Investors are neglecting their duty to hold auditors to account. Shareholders should be demanding high-quality annual reports, and ensuring robust and independent audit, so why don’t they? Even in cases of exposed accounting misdemeanours (never mind concerns over more borderline aggressive accounting) investors hardly ever vote against the annual accounts, auditor reappointment, or auditor remuneration at companies’ annual general meetings (AGMs). And where audit failures can be traced back to weak oversight on the board, it is extremely rare for shareholders to vote against directors on the audit committee. This needs to change.
Reliable annual reports and accounts are arguably the most important building block for effective corporate governance and long-term stewardship. This was made clear by the Cadbury Committee’s influential report to Parliament, The financial aspects of corporate governance. Shareholders rely on companies’ numbers to determine whether or not they can entrust their capital to executives, and then to hold those executives to account for their performance. Directors rely on the audited accounts to provide a transparent basis for judging the entity’s viability, and determining a prudent and legally sound level of distributions to shareholders. Where trust in companies’ reported numbers is undermined, the system breaks down. This has damaging impacts for investment and, ultimately, economic growth.
But if reliable accounts are so critical to shareholder protection, why do shareholders spend so little time holding auditors to account? Auditors can face powerful conflicts of interest due to their close relationships with executives, often including valuable non-audit work where executives – not shareholders – are the customer. So, scrutiny by shareholders is essential to remind auditors who their end-client really is. Yet, even in companies where the auditor’s failures have been dramatically exposed, shareholders appear supine.
Take the US retail bank Wells Fargo, which was last year found to have fraudulently opened around two million accounts for unsuspecting customers to meet aggressive growth targets. As the scandal unfolded in autumn 2016, the bank announced that over 5,000 staff had been let go. The bank was fined $185m by the Consumer Financial Protection Bureau, the Office of the Comptroller of the Currency and the LA City attorney general for reckless, unsafe and fraudulent sales practices. Follow-on litigation and regulatory investigations are still ongoing. Not only was Wells Fargo’s failure in internal controls far from isolated, but it persisted over at least fifteen years. Yet while the banks’ directors faced a shareholder revolt at its AGM in June, KPMG – auditor of over 85 years – was reappointed with over 97 per cent support.
What exactly needs to go wrong before shareholders will vote against the auditors?
As the financial crisis of 2007/08 developed, auditors failed to alert shareholders to impending capital destruction. Following a clean audit by Deloitte, the Royal Bank of Scotland (RBS) received the largest UK bank bailout of the crisis, worth over £50bn. In a review of the auditors’ role in the crisis undertaken by the House of Lords’ economic affairs committee in 2010, Lord Lawson described Deloitte’s UK managing partner as “extraordinarily self-satisfied” following his claim that the firm had audited RBS well.
In the case of RBS, many red flags went unheeded by investors. Incoming chief executive Fred Goodwin had brought in Deloitte as new auditors in 2000, having previously been a partner at Deloitte for seven years. This should have raised alarm bells for the board’s audit committee and shareholders, as should the very high level of non-audit fees RBS paid to its auditors over the years. In 2007, the year of RBS’s fateful acquisition of ABN Amro, Deloitte earned £14.2m in non-audit fees, almost 85 per cent of the audit fee.
In 2003 and 2005 the non-audit bill exceeded the audit fee. Shareholders supported Deloitte from the start. Even once the bank began to collapse, shareholders continued to support the auditor’s reappointment. Only in 2014, with the introduction of new EU rules requiring audit firm rotation, did RBS announce that Deloitte would be replaced by EY. Shareholders were not a catalyst for change.
In recent months, UK-listed telecoms giant BT announced a £530m write-down for accounting mis-statements uncovered in its Italian business. The fraud was conducted by local staff in Italy over several years, with the duplicity finally exposed by a whistleblower. The auditor in place since privatisation in 1984, PricewaterhouseCoopers (PwC), had failed to alert shareholders. While Italian prosecutors and the UK’s Financial Reporting Council are still investigating the case, the main voting advisory firm, Institutional Shareholder Services (ISS), recommended that shareholders abstain on the reappointment of PwC at the AGM. Our policy is to oppose the reappointment of audit firms which have been been in situ for more than 15 years. In the end, ignoring withheld votes, over three-quarters of votes were in favour of PwC’s reappointment, but we are pleased that a new auditor has recently been announced.
Or take the growing number of UK-listed companies that have admitted to having paid illegal dividends because they failed to properly file their audited accounts demonstrating they had sufficient distributable reserves. Even with these revelations, in no case have shareholders voted against the reappointment of the incumbent auditor who should have ensured these important shareholder protections were adhered to. In the case of Domino’s Pizza Group, for example, this summer over 97 per cent of shareholders supported the reappointment of EY – in situ for 20 years – despite Domino’s admitting to having failed to meet the necessary disclosure requirements over a period of ten years.
These are all examples of exposed accounting failures. What about the companies where we see aggressive accounting? Or instances of high levels of non-audit work, or auditors that have not changed for decades? In general, it would appear that doubts over the accounting behaviour or auditor independence do not translate into votes against the auditor, or against audit committee directors who are responsible for ensuring the audit is effective.
According to ISS, during the latest voting season all companies in the FTSE350 and S&P500 saw the resolutions on annual report pass – and most with near 100 per cent support. In no case did ISS recommend investors vote against. And yet just over a quarter of companies in the FTSE350 have auditors that have been in place for at least 15 years (identified by a group of European institutional investors in 2013 as a threshold after which independence would be at risk), and non-audit work accounted for over 50 per cent of the audit fee in 25 companies (another threshold identified by institutional investors as a risk to independence). For the S&P500, 70 per cent have not changed for at least 15 years, and 69 companies have had their auditors for over 50 years.
Technical and dull
Of course, not all shareholders are inactive on audit. But unlike remuneration, which provokes public anger and shrill media attention, audit feels technical and dull (even though getting accounts right is key in addressing misaligned pay). Perhaps this explains why fewer resources are being channelled to pushing for higher quality audit? Or maybe investors have got used to company accounts that need adjusting to deliver a truer view of performance, so audit is meeting our low expectations? Some asset managers may even see advantages in weak audits: their ability to deconstruct accounts and find problems gives them an edge over peers (which is often the basis for judging their performance).
Whatever the reason, the fact remains. Hardly any investors withhold support for faulty accounts or ineffective auditors at AGMs. This is a grave omission in oversight, perpetuating a growing gulf that exists between shareholders and their auditors. Shareholders are already suffering the consequences. Broader market efficiency and capital allocation are also casualties.
Natasha Landell-Mills is head of stewardship at Sarasin & Partners
Charity Finance wishes to thank Sarasin & Partners for its support with this article