors with a focus on sustainability. As noted recently by IOSCO Secretary General Ashley Alder, it will largely fall to auditors to verify that companies’ reporting of ESG risks under standards set up by the IFRS Foundation’s planned Sustainability Standards Board.

According to Bush, PIRC is very much alert to the need to scrutinise on behalf of investors companies’ commitments to decarbonise their operations and address the full range of ESG risks.

“The link between false accounting and false climate change accounting is getting quite similar. You’ve got off-balance sheet greenwash that they’re trying to bring on balance sheet, for example by claiming the credit for an existing forest,” he observes.


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