Speech by Rachel Reeves MP: Audit, trust, and the future of capitalism

12 November 2018

On Monday 12th November, Rachel Reeves MP, Chair of the Business, Energy and Industrial Strategy Committee, delivered a speech on the future of audit at the London headquarters of the Institute of Chartered Accountants in England and Wales (ICAEW).

Introduction

Can I first thank the Institute for inviting me here today to speak. Actually, the initial invitation was for a Monday in October that turned out to be Budget Day. So here I am, two weeks later…

Trust & audit

It is trust I want to focus on today. Trust in audit, trust in business, and in the foundations of the economy in which we all operate, but which need a system of shared rules, customs, and trust to survive and to thrive.

At the root of so many of the challenges our country faces today is trust. From politicians to journalists to ‘experts', a revolt against elites has been driven by a breakdown in trust. People stopped believing in politicians represented them or that in experts. Faith in business was hit hard by the financial crisis, and the malpractice and incompetence evidenced by executives at BHS, Carillion, and a number of other companies recently has only made this worse. But that means that this is a critical time to talk about the role of audit and the audit market as a check against these sorts of excesses and abuse, and as means of generating and maintaining the trust in business that must be the cornerstone of any healthy market economy. But also, we must address the damage to trust when audit fails to spot and point out glaring weaknesses, fraud, or the imminent collapse of a business.

So what of the role of Parliament in this?

My Select committee has, like its predecessors, dug around in the ruins of failed businesses and been, frankly, horrified at what we found. Bullying chief executives riding roughshod over any semblance of boardroom challenge, sponsoring ingenious forms of financial engineering designed to extract profit where none was being made, and concocting accounts that weren't fooling the markets, yet satisfied the auditors.

To those who say that it is the activities of parliamentary committees that help to undermine trust in business, I am afraid that I have only bad news. We will continue to hold chief executives to account, in public, where it is warranted, in a way that regulators don't, boards sometimes won't, and shareholders often can't. You don't blame a doctor for diagnosing a disease, and we will continue to call out excess and abuse that undermines our economy and our democracy.

More importantly, if we judge that the issues we identify are not just occasional failures caused by the actions of the unlucky or the maverick, if we see untrustworthiness as the mode of the many and not the few, then we will act. We will design tighter ties of corporate governance and regulation.

We will do what it takes to support and challenge British business. Supporting real wealth creation cannot mean turning a blind eye to bad practice, systemic dysfunction, and – in some cases – individual avarice.

So let me set out the case for action

Brexit should have served as a reminder that if a system does not work for the majority, if our society continues to feel like it is rigged, then there will be a reaction over which traditional elites will not have control. This is not a question of asking companies to behave altruistically. It is about recognising that we are embedded within a complex society and that, when individual decisions are made in boardrooms, there are people's jobs and pensions at stake. Business leaders must better understand that it is in their interest, and that of the firms they oversee, to demonstrate behaviour that serves the interests of everyone within a business – shareholders, managers and workers – as well as wider society. I don't think that is difficult.

If we don't respect, and take heed, of the foundations of our economy and society, then don't be surprised if they come loose or begin to crumble away. And of course, when they do, the businesses that are supported by those very foundations begin to crack and quake too.

What sort of behaviour I am talking about? Let me give some examples.

What sort of behaviour am I talking about? What sort of trust do we need to work on. So let me give some examples.

Can we trust the 240 companies named and shamed this year for not paying the national minimum wage?

Can we trust Volkswagen, a car company - even one with workers on its board - that deliberately fixes emissions tests?

And can we trust our world-leading businesses that earn billions through audit and financial services yet repeatedly are fined millions for failing to conduct audits of acceptable standards?

If businesses want to earn the trust of concerned investors and informed consumers, they will have to stop earning headlines for the wrong reasons.

What possessed Royal Mail to award a £5.8m golden hello to a new chief executive, from within its own group, who paid no tax on it in this country?

Jeff Fairburn, CEO of Persimmon, just walked away from legitimate questions about his ridiculous £75m bonus. I hope that his leaving Persimmon is recognition that the costs to reputation of such madness are even greater than the awards themselves. The new boss of BT was paid a £1.3 million bonus two weeks after announcing 13,000 job losses.

These examples of what I call greed and largesse send a message to ordinary workers and consumers that business elites live in another world to them, totally detached from their everyday lives, with no regard for them unless it is how to squeeze more profit from them.

And when my constituents, and ordinary people in communities across our country, ask why no one is holding corporate behaviour in check – the buck has to stop with Parliament. It is up to Parliament to set the rules of the game, and to make sure those rules are enforced.

Our country has grown much richer over the past forty years. But it has also grown more unequal – power and wealth have shifted sharply towards London and the South East, and from labour to capital. Stark divides have grown along lines of geography, generation, class, education and housing tenure.

Companies have become increasingly detached from the societies in which they do business. It is difficult for those earning £7.83 an hour, on the minimum wage, or even on the average salary of £27,000 to understand how their day of hard work is valued so little compared to that of their bosses, who are taking home several million. It would take 167 years for a worker on an average wage to earn what the CEO of a FTSE 100 company earns in just one. Too many businesses lack the wider sense of social purpose that should animate the best companies, which understand they are rooted in local communities and national societies, in an environment and in partnership with their employees, communities, and local and national institutions in order to thrive.

Meanwhile, the sluggish growth that has been achieved since the 2008 crisis depended on consumption fuelled by unsustainable levels of household debt. From the mid-1970s, the labour share of our national income fell sharply, in common with most western economies. While many families struggling with the rising cost of living rely on credit to buy the essentials, those at the top of society have accumulated a greater and greater share of our wealth. A sense has grown that there are people at the top of our society and our economy for whom the rules no longer apply. And another group struggling on low and middle incomes who wonder how they will ever get the security of a decent wage that they crave.

We are not talking about a few rotten apples, or individual issues to be ironed out in an otherwise thriving system. Executives at Carillion, BHS and elsewhere have been the beneficiaries, and in some ways the fall guys, for a national economic model that has increasingly become one of wealth extraction rather than wealth creation. No wonder people are angry when they see evidence of the incompetence of people who seem to have barely noticed there ever was a crisis.

And when we talk about concentrations of power, nowhere is this more evident than in the case of the huge businesses which have been able to accumulate such a great share of economic and political power that it seems impossible to hold them accountable. A market in which the state steps back but a small group of executives at the head of firms that wield vast, unaccountable power isn't ‘free' at all; it's an oligarchy.

I think it is worth going back to the beginning to rethink the purpose of audit and why it matters in this wider context.

Audit arose alongside the creation of the limited liability company in Britain, in the wake of the 1878 collapse of the City of Glasgow Bank. Both were meant to act as a check on reckless corporate behaviour, in the interests not of workers or of society as a whole, but of capital itself.

A dominant ethos of prudence, commensurate with the capitalism of the later decades of the nineteenth and first half of the twentieth century, developed in the auditing industry.

Under this system that placed such emphasis upon prudence, managers could not simply conjure up unrealised gains and profits, to be presented as fact.

Western economies have undergone an extraordinary transformation in the last forty years. Deindustrialisation, globalisation, financialisation, the rise of neoliberalism have all changed business and society profoundly.

In Europe and the United States, the nature of the relationship between the state and private enterprise have been transformed.

The transformation of audit is an under-told part of that story.

As with so many institutions, audit changed over the decades from the 1960s to the 1990s, as ideas from the University of Chicago and elsewhere permeated into the practice of British capitalism. Methods became more speculative, and more tailored to what clients wanted.

Often it seems that audit has gone too far – telling clients what they want when hard-headed, impartial and – yes – prudent advice is needed.

Modern auditing emerged to provide faith in the market for investors and the public alike. This remains its primary role today.

But to be able to provide trust in the operation of the market, we must be able to have confidence in the market for audit itself. The examples of BHS and Carillion have eroded that trust and cost thousands of jobs. In both cases audit played a role into failing to identify any issues. This has caused us to question a market of few major players and questionable competition.

Let's remind ourselves of the BHS audit. The select committee report into its collapse noted that: PwC had a long-standing relationship with Sir Philip Green and had provided auditing services to its parent company, Taveta, for over a decade. The same PwC partner, Steve Denison, was responsible for auditing the accounts of Taveta and its subsidiaries for the whole period.

Two years later the FRCs report on the PwC audit of BHS said: "They failed to gather any audit evidence on which to conclude that the going concern assumption was appropriate. Based on the audit evidence obtained, they should have concluded that a material uncertainty existed about BHS Group and BHS's ability to continue as going concerns."

It seems to me that the first observation helps to explain the second.

This was no isolated example of auditors failing to call out an unsustainable business. Let me now turn to the report on Carillion published by the BEIS Select Committee – which I chair – alongside the Work and Pensions Select Committee, chaired by Frank Field. This was, I should emphasise, a collaboration of committees comprised of Conservative and Labour MPs, as well as an SNP member. It said:

Carillion's business model was an unsustainable dash for cash. The mystery is not that it collapsed, but how it kept going for so long… The truth is that, in acquisitions, debt and international expansion, Carillion became increasingly reckless in the pursuit of growth. In doing so, it had scant regard for long-term sustainability or the impact on employees, pensioners and suppliers.
KPMG audited Carillion for 19 years, pocketing £29 million in the process. Not once during that time did they qualify their audit opinion on the financial statements. In failing to exercise—and voice—professional scepticism towards Carillion's aggressive accounting judgements, KPMG was complicit in them.
Deloitte [the internal auditor] were either unable to identify effectively to the board the risks associated with their business practices, unwilling to do so, or too readily ignored them.
And, in the case of EY….By the end, a whole suite of advisors, including an array of law firms, were squeezing fee income out of what remained of the company. Chief among the beneficiaries was EY, paid £10.8 million for its six months of failed turnaround advice as Carillion moved inexorably towards collapse.

The findings here are damning. And I refer to these not to embarrass anyone but to remind us why this is important. The entire industry was implicated. One audit company profits from conducting the feeble audit on the failing business; another one then advises – unsuccessfully - on how to save it; a third – in this case PWC - stands by to name its own price for administering the liquidation. I am sure everyone here is in agreement – we cannot allow this situation to be repeated.

Let me know turn to the failure of competition

Michael Izza has called this a watershed moment. I welcome his honesty, as head of profession, and his leadership of the current debate.

Quite simply, the audit market is broken. We are looking at a complete breakdown in trust among the public and investors in the integrity of company accounts.

In part, this is a question of competition. Increased focus on the new platform giants and the privatised utilities means people are increasingly conscious of the dangers of monopolies and cartels within our economy.

I think that everyone now recognises that a market in which 4 companies sweep up 97% of FTSE 350 audits is not a healthy one. For many of these companies, who use the Big 4 for a range of services, too often a choice of four turns out to be a choice of two, or no choice at all. PwC were appointed as special managers for the administration of Carillion because they were the least conflicted of the Big 4. No-one outside this quartet was considered capable.

When Goldman Sachs sought to break out of the Big 4 stranglehold, they were rounded on by the regulator (the FCA) who were worried about the ability of anyone else to do the job. This hardly promotes competition, and is a reminder about the gap between the Big 4 and the rest.

The Financial Reporting Council has described the performance of one of the Big 4 as being subject to “unacceptable deterioration” in quality; criticising the audit of BHS as “incomplete, inaccurate and misleading.” This is the performance of our flagship auditors - the ones who should be most able to deliver high quality.

So I don't think anyone in this hall will dispute the fact that the market is not working. Some people tell me that if you break up the Big 4 or give more work to the smaller firms, quality will suffer. That would be a fair argument, if the quality of audits today were good or outstanding. They are not.

Let me know address issues of audit and quality

But ultimately, greater competition is nowhere near enough.

In most markets an economist will tell you that increased choice leads, through the furnace of fierce competition, to twin outcomes: higher quality and lower prices. But while we can see the quality of a pair of shoes and, for services, assess the quality of advice, albeit over time, we cannot readily judge an audit. It is only when it is too late, when a company has gone bust and jobs have been lost, we begin to question the audit. And if, after many months or years later, an investigation finds the audit faulty and fines an auditor (whose company will probably pay it anyway), that is of little comfort to the unemployed, or to suppliers who are left unpaid.

Nor, in the instances of companies like Carillion, have we any reason to believe that executives were interested in a rigorous auditing process.

The Big 4 have their faults – I have highlighted some of these today - but there is no safe reason to assume that handing over to another auditor will resolve the problem. Only recently, the scandalous mismanagement of Patisserie Valerie – a firm reliant on Grant Thornton, a non-Big 4 auditor – showed how much we would be deceiving ourselves if we thought the solution were that simple.

So what are the causes of failures in quality

We should consider what other factors, apart from lack of choice, have contributed to a failed market.

Quality of personnel, for example. Although if the Big 4 snap up the best talent that would seem unlikely.

Perhaps resources? Too many junior people doing the legwork, not equipped to offer the necessary challenge. Can it be credible, for example, that the lead auditor on the BHS audit spent no more than two hours on it?

Maybe it is accounting rules themselves. When we questioned those responsible for the accounts of Carillion, they could not tell us what was going on. On one contract, there was agreement between company and contractor that £200 million was the amount in question. They just could not work out who owed it to whom.

We found weak systems of internal controls. We found accounts that were described by one investor as “works of fiction”. We found goodwill that CFOs refused to write down, year after year. All apparently within the rules. I can accept that accountancy is an art not a science, but maybe there is a need for a bit more John Constable and less Jackson Pollock.

So if audits have too often not been up to scratch, attention naturally turns to the regulator responsible for audit quality. My impression is that the FRC has for too long been going for the quiet word over G&Ts in City watering holes, when it should have been shouting from the rooftops about unacceptable performance and imposing effective sanctions. Carillion is only the latest example of a toothless regulator who was asleep on the job. Or co-opted by the industry it is supposed to regulate. The FRC has been far too passive, too timid, and too close to the firms it regulates.

Let us turn to the purpose of audit

If the rules of audit are to be looked at, we have to start with the question of what are they there to do. What is the purpose of audit? Is it to provide an external check that the books are not being cooked, that the letter of the law has been complied with sufficiently to keep the regulators happy, if they were to check, and that investors can be reassured?

Is this version of audit performing a useful role, when costs run into millions and are increasing, while trust - which is priceless - is diminishing?

What is the point of audit if it cannot or will not flag up fundamental weaknesses or risks in a company's finances? Are we expecting too much of audit, or should we want it to do more? Shouldn't it be more than a perfunctory backward looking tick box verification and instead provide some assessment of future performance?

Would this be useful? Would it be within the skill set? What further problems could this cause? Would it help to restore trust, or will it erode it further?

These are questions we need to examine seriously in the coming months, as we consider remedies.

So in order to tackle quality, we need to re-examine the purpose of audit, the rules of accountancy, the way the market operates.

But we also have to consider whether an underlying cause is the bizarre nature of the relationship between the auditor and the audited. The auditor is required to provide an honest assessment of the finances of the company, on which it relies not only for repeat business, but for other services as well. That is not a healthy business relationship.

Just as we are not surprised when a travel reviewer gives rave reviews to the holiday company which has funded her holiday, we are not surprised when an auditor fails to challenge the company that it has been auditing for the last 20 years. Or in the case of one bank (Barclays), 119 years! At least until the rules were changed by the EU in 2016.

I hear it said that auditing is all about relationships. That good auditing depends on building up relationships with companies that enable them to understand the business and ask the tricky questions. I get that. As chair of the select committee it is my job to challenge Government, and to do that it is helpful to have good working relationships with the ministers I am holding to account.

But I am clear that it is the challenge that is the objective of the job; not the relationship. If government at times thinks we are too critical, so be it. I am not reliant on those whom I am scrutinising for future work. Unlike the auditors.

To put it at its mildest, close and mutually beneficial long-term relationships are not the conditions in which you would expect objectivity, challenge and independence to thrive. The rules must recognise that reality.

So what are the potential solutions

So how can trust be restored?

A number of suggestions are ripe for debate, and it is good that some have come from the auditors themselves.

Let me mention a few.

Competition might be improved by a cap on the share of the market enjoyed by the Big 4. The questions here are about which bits of the market they should shed, over how long, and who can determine this.

Or firms could be required to be audit only and help allow challenger firms to grow.

We could propose a system of dual audits may improve trust. This would allow challengers to gain experience and grow, and it may improve trust, but there are concerns about cost.

We could advocate further restrictions on non-audit work for the company audited, in order to reduce potential conflicts. Some in this room are already moving in this direction; and others may follow. I welcome the announcement by KPMG on this and look forward to seeing how this works in practice and to the responses of other firms in the sector.

Another idea floated is to remove any element of choice in the allocation of auditors, with companies paying a fee to a government body tasked with assigning them a suitable auditor.

And what about making individual executives liable for fines, rather than companies that are so easily able to absorb the impact of a few million here or there?

Then there is the option of the break up the Big Four. Either by separating non-audit from audit or by breaking them up into a larger number of companies. No options should be off the table when the problems are so severe.

The question now is not whether reform is needed, but what reform will increase competition, improve audit quality, and reduce conflicts of interest. And, of course, we are also mindful of creating problems worse than those we are trying to solve. Particularly, when this country is a global leader in professional services, an area where we are growing jobs, investment and exports.

But at the same time, everyone here should be conscious that the more auditing appears to be a dysfunctional industry, the more appetite will grow in among investors, contractors, employees, and in Westminster and out in the country for more radical reforms.

There are a whole host of ideas to explore. They must seek to encourage more entrants to the market, and a lower concentration among just 4 firm, greater transparency and better engagement from shareholders. We can surely improve on the current situation. I would say we must do so, in order to rebuild the trust that has been so undermined.

Doing nothing is no longer a sustainable option: scandals are doing huge damage to trust in audit and to the reputations of the businesses they audit. And employees, pension-holders and taxpayers are footing the bill for a fatally flawed system.

Want to end with a word on process

You will be all too aware of the different Government-backed reviews that are underway. The reports of the CMA market study and the review of the FRC by Sir John Kingman are expected to be published by the end of the year. We still await the appointment of a chair for the future of audit inquiry, known for some reason as Project Flora. These are all welcome and we await their results with interest.

However, the outcome of these reviews will be decided behind closed doors, on the basis of submissions, private conversations and often opaque processes.

Given that it was our joint select committee that uncovered some of these failings and raised these issues, and given the level of public interest, I believe it essential that parliament and the public is part of this debate. We in parliament want to ensure that the proposals of the Government and regulators are not carefully filed away on the “too difficult” pile, but are taken up and implemented swiftly.

My Committee will want to see how the proposals relating to competition are consistent with those relating to quality. What impact they have on future of audit debate. And how the proposed changes fit in to the broader regime of corporate governance that we already have. We will want to hear in public the views of those with most and least to gain, and those with responsibility for turning proposals into reality.

So, today I can announce that the Business, Energy and Industrial Strategy Committee are launching an inquiry into the delivery of a new landscape for audit. In the new year, once the CMA and Kingman reviews have been published, we will begin a series of hearings in public, exploring reactions to these reviews and some of the wider questions I have mentioned. We will hear from the Big 4, challenger firms, audit committee chairs, investors, regulators and experts in this field. And we will give a strong parliamentary input into the debate, before the CMA reaches its final verdict on competition in the market.

I know that you will all engage constructively in this work. Because it is in your interests as well as ours. Business and the public alike will benefit from successful reform. From enhanced trust, more financially stable businesses, more secure jobs. The UK can and should play a leading role in setting the agenda on audit reform.

Change is coming, and no doubt it won't be comfortable for everyone here in this hall. But it will be far more comfortable to embrace it for the wider public benefit than to resist for reasons of narrow self-interest. I hope that it is on this shared understanding that we can move forwards to deliver for everyone.

I look forward to being part of that debate and finding the right way forward.