THE FRC has been warned that changes to the way disciplinary sanctions are calculated could damage the profession and deter people from entering into the industry and continuing membership with institutes.
The FRC’s disciplinary arm, the Accounting and Actuarial Disciplinary Board (AADB), wants to increase fines on larger member firms because current penalties do not incentivise the right behaviour and are failing to be a “credible” deterrent to misconduct.
Plans to introduce new penalties based on a percentage of firms’ annual turnover and/or members’ yearly income were the subject of a backlash from firms and institutes that labelled the changes as “irrational”, “flawed” and “damaging” to the profession.
The Big Four are up in arms. The changes could result in them having to shell out tens of millions of pounds in fines in instances where they are found to have been negligent or guilty of misconduct.
In consultation documents published on the regulator’s website, PwC, Deloitte, KPMG and Ernst & Young lined up to voice a litany of complaints centred around how the FRC’s proposals would leave them disproportionately out of pocket.
Deloitte said the method for calculating the fine as a percentage of turnover of a member firm is “an irrational mechanism, leading to disproportionate, unfair and inappropriate sanctions, inconsistent with both the purpose of sanctions in the context of professional discipline and the desirable outcomes which such sanctions should promote.”
Ernst & Young was no less critical, labelling this type of calculation as “flawed”, arguing it would result in disproportionately high fines. It suggests that a fixed fine would give clarity to a case and instil simplicity.
Also, as pointed out by KPMG, the majority of cases that have shown audit failings are due to negligence or unintentional error and claimed it is difficult to see how the risk of errors would be wholly eliminated through sanctions.
PwC agreed, adding that human error will not be deterred by large financial sanctions which are primarily punitive rather than aimed at upholding standards, given that firms or members do not set out to make human errors.
For instance in a recent High Court case cited by PwC, Coke-Wallis v ICAEW, it was ruled that the “primary purpose of professional disciplinary proceedings is not to punish but to protect the public, to maintain public confidence in the integrity of the profession and to uphold proper standards of behaviour.”
“However, we are concerned that the effect of the guidance particularly in terms of the proposals concerns the calculation of financial sanctions, appears to be primarily punitive,” PwC said.
However, it was not only the Big Four – with an undeniable vested interest in the sanctions – that were volleying complaints at the FRC. Institutes also noted some inherent risks to the wider profession with ICAEW cautioning that punitive financial sanctions could “undermine the growth and development of professional services firms and the sector generally” while ACCA argued that percentage-based sanctions could have a particular “damaging effect on the provision of audit services in the UK”.
Firms are deriving increasing amounts of revenue from the provision of non-audit work. As a consequence, sanctions dished out to the audit arm would include calculations based on the size of the non-audit division. According to ACCA, firms could start to distance themselves from their audit practice to create an independent firm, and mergers and acquisitions, to benefit from economies of scale, could see the UK end up with just one firm able to provide audit services to large companies.
In its response, ICAS warned that adopting such a “severe penalty formula” based solely on turnover or gross personal earnings would “surely undermine the purpose of professional discipline and regulation.”
ICAS even claimed that the structure of proposed sanctions is more akin to criminal proceedings as opposed to professional discipline and regulation and pointed out that most cases stem from a systematic breakdown rather than wilful recklessness.
Change is needed
The gripes coming from the profession are the nit-picking and lobbying expected with changes of such magnitude. Indeed, all the respondents agree the primary purpose of sanctions is to protect public interest, and all agree with most of the draft guidance under consultation.
Following a disciplinary case involving PwC in 2011, it became patently obvious that the AADB needed to introduce tougher sanctions. The tensions came to head when the AADB appeared frustrated at the low-level fines tribunals are able to dish out.
In a case heard last year, in which PwC was fined over audit work of financial services company JP Morgan, the AADB applied to have the Big Four firm charged a record smashing £44m, later reducing that to £6m, with the independent tribunal dishing out just £1.4m – in itself a record fine.
At the time those arguing for a change, suggested that £1.4m was a drop in the ocean for the Big Four firm, with UK fee income coming in at £2.4bn.
“… we do consider that the increases in recent times of the fees payable by firms such as [JP Morgan] to firms such as [PricewaterhouseCoopers] indicate the need for a substantial increase in the level of penalty payable for misconduct of the kind under consideration in this case,” the AADB consultation document said.
Deloitte, however, was not wholly swayed by the AADB’s argument. “We are concerned that the AADB, having failed to convince an independent tribunal established under its own scheme to increase the level of sanction to a level which it (the AADB) considered appropriate, has decided to achieve that objective through the use of influential (although non-binding) sanctions guidance,” it said.
E&Y also pointed out that the AADB tribunal in the 2011 JP Morgan case “considered and rejected without hesitation as “irrational” a submission that a financial penalty for defective audit or reporting be linked to the percentage of revenue based penalty imposed on the client.”
By changing its penalty calculations, the AADB is merely making its own fines more in-tune with those levied by the FSA. In the JP Morgan case the FSA fined JP Morgan £33m while the auditors received a sanction of £1.4m.
However, comparisons between the AADB and FSA reveal a discrepancy in the way sanctions are calculated.
“The FSA level a financial penalty based on the percentage of a firm’s revenue or income from the relevant products or business areas not the group or even the entity as a whole,” said KPMG.
Not the only option
Throughout the responses it was highlighted that other countries were not using this type of structure. All the Big Four said the US, Australia, Canada, Germany and South Africa use a range of sanctions.
Deloitte highlighted that the level of sanctions are not spectacularly high, in other countries, compared to the £44m that the AADB petitioned for in the JP Morgan case. The firm said in the US the PCAOB (Public Company Accounting Oversight Board) fines firms $2m (£1.27m) per violation, the SEC $750,000 and Germany €500,000 (£393,880) so there is no reason UK fines should be so much higher.
Ernst & Young adds that no regulator in the US, Australia, Canada or South Africa apply a percentage of revenue as a sanction, but they have other sanctions available such as third party reviews and stripping firms of licences.
“We are also disturbed that the AADB seems to believe that only a monetary fine can act as a deterrent,” said KPMG.
Reputation is everything
One thing that the AADB seems to have failed to mention is that aside from the monetary fine, the publicity which includes naming and shaming the member firm as well as the individual member has a hugely damaging effect on reputation and in itself is a deterrent.
Deloitte says it thinks it is important the AADB understand the impact the publicity on an investigation has. Not only will the investigation or tribunal impact a member’s work but puts their reputation and them under “enormous” stress.
The “mere fact that it is known in the financial and business communities that an investigation is in process has a severe effect on reputation,” said PwC.
“Lest we forget Arthur Andersen, [which collapsed in 2002 following its role as auditor of Enron] albeit that was in the context of criminal rather than professional disciplinary proceedings,” it added.
It would be disingenuous, however, to suggest that the profession is united in its opposition to the FRC’s proposals. For instance, PKF, ranked 12th in the Accountancy Age Top 50 +50, said it agrees “fines for member firms should be proportionate to financial resources.”
However, it argues that sanctions on members should be according to a set tariff which will not cause serious financial damage to the member. Using a percentage calculation on individuals could send a negative message to people about becoming an auditor and to smaller firms on taking public company audit clients, (basically reducing competition).
ACCA agrees that while percentage sanctions could be a good idea, if the same calculation is used on individuals this would be wholly unfair. The individual may have no control over the way an audit function is managed in a firm.
The ICAEW also argues that individual executive and non-executive board members who are chartered accountants will be liable for significant sanctions above and beyond other board members. This could lead to discouraging people from becoming chartered accountants or discourage continuing membership of the accountancy bodies.
KPMG made the same point adding it would be a huge disincentive and members in business do not have to renew membership and could be happy to relinquish their title.
But if you must
Aware this could be a losing battle, Deloitte concedes if the AADB pushes ahead with percentage-based sanctions it should be based on income after tax, and figures for the year of the misconduct not the year the fine is handed out.
Many also highlight that if a percentage-based approach is needed, it should be based on revenues garnered from the service line at fault. Fines should be used to cause “financial hurt” to a firm, said PKF, but, it should be based on profit not turnover and the largest firms may have much higher profits per partner than smaller firms.
There are also a number of kinks that will need to be worked out if the proposals in the current form are to be implemented. The ICAEW asks whether fines levied at firms that are European LLPs would be based on the European figures or is the firm expected to come up with a UK only turnover, while ACCA raises the important question that is also not clear how a tribunal and sanctions system would work if a company opts for a joint audit.
Also PwC said that it would like to see more action taken against those who perpetrate fraud if changes are to be introduced. However, it also highlighted that because an auditor failed to discover fraudulent behaviour it is not an audit failure.
“We are considering carefully the views expressed in the various consultation responses. We are aware of the audit firms’ concerns on this matter which, in finalising the guidance to disciplinary tribunals, will be balanced against other responses and the need to ensure that sanctions are proportionate, serve the public interest and act as an appropriate deterrent against misconduct,” said an FRC spokesman.
“The consultation responses have been overwhelmingly supportive of the value of issuing sanctions guidance, the need for which was also underlined in a High Court judgement last year. The FRC will issue its response later in 2012.”
Overall the profession is worried about the damaging effects higher fines will cost to the reputation of audit in the UK, and whether it will reduce the number of people entering the profession, reduce the renewing of membership figures, decrease competition or actually have any effect other than revenue raising.
The AADB has made one thing clear, which all respondents have agreed, that change is needed but it must be aware to tread lightly, there are many large firms who will not go quietly.
Simon Wright of CareersinAudit.com discusses how an effective cyber defence force is critical to businesses worldwide and how internal auditors can make the transition to a new career in cyber security
The FRC has said that the investigation will 'consider, but not be restricted to, issues regarding misstated accounting balances'
Craig Maxwell joins the audit and assurance team in Scotland
Stephen Grayson to join the audit department in Manchester