Technical
27 Jul 2012

Deep pockets

Proposals for tougher fines for audit misconduct at public interest entities raise some worrying questions, as Caroline Biebuyck finds out

Audit regulation broke a barrier earlier this year when PwC was fined £1.4m for an audit failure in respect of its work at JP Morgan Securities – the largest fine ever to be imposed on a UK accountancy firm.

But the regulator involved, the Accountancy & Actuarial Discipline Board (AADB), wasn’t celebrating. It had suggested that the tribunal it had convened to hear this disciplinary case levy a fine linked to PwC’s profits. Figures in the tens of millions had been bandied around, numbers that would have brought the fine in line with the £33m paid by JP Morgan Securities to the Financial Services Authority in respect of the same issue (the bank had not ring-fenced client funds; the auditors had failed to spot this).

None of the firms ignore this issue. We are all busting a gut to ensure that errors don’t occur

Just a few months later, in April 2012, the AADB’s parent body, the Financial Reporting Council (FRC), issued a consultation paper setting out proposed formal guidance for its tribunals when determining sanctions in disciplinary cases.

This is the first time the AADB has issued any kind of guidance to the tribunals it convenes to hear disciplinary cases. In the past it has relied on precedent, sometimes from cases dating back two decades.

The consultation paper talks of the need for clarity and predictability of the sanctions-setting regime. It says it is normal for regulators to issue guidance on sanctions – last year a judge criticised the solicitors’ regulator for not having sanctions guidance for its tribunals.

But while there’s little doubt that guidance was needed, the timing of the consultation suggests that the PwC/JP Morgan Securities case left a bitter taste at the AADB. There’s a sense among accountants that the regulator was unhappy its fine was so much lower than the fine levied by the FSA. The AADB would like to be seen to be sitting at the top table of regulators when it comes to the fines it can levy.

Upward trend

The consultation proposes fines be levied using a percentage of audit firms’ turnover. This brings the independent audit regulator’s sanctions closer to those of the FSA, which based its fine on JP Morgan Securities on a percentage of the assets under the company’s management.

The underlying message is clear: penalties are going to rise. And while AADB executive counsel Gareth Rees QC says there isn’t a direct comparison between the FSA and proposed AADB sanctions, he would like to see a situation where "that level of [FSA] fine can become the norm so that [the sanction] really matters". The consultation paper talks about the primary purpose of sanctions not being to punish but to act in the public interest. This suggests the need for a deterrent against poor work by audit firms.

Not surprisingly, members of the profession take umbrage at the implication that they need a deterrent to do their work properly. They say the FRC’s monitoring work through its Professional Oversight Board has not shown there to be a systemic problem with audit quality.

"None of the firms ignore this issue. We are all busting a gut to ensure that errors don’t occur," says one senior member of the audit profession. "If you can’t identify something the firm did that could have been avoided by a behavioural change all you’re doing by levying a fine is punishing."

An interesting aspect of the recent PwC case was that just as the AADB appeared to be unhappy over the fine levied by the tribunal, so the tribunal was unhappy that the AADB had not taken action against individuals at the audit firm.

Held to account

The consultation tackles this issue by underlining the collective responsibility of member firms for the conduct of individual partners, directors and employees. Member firms need to be held accountable if they are to have an incentive to comply with the rules, says the AADB – particularly given their size, scale and the breadth of their business interests.

Another senior accountant is unhappy with this view. "Understanding what people are guilty of rather than blanket misconduct is the key to making sanctions guidance like this work. You have to understand that before you start levying what are meant to be deterrent fines where the fine will have no effect on the behaviour of the firm."

Focusing on the member firm has allowed the AADB to shift the fine-setting mechanism to a wider environment. It wants to calculate fines with reference to the turnover of the whole group to which the audit firm belongs, not just the member firm. The implications are startling as all partners, whichever business area they work in, would have to take collective responsibility for shortcomings in the audit department.

So is this just a way of providing a basis for levying much larger fines? Rees does not deny it. "The last thing that should happen is for the tribunal only to be looking at a very small entity of an international group, a group that has been structured so that the audit entity’s turnover is tiny and the tribunal be limited to imposing a fine just on this entity," he says. "It would be wrong if the conglomerate’s structuring were done in a way so that proper sanctions could not be imposed."

There are questions over the legitimacy of this approach. Some ask whether this will be open to appeal on grounds of natural justice; others wonder how the AADB can impose fines on a business area over which neither it nor the FRC has jurisdiction. "The fines have to be proportionate but they cannot be extortionate," says the senior accountant.

The consultation sets out three possible mechanisms under which fines could be calculated. Although the consultation refers to each mechanism being based on an assessment of how serious the misconduct is found to have been, the crux is that the fine should be calculated by referring to the member firm’s financial means.

Range of fines

One mechanism uses a fixed starting point depending on the level of turnover. A second option uses a range of fines, with the percentage of turnover applied depending on the seriousness of the misconduct. The third option uses a maximum starting point.

While the proposed options are set out at some length, one crucial detail is missing: the percentages to be applied to turnover to calculate the fines. How can firms and other interested parties properly respond to the consultation without this vital piece of information?

"It’s difficult to reply intelligently to the paper when you’re not sure what ball park the AADB is playing in," one commentator told us.

Rees says it’s important to remember that the fine must have an impact. "You can see this is a genuine consultation because we’ve put forward three different ways in which the fines can be calculated," he says. "We are genuinely interested in people’s views as to how we can achieve what we need to achieve. We hope we’ll be assisted by constructive suggestions as to how we arrive at a full and proper solution to this."


Out of harmony

The AADB looks at possible audit misconduct cases at public interest entities. Other disciplinary cases are dealt with by the recognised supervisory bodies, one of which is ICAEW.

Fines imposed by ICAEW disciplinary committee tribunals in connection with audit-related offences at non-public interest entities are generally fixed or calculated with reference to the audit fee, using a multiplier that can be reduced depending on circumstances.

So if the AADB proposals are implemented there would be a wide gulf between its sanctions and those levied by ICAEW.

AADB executive counsel Gareth Rees acknowledges this but it’s clear he doesn’t expect the AADB to be the one to give ground. "We’d say that if we’re right this means ICAEW – and the other recognised supervisory bodies – will have to look at their sanctions as well."

The consultation also mentions a possible route for settlement of cases. Rees says guidance on sanctions will help here as both parties will arrive at the negotiating table with a view on an appropriate settlement. Would this be disclosed? "It is important that so far as possible the settlement process is both fair and transparent," he says.

Others are concerned that having a type of plea bargaining system has nothing to do with public interest but more to do with the AADB being seen as ticking off a positive result. "They should want to get to the truth, not to get someone to plead guilty because they want scalps," says a senior auditor.

 

Member panel view

Firms are being put in a difficult position, having to respond to proposals without knowing what sanctions will be in practice. The profession thinks it has been doing all it can to get its house in order, but does the public share that view? Currently the situation appears akin to that of disciplinary fines for serious misconduct by Premiership footballers, where significant fines arguably have no real deterrent effect in practice as they are not linked to earnings. Those outside the profession may well consider that larger fines will lead to greater diligence.

Stephen Dunstan, Blackpool Coastal Housing

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