Audits are for shareholders. Few pillars of good governance are so widely ignored. Auditors are there to provide a robust and independent check on companies’ accounts, such that investors can trust the numbers; allocate capital efficiently; and ensure remuneration is paid to executives for genuine performance, not mythical returns. Efficient and stable markets depend on audits working well.
The Audit Reform Lab’s latest report demonstrates how audits are malfunctioning: of the 250 UK companies that went bust between 2010 and 2022, three in four audit reports failed to raise the alarm[1]. Worse still, 38 of these companies declared dividends in their last set of accounts, suggesting the directors were either guilty of malpractice or oblivious to the risks management were taking.
Evidence of weak auditing is not just a UK phenomenon. The International Forum for Independent Audit Regulators found that across 51 jurisdictions it surveyed in the year to 30 June 2023, nearly a third of listed company audits had at least one ‘inspection finding’, or audit quality deficiency[2]. In any other industry, few companies would survive, never mind thrive, where their key product exhibited such a high fault rate.
There are many well-rehearsed reasons why audit is failing but one of the most important remains largely off regulators’ radars: shareholder neglect.
Auditors are frequently criticised for being too close to management and thus not sufficiently independent to ensure effective challenge. But who has allowed this to happen? Shareholders.
In most jurisdictions, shareholders have the right to appoint their auditors and often also to approve their remuneration[3]. Shareholders also generally have the power to approve a board’s audit committee, which is responsible for managing the auditor selection process and oversight. These rights exist to ensure auditor accountability to shareholders, their clients.
Even where these votes are non-binding, for instance in the US, companies would be wary of ignoring a heavy vote against either the auditor or audit committee directors.
The problem is that these rights have been sitting in the cupboard gathering dust. Investors routinely approve auditors without so much as a passing consideration as to whether they have done a good job. Even where there is plenty of evidence of failure, shareholders continue to reappoint the same auditors.
Following reports of fraud and a police raid on the German electronic payments company Wirecard’s Singaporean headquarters in early 2019, for instance, shareholder reappointed EY with over 96% support[4]. A year later, Wirecard admitted that €1.9 billion of cash balances did “not exist”, its CEO was arrested and soon after it filed for bankruptcy.
In 2017, the UK’s telecoms company BT wrote down £530 million due to accounting irregularities in its Italian business, leading to 37% hit to quarterly profits[5]. At the Annual General Meeting, 79% of shareholders voted for PWC’s reappointment[6]. PWC was eventually sanctioned by the regulator for failing to ensure “the necessary professional scepticism” and for failing “to adequately document their audit work”[7].
Where shareholders show minimal interest in audit, auditors can become more vulnerable to pressure from the executives they interact with day-to-day. Auditors that give ground are unlikely to face sanction from investors. Standing up to strong executive pressure takes courage and may be viewed as detrimental to the commercial relationship with the audited entity today and in the future, whether that is audit or non-audit. Executive pressure fills the void created by shareholder absence.
Of course, a Board’s audit committee should step in on behalf of shareholders. But the problem repeats here. Rarely do shareholders hold audit committees accountable for this function. In the BT example above, the Audit Committee Chair received 88% support[8]. At Wirecard, where the full supervisory board was assigned audit oversight responsibility, all the directors received over 87% support. Data for the UK and US market shows that in 2023 directors on the audit committee received 97% and 93% support, respectively.
As regulators globally continue to wrestle with flat-lining audit quality, it is time they gripped shareholder absenteeism. In many jurisdictions, a natural first step would be to add an explicit expectation for audit oversight into existing Stewardship Code requirements. These Codes set out core expectations for investors to deliver more responsible and engaged shareholders thereby underpinning market efficiency. Investors are generally required to report annually on how they have implemented these responsibilities, including their voting record.
While Stewardship Codes tend to be voluntary, they provide a best practice standard. Ultimately, stricter requirements may be needed but this is an obvious place to start. The UK’s Financial Reporting Council has an opportunity to lead on this matter as it reviews its Stewardship Code later this year.
In the end, aggressive accounting is permitted by weak auditing, which persists due to inattentive shareholders. Rather than replacing investor oversight, regulators often have the power to recruit investors to the task of driving up audit quality. They should use it.
[1] https://auditreformlab.group.shef.ac.uk/reward-for-failure/
[2] https://www.ifiar.org/?wpdmdl=16740
[3] https://www.oecd-ilibrary.org/sites/2849259e-en/index.html?itemId=/content/component/2849259e-en#
[4] https://www.ft.com/content/284fb1ad-ddc0-45df-a075-0709b36868db
[5] https://www.bt.com/bt-plc/assets/documents/bt-plc-financial-results/annual-reports/2017-bt-plc-annual-report.pdf
[6] https://www.bt.com/bt-plc/assets/documents/investors/financial-reporting-and-news/annual-general-meeting/2017/bt-group-plc-results-of-pollat-agm-2017.pdf
[7] https://www.frc.org.uk/news-and-events/news/2022/08/sanctions-against-pricewaterhousecoopers-llp-and-audit-partner-2/
[8] https://www.bt.com/bt-plc/assets/documents/investors/financial-reporting-and-news/annual-general-meeting/2017/bt-group-plc-results-of-pollat-agm-2017.pdf
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