Back in May the Audit Reform Lab suggested that after multiple delays, the government was likely to kick audit reform into the long grass. A matter of days ago, this was all but confirmed as it transpired that this much needed overhaul would not be included in the King’s Speech which sets out the government’s reform priorities for 2023-24. The historic tendency for governments to water down or duck out of difficult decisions about the audit industry continues. Plus ça change, plus c’est la même chose.
A facility for can-kicking may well be the defining characteristic of this government. This will bequeath all kinds of difficult political choices to the next incumbents. And if the next government is to be a Labour one, it is better that they ready themselves for what is likely to confront them when they arrive. The primary challenge will be what to prioritise – no mean feat when the present government has presided over a decade of reckless and unnecessary austerity budgeting that leaves public provision and infrastructure literally crumbling. But the next government will also need to ready itself for the scant regard paid to the quality of our regulatory institutions.
The ‘regulatory state’ that emerged after the privatisations of the 1980s to prevent the egregious and predatory behaviour of new private suppliers, has also been allowed to crumble through irresponsible neglect. This vacuum in oversight has shaped business expectations and culture, which has grown accustomed to wrist-slapping not sanctions (‘it would disincentive investment’!), and where irresponsible stewardship is as likely to rewarded with emergency financial or regulatory support than bankruptcy and the striking off of directors. Consequently, business is more willing to push at the moral and legal boundaries of what is acceptable, safe in the knowledge that the profitable upside is greater than the regulatory downside. The government has in a sense created a generalized culture of permissiveness – a moral hazard – within parts of the UK economy, where excesses are incentivised because companies do not experience the cost of their errors.
This all matters in two regards. First, collapse in the regulation and oversight of audit is part of that moral hazard. Auditors should police directors and stop them cooking the books. They should also enforce prudence to prevent excessive generosity in the application of accounting rules, where there are many grey areas. When auditors fail to do that, businesses accumulate too many risks that are often hidden from view. When those risks eventually materialise, trust in all audits is challenged: shareholders become wary of investing their capital, banks become reticent to lend, workers jobs are put at risk and suppliers don’t know if they’re going to be paid on time or at all. By kicking audit reform into the long grass, the Tories are not just simply passing on some arcane and trivial regulatory chore, they have bought a put option on their responsibility for future economic turmoil – they have bought the right, in other words, to sell blame for economic hardship as the result of audit failures to the next government.
This leads to the second point. Our previous work has highlighted the risks that businesses, large and small, have taken on during the period of low interest rates for much of the last ten to fifteen years. We found that over the period 2009 – 2019 the highest distributing firms in the FTSE350 paid out on average 178 per cent of their net income attributable to shareholders as dividends and share buybacks. This was achievable through below the line gains classed as ‘profit’ from asset revaluations, which were borrowed against and distributed to shareholders, leaving those companies with much higher leverage levels. Now, in a context where interest rates are higher, asset values should be more exposed to impairment pressures, just as borrowed money will be more expensive and cash will be harder to come by. This is likely to put considerable strain on corporate balance sheets, and will incentivise accounting creativity and potentially fraud as companies try to avoid breaching their debt covenants or outright insolvency. Robust audits are needed in such a context, hard though that may be.
The opposition has a small window to allocate blame for this intransigence where it should rightfully lie – with the incumbent government. Since their one big idea – Brexit – the Conservatives have been effectively asleep at the wheel; out of ideas before having one of any great utility. Highlighting that intransigence, and the waste of taxpayers money and civil service time put into all of the reviews so far, would be an immediate political win. But pointing out the potential consequences for the delayed reform and why it is so necessary would render the longer term Tory put-option worthless. All the more reason for Labour, and any other party with governing aspirations, to push the audit reform agenda hard now and so distance itself from the corporate turmoil that could happen in the near future as the result of long-standing audit failure become visible.