It is now recognised in the UK that International Financial Reporting Standards (IFRS) mandated by the EU along with the voluntary adoption by the Financial Reporting Council (FRC) of International Auditing Standards (ISAs) in 2005 contributed significantly to the financial crisis by allowing banks to overstate profits and asset values.
The FRC, which continues to support global accounting and auditing rules, has not been held to account for failure to acknowledge the extent of economic harm that the new rules caused and neither has the Department for Business, Innovation and Skills(BIS), despite major challenges from politicians and investors.
These include: BIS claiming that IFRS delivers prudent accounts in a 2011 response to a House of Lords Economic Affairs Committee Inquiry; and FRC insisting that the true and fair view accounting principle, a key tenet of UK company law which underpins prudence, going concern, capital protection and directors’ duties, has not been undermined by IFRS.
The FRC recently re-organised to take more control over its subsidiary boards and become a bit more pro-active, five years after the crisis and at least seven years after the defects in the accounting regime were known to experts. There has been no definitive guidance from FRC about realised and distributable profits, a major issue in the banking crisis. Instead FRC has relied on guidance issued by the Institute of Chartered Accountants in England and Wales (ICAEW) and has delegated some work on corporate governance, which is FRC’s responsibility.
A point has now been reached where the Bank of England and the Parliamentary Committee on Banking Standards believe a separate set of audited accounts is needed for the Bank properly to discharge its supervisory duties.
FRC promotes top down rules which disadvantage the SME sector. It is introducing a version of IFRS for SMEs from 2015 onwards, imposing cost without any obvious benefits to an already hard hit sector. Audit has become impossibly expensive for smaller corporate and third sector entities because FRC has stuck to the mantra of ‘an audit is an audit is an audit’, when it is the quality of the opinion that matters not how it is reached. BIS’s solution has been to raise the audit threshold to the highest level permitted by the EU rather than even attempt fix the top down problem.
FRC was set up in 1991 to take over control of UK accounting rules and enforcement from the accountancy profession because of poor quality accounting. A system of Audit Regulation was introduced requiring auditors to be registered and licensed, suitably qualified, to maintain competence and be subject to inspection and disciplinary proceedings. This system was delegated by BIS to the relevant professional accountancy bodies. As with audit, one size fits all for the audit licences, which are still issued to the largest accounting firms mainly by the ICAEW.
In 2004, after the Enron scandal, the FRC was mandated by BIS to take responsibility for inspecting public interest audits and setting audit rules independent of the profession. The UK audit rules were promptly changed, without proper consultation, to International Standards on Auditing (ISAs) set by the profession internationally.
By 2005 the UK, with its significant capital markets, had no direct control over its accounting or auditing rules for listed entities. FRC also took responsibility from the profession for investigating major accounting and auditing scandals but this process is limited to those involving UK qualified accountants i.e. auditors, directors and others. FRC has no power to compel evidence from non-accountants, and it may also pass over to the audit licensing bodies cases of regulatory breaches found by its own enforcement activities. These relationships seem rather too cosy.
The fragmentation of responsibility for financial reporting, auditing and conduct of directors goes much wider than the cosy relationship between the FRC and the accountancy professional bodies. UK Companies are required to file annual accounts and other key company information, such as names of directors, at Companies House. Late or inaccurate filing can lead to fines imposed via BIS’s own procedures. BIS can also ban individuals from holding company directorships if they breach company law, such as trading whilst insolvent. BIS is also responsible for maintaining and developing company law, compliance with some aspects of which appears to have escaped FRC’s notice.
The London Stock Exchange is regulated by the UK Listing Authority (UKLA) which is accountable to the Treasury. UKLA has its own listing rules and enforcement procedures. Financial reporting and auditing over which UKLA has little control are important to the UKLA, as well as the listing rules. In addition to investors, UKLA too needs reliable financial information to avoid being misled.
Defragmentation the way forward: a new Companies Commission
So what should be done to tidy up this fragmented mess? We have found to our great cost what can happen in the UK if accounting, auditing and its relationship with company law is mismanaged and a regulator gives priority to promoting global rules rather than the UK public interest.
The next UK government should set up a Companies Commission (CC) which would be totally detached from the accountancy profession. The CC should take responsibility for: UKLA; Companies House; regulation and rule making for UK accounting and auditing (including audit licensing); the corporate governance code; company law; and addressing failures in accounting, auditing and the listing rules, all under the same roof. CC should also provide a much needed whistle blowing facility for auditors and others who are concerned about corporate behaviour.
The SME sector and the third sector have been badly served by the FRC’s concentration on top down rules. The CC should also set up a separate and powerful body with specific responsibility to develop appropriate accounting, auditing, governance and legal regimes for SMEs.
The battleground will be to which government department the putative Companies Commission should be accountable. An interesting challenge for policymakers is whether BIS can be trusted. The Chancellor of the Exchequer has launched in inquiry into enforcement in the financial services sector. It is high time government looked at fragmentation and regulatory capture in the rest of the corporate sector.
Stella Fearnley is Professor in Accounting at Bournemouth University. She provided oral and written evidence on the banking crisis to the Parliamentary Commission on Banking Standards and to the House of Lords Economic Affairs Committee
Note: Professor Fearnley is grateful to Dr Lyton Chithambo for his assistance in developing this article.