In the wake of the accounting scandals at Wirecard and NMC Health, auditors find themselves yet again in an uncomfortable spotlight. The FRC has rightly responded with concrete proposals to ringfence audit from consultancy activities at the Big 4. However, a more lasting impact on audit quality may be achieved by some of Sir Donald Brydon’s proposals from his December 2019 report on the future of audit.
The timing of this report was unfortunate – appearing as it did on the cusp of a major global pandemic. However, it would be a shame if Brydon’s report recedes into obscurity as it contains some useful ideas not only for reforming the statutory audit process, but also corporate governance in a more general sense.
One of Brydon’s main proposals is for the establishment of new ‘corporate auditing’ profession – distinct from accounting, and encompassing expertise from a range of increasingly relevant fields beyond financial reporting – such as cybersecurity and sustainability. According to Brydon, a professional structure for auditing would provide ‘much greater clarity about what an auditor is and to whom he or she owes a professional duty’.
Brydon has some interesting things to say about organising activities through a professional structure rather than just through an extension of regulatory requirements. For example, he states that ‘professionals are not merely individual agents isolated from others, accountable for only their individual acts...professional status carries with it role responsibilities that change the normal moral relations existing among members of society’.
In other words, professional status brings with it a commitment to overarching principles of excellence, ethics and a role in society rather than just a tick-box approach to the prevailing rule-book.
Without wishing to downplay recent auditor shortcomings, Brydon also makes the point that there has been more to recent corporate collapses than the failure of statutory audit: ‘It is not, however, auditors that cause corporate failures; that responsibility lies with the directors who may or may not have been able to take evasive action’.
Consequently, as we look for effective remedies that will prevent future scandals, we should move beyond a narrow focus on auditors and consider how corporate governance in a broader sense can be effectively improved. As Brydon acknowledges, the board of directors should be a particular focus.
In fact, Brydon’s argument that corporate auditing should be established as a distinct profession is equally applicable to corporate directorship. Both audit and directorship are crucial areas of governance in need of a professional framework which goes beyond a legal baseline and encompasses conduct, ethics and relevant training.
The IoD has long argued that a code of conduct and professional development requirements for directors (including the wider adoption of professional qualifications such as Chartered Director) would be important components of this framework.
The Brydon report also emphasizes the importance of a greater orientation towards a wider group of stakeholders in the work of auditors. In particular, it recommends that ‘the audit report should include a new section in which the auditor states whether the company’s section 172 statement is based on observed reality...responding to the needs of stakeholders in this way is part of restoring trust in business’.
A greater emphasis on stakeholders is also a pressing need for directors. To be fair, a much stronger stakeholder orientation has been apparent in many enterprises during the Covid-19 pandemic - as boards have sought to sustain the existence of their enterprises and employment levels while at the same time suspending dividend payments and buybacks.
However, a narrow alignment with short-term shareholder value still manifests itself in certain quarters.
For example, at the end of June, the board of Boohoo raised eyebrows – and the disapproval of one-third of institutional investors – when it approved an incentive scheme for its founders and key managers entirely structured around relatively short-term increases in the share price.
In essence, if top management could drive up the share price by 66% over a three year period, then the key managers would receive a payout of £150m – around 5% of the increase in market capitalisation.
Such an incentive structure created a strong incentive to prioritise an increased share price over everything else. Non-financial metrics relating to stakeholder or ESG criteria were not included in the calculation. Hence the new pay policy could be interpreted as a source of governance risk from a stakeholder perspective.
We did not have to wait long for this risk to manifest itself. A week or so later, factories supplying Boohoo in Leicester became implicated in allegations of poor health and safety practices relating to Covid-19, and the payment of wages below the legal minimum.
As a result, Boohoo has found itself the target of critical remarks from ‘influencers’ on social media, and various clothing retailers suspended it as a supplier. An independent investigation into working practices has come too late to prevent a decline of one-third in Boohoo’s share price – not the kind of share price evolution that the founders had envisaged a week or so earlier when designing their new incentive plan.
The moral of this unfortunate episode is hard to ignore: if Boohoo had focused a bit more on its supply chain and a bit less on top management incentives, everyone might have ended up better off.
Roger Barker is the IoD's Head of Corporate Governance