EVERY company failure puts the spotlight on company boards, executives and auditors. Even administration and restructuring is painful for employees, suppliers and investors, yet little is done.
The regulatory framework for corporate and board behaviour lacks enforcement and watchdogs seem toothless. The audit industry is also concentrated, dominated by four firms, with clients focused on costs rather than audit quality.
Public frustration has finally delivered a result, though, and change is underway. Investors might care little for the workings of the Financial Reporting Council (FRC), but the news that the FRC is to be abolished could mean a step change in regulating company reporting. All investors should benefit from this if it heralds a new era with corporate behaviour coming under tougher scrutiny.
The next few months should reveal how the replacement body will operate. It is clear it will have stronger powers and will be able to behave more like a regulator than a well-intentioned quango. The proposed new accounting regulator will raise the bar for audit and reporting, recognising that the FRC has proved ineffective.
While some recent high-profile corporate failures have been linked to unreliable reporting and poor audit quality, not all reporting problems can be blamed on auditors. Some companies not at risk of failure are flattering their reported profits with their own adjustments. In doing this, boards hope that investors and commentators will pay less attention to the official audited numbers, focusing instead on a more positive message.
Shareholders demand candour from management and boards, combined with audit rigour. Many other stakeholders have an interest in avoiding nasty surprises, with taxpayers usually ending up paying for company failure alongside employees, landlords and others. Most high streets have seen an increase in the number of boarded-up shops and not all of these will find an attractive change of use or new tenant. Some of these retail failures represent chronic underinvestment and poor strategy by company boards – a failing typically glossed over in annual reports.
It is clear that company reports should be scorecards that the public can trust. Part of the problem is also that auditors only owe a duty of care to shareholders as a body, rather than to individual shareholders. Auditors have no direct obligation to others such as lenders and suppliers. Audit responsibilities seem strangely out of sync with the wider obligations that the Companies Act now imposes on company directors. Changing this may need legislation.
It is also clear that the focus of accounts – the accounting standards themselves – do not impose an obligation for good stewardship. Company balance sheets can be depleted by dividends, with the holes filled in by goodwill and questionable valuations.
In a world that is moving towards stewardship and responsible investing, the present short-term financial focus of accounts seems anomalous. Accounts should reflect sustainable returns rather than glossing over short-termism and behaviour.
The need for a new accounting regulator, and recognition of the problems with company reporting, highlights the risk in investing in indices, hoping that other investors have analysed the numbers to price shares. Investors should examine company information alongside industry patterns in a process to understand risks.
It also highlights the value of examining company governance, as part of an environmental, social and governance approach. Delayed or less than candid reporting of company problems often runs alongside poor governance and boards that lack challenge often do not give good transparency on company performance.
The prospect of tougher regulation alongside greater focus by investors on stewardship should reduce some investment risks.
Colin McLean is managing director of SVM Asset Management.
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