An opportunity for change in the accounting sector – a need for reinvention

An opportunity for change in the accounting sector – a need for reinvention

There is usually a silver lining to every dark cloud, and the one hanging over the UK accounting sector is no exception, says Leon Kamhi, Head of Responsibility at Hermes Investment Management.

An opportunity for change in the accounting sector – a need for reinvention

Over the last 20 years we have worked our way into a crisis of trust in accounting. We have lost faith not only in the institutions that are meant to oversee the process of validating company performance, but the in the process itself. It has become common practice to try and pass the blame around for what has happened to the sector, but the truth of the matter is that we are all partly responsible. Investors, regulators, politicians and bankers all share some fault with companies and accountants in bringing us to where we are today.

That is why we are all now responsible for fixing this sector. What is key to moving on from the blame game is accepting that there are many aspects to the sector’s reinvention, and that we all need to change our ways. The good news is that if we all step up to the plate, it will be a real moment of opportunity for profoundly positive change.

The challenge

The reinvention of the accounting sector must be based on one key objective: accounts should reflect the real performance of the business. This is what most people outside financial services think they should do, and they are mystified as to why this is not the case. For those of us on the inside, we know that accounts do not always demonstrate a true and fair view of a company because they are often prepared to ensure that they maintain a technical adherence to accounting standards rather than ensuring that they reflect the underlying business performance.

As a consequence, when investors read audited accounts, we are often left wondering whether the profits being reported are “realised” or “unrealised”, and if “unrealised”, will they ever be “realised”? Does “cash” always mean “cash”, and just how is “goodwill” written down?

Why are some new CEOs able to “kitchen sink” by writing off as much as they can when they take up the position? And why do Boards, who signed off previous accounts, let them? Could these write-offs have been made before – and, if so, why wasn’t it done previously? There are issues concerning the way revenues are recognised and the same is true for lease payments. There is also an extensive suite of obscure instruments that purport to inform, but in fact serve only to obscure and confuse.

As investors, we are not alone in demanding change – it will help everyone in the chain, from companies to investors, to function more clearly, cleanly and effectively.

If accounting is to fulfil its potential of being a truly useful activity in supporting sustainable wealth creation by companies, the industry needs to confront how accounts can be put together, audited and regulated in a way that clearly and honestly reflects the performance of the business. Without a firm answer to this, the hope for a reinvention of the accounting sector will never become a reality. Therefore, we must examine the different actors and what they need to do to effect positive change.

The companies

Clearly, companies that are being audited have the greatest responsibility. They have the information that can and should be made available to comply with the rules and most of the time they will provide it. However, in the rules is where we find our first opportunity for reinvention.

For companies, the question around reinvention is; to what extent is the Audit Committee willing to act independently from the management?

In reality, it is very easy to stay inside the relatively wide lines of many accounting standards, and company Audit Committees generally do a good job within these rules. They make every effort to ensure that regarding their accounts, the CFO, the finance department and the auditors comply with the exact letter of the law.

Most Audit Committees have a good range of people – from those with hard accounting skills, to those who are there to ask the “stupid” questions. For companies, the question around reinvention is; to what extent is the Audit Committee willing to act independently from the management? Moreover, how determined are they to show not only what they are required to from a regulatory perspective, but what they should in order to help investors and other users understand the true performance and position of the company?

The auditors

Auditors have the greatest opportunity to address current accounting issues. Firstly, they have unbeatable knowledge about how companies across every spectrum operate as they interact with so many of them. Secondly, they are able to remunerate staff relatively well, so can attract talented people.

However, there are justifiable concerns around auditors’ incentives and their perception that the regulator sees technical compliance as the primary objective, and a true and fair view of the underlying business performance as a secondary issue for accounts. Unfortunately, the pressure to achieve “profit per partner” has led the auditors to create overly leveraged teams with senior members often not spending enough time with a client. It is also understandable that there is immense focus on the technical side, and one can make a case for the benefit of bringing in a team who are laser-sharp on procedures. However, it should not come at the expense of having an individual with specialist sector experience who truly understands the business.

Audit firms need to develop far greater transparency around their activities and be able to explain how remuneration is not only driven by the profit-per-partner, but also by the quality of the audits they deliver.

There are teams that are competent and capable in the technical skill of auditing, but without visiting a company – or a range of them – and actively engaging with them, how can they really understand the business? Furthermore, if you do not understand the business or sector, it is impossible to carry out an effective assessment and audit of a firm. It would be as if you put a fund manager in charge of running an Asia strategy without taking them to Asia. There is a further issue with auditing firms that needs addressing from a corporate level, if they are to reinvent themselves.

As a partnership, there is no legal requirement to have an independent chair or majority independent Board. However, because of the privilege of limited liability enjoyed by companies and their shareholders, the wider impact of company failure and potential job losses can ripple out to the local economy and society. Consequently, auditors are in effect providing a public service, and this demands stronger governance.

Audit firms need to develop far greater transparency around their activities and be able to explain how remuneration is not only driven by the profit-per-partner, but also by the quality of the audits they deliver.

The regulator

During the FRC review led by Sir John Kingman, it became clear that the regulator has struggled from having a relatively limited talent pool from which to draw its staff. It is also our perception that the regulator had been over-focused on procedure rather than on understanding whether the accounts that audit firms were auditing really reflected a business and its underlying performance. There was an inherent fear that any review of an audit or account that had been flagged as suspect would take such a long time to unravel, that the FRC instead focused on whether something would stand up in court, rather than if the industry’s general practice could be improved by examining, updating or clarifying an issue.

The Kingman Review recommended the creation of a new regulator to replace the FRC – the Accounting Reporting and Governance Authority. This presents a strong case and opportunity for the reinvention of the regulator to build something that is fit for purpose.

Instead, the new regulator must demand of companies and auditors that they make their highest priority and purpose to be that accounts are prepared on the basis of a prudent approach at the same time as representing a true and fair view of the company’s performance and position. With the introduction of a new regulator we should hope and expect that these issues will all be addressed as a matter of urgency.

The investors

It is imperative that investors put as much emphasis on acting as stewards of capital as they do as stock-pickers. Alongside the auditors, we have a responsibility to society as well as to our clients and beneficiaries. We are taking on the duty of a steward of other people’s capital and ownership of a company that provides a livelihood to many and goods or services to many more.

Unfortunately, across the industry much of fund manager activity is not focused on engagement or on turning poor companies into better ones. Nonetheless, as a group, we need to treat the time between the purchase and disposal of a company stock or bond as equally important as the buy or sell decision.

Stewardship is a growing area, but across the investment management industry it is currently woefully under-resourced, in terms of both the seniority and the knowledge and experience of those who carry the responsibility – but that is changing. To date, a disproportionate level of investors’ stewardship efforts have been focused on executive remuneration. Only now is the industry increasing its attention and resource available to address hugely important environment and social issues.

The sad reality is that in 2019 there is very limited stewardship that focuses on the quality and relevance of a company’s accounts nor the membership and activity of the Audit Committee, all of which are fundamental to the running of the business. Yes, we will spot when an audit firm has been there too long, or if non-audit fees get too high. Equally, when there is a crisis, a fraud or a particularly egregious accounting issue, investors get busy. There is, however, plenty more we can do before this happens, which may mean we even avoid getting to that stage.

As investors, we must be more systematically engaged with the Audit Committee Chair and the CFO. It is vital that we examine how business performance is being reflected in the accounts and why certain accounting treatments are being used.

To do this, through informed discussion, we need to have the right skills and resources available. Our investment teams may already contain people who fulfil this need, but if not, investors need to consider how to resource the function to carry it out effectively. Rather than lay the blame solely elsewhere, if we as investors fulfilled our stewardship responsibilities, Audit Committee chairs would start listening and put more pressure on their audit firms, too.

The conclusion

We have already seen how improvements in this area help investors make better decisions. Viability statements, which were introduced three years ago, provide a clear view of whether a company is in good health or not. According to many of the Audit Chairs we speak to, viability statements generate a Board discussion which leads to better business decisions. Accounting rules are not going to change in a hurry – but we do not need them to do so in order to make the improvements we seek.

Instead, when a certain standard does not reflect underlying business performance, an auditor and a company should feel empowered to explain why they are not following the standard and provide additional information that delivers a true and fair. Company accountants, Audit Committees, auditors and investors – we all have our role to play and need to work together much more closely to improve, including the regulator.

We have an opportunity – and necessity – for reinvention, but more importantly, we have a responsibility to get it right.

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