The bigger they are the harder they'll fall

RESPONSES to an FRC consultation to change the way disciplinary sanctions are calculated could damage the profession and deter people from entering into the industry and continuing membership with institutes.

The FRC’s disciplinary arm, the Accounting and Actuarial Disciplinary Board (AADB) wants to increase fines on larger member firms because the way they are currently calculated is not adequate to incentivise the right behaviour and is failing to be a “credible” deterrent in the public’s eyes.

However, a large firm fined significantly more than a smaller firm could give the perception it was more at fault.

Other issues to arise include the profession could struggle to entice talent or could see firms separate their audit function.

Currently the AADB is consulting on three structures in which to calculate fines. However, the backlash from one of the proposed structures – in which the fine is based on a percentage of the group turnover – has been unanimous.

Unsurprisingly the Big Four believe this type of calculation is damaging for the profession. However, they, the institutes and other large firms raise some interesting points.

ACCA believes that percentages based sanctions could have a “damaging effect on the provision of audit services in the UK”.

It claims firms could start to distance themselves from its audit arm to create an independent firm, and mergers and acquisitions, to benefit from economies of scale, could see the UK end up with just one firm that can provide audit services to large companies. At the moment the Big Four service 99% of the FTSE 100 audits.

“Punitive financial sanctions may undermine the growth and development of professional services firms and the sector generally,” said ICAEW.

PwC also argues that a lot of the revenues in a firm could come from non-audit work, meaning the greater the size of the non-audit business the greater the fine because of the sanction dished out to the audit arm.

ICAS believes: “The future adoption of such a severe penalty formula based solely on turnover or gross personal earnings would surely undermine the purpose of professional discipline and regulation.”

Ernst & Young, also raises concerns that less profitable firms with fewer resources may be unfairly intimidated into settlements.

ICAS even claimed that the structure of proposed sanctions is more akin to criminal proceedings as opposed to professional discipline and regulation

Deloitte said: The mechanism for calculating the fine as a percentage of turnover of a member firm is “an irrational mechanism, leading to disproportionate, unfair and inappropriate sanctions, inconsistent with both the purpose of sanctions in the context of professional discipline and the desirable outcomes which such sanctions should promote.”

Ernst & Young label this type of calculation as “flawed”, arguing it would result in disproportionately high fines. It suggests that a fixed fine would give clarity to a case and instil simplicity.

Also, as pointed out by KPMG, the majority of cases that have shown audit failings are due to negligence or unintentional error and claims it is difficult to see how the risk of errors would be wholly eliminated through sanctions.

PwC agrees adding human error will not be deterred by large financial sanctions, given that firms or members do not set out to make human errors.

Most cases stem from a systematic breakdown rather than wilful recklessness, said the ICAS response.

PwC highlights that in a recent High Court case, Coke-Wallis v ICAEW, it was ruled that the “primary purpose of professional disciplinary proceedings is not to punish but to protect the public, to maintain public confidence in the integrity of the profession and to uphold proper standards of behaviour.”

“However, we are concerned that the effect of the guidance particularly in terms of the proposals concerns the calculation of financial sanctions, appears to be primarily punitive.”

Change is needed

All the respondents agree the primary purpose of sanctions is to protect public interest and not punish, and all agree with most of the draft guidance under consultation.

However, Grant Thornton highlights that percentage of turnover fines would not be appropriate and would produce results that are unfair.

Also the disciplinary process could see the level of appeals go up which would increase everyone’s cost, said Ernst & Young.

This all came to head last year when the AADB, was unhappy at the low level fines tribunals are able to dish out.

In a case heard last year, in which PwC was fined over audit work of financial services company JP Morgan, the AADB applied to have the Big Four firm charged a record smashing £44m, later reducing that to £6m, with the independent tribunal dishing out just £1.4m – in itself a record fine.

At the time there was much speculation that £1.4m is a drop in the ocean for the Big Four firm, with UK fee income coming in at £2.4bn.

“… we do consider that the increases in recent times of the fees payable by firms such as [JP Morgan] to firms such as [PricewaterhouseCoopers] indicate the need for a substantial increase in the level of penalty payable for misconduct of the kind under consideration in this case,” the AADB consultation document said.

However, Deloitte hit back that: “We are concerned that the AADB, having failed to convince an independent tribunal established under its own scheme to increase the level of sanction to a level which it (the AADB) considered appropriate, has decided to achieve that objective through the use of influential (although non-binding) sanctions guidance.”

According to Ernst & Young: “The AADB tribunal in the 2011 JP Morgan case considered and rejected without hesitation as “irrational” a submission that a financial penalty for defective audit or reporting be linked to the percentage of revenue based penalty imposed on the client.”

However, the ICAEW highlights that the AADB wants fines to be more in-tune with FSA penalties. In the JP Morgan case the FSA fined JP Morgan £33m while the auditors received a sanction of £1.4m.

But: “The FSA level a financial penalty based on the percentage of a firm’s revenue or income from the relevant products or business areas not the group or even the entity as a whole,” said KPMG.

Not the only option

Throughout the responses it was highlighted that other countries were not using this type of structure.

All the Big Four said the US, Australia, Canada, Germany and South Africa use a range of sanctions.

Deloitte highlighted that the level of sanctions are not spectacularly high, compared in other countries, compared to the £44m that the AADB petitioned for in the JP Morgan case. The firm said in the US the PCAOB (Public Company Accounting Oversight Board) fines firms $2m (£1.27m) per violation, the SEC $750,000 and Germany €500,000 (€393,880) so there is no reason UK fines should be so much higher.

Ernst & Young adds that no regulator in the US, Australia, Canada or South Africa apply a percentage of revenue as a sanction, but they have other sanctions available such as third party reviews and stripping firms of licences.

“We are also disturbed that the AADB seems to believe that only a monetary fine can act as a deterrent,” said KPMG.

Reputation is everything

One thing that the AADB seems to have failed to mention is that aside from the monetary fine the publicity which includes naming and shaming the member firm as well as the individual member said CIMA, which has a hugely damaging effect on reputation and in itself is a deterrent.

Deloitte says it thinks it is important the AADB understand the impact the publicity on an investigation has. Not only will the investigation or tribunal impact a member’s work but puts their reputation and them under “enormous” stress.

The “mere fact that it is known in the financial and business communities that an investigation is in process has a severe effect on reputation,” said PwC.

“Lest we forget Arthur Andersen, albeit that was in the context of criminal rather than professional disciplinary proceedings,” it added.

Individuality

Although, not all firms disagree with this calculation. “We agree fines for member firms should be proportionate to financial resources,” said the 12th largest firm PKF.

However, it argues that sanctions on members should be according to a set tariff which will not cause serious financial damage to the member.

Using a percentage calculation on individuals could send a negative message to people about becoming an auditor and to smaller firms on taking public company audit clients, (basically reducing competition).

ACCA agrees and also points out percentage sanctions could be a good idea, but, highlights if the same calculation is used on individuals this would be wholly unfair. The individual may have no control over the way an audit function is managed in a firm.

The ICAEW also argues individual executive and non-executive board members who are chartered accountants will be liable for significant sanctions above and beyond other board members. This could lead to discouraging people from becoming chartered accountants or discourage continuing membership of the accountancy bodies.

KPMG made the same point adding it would be a huge disincentive and members in business do not have to renew membership and could be happy to relinquish their title.

But if you must

Aware this could be a losing battle Deloitte concedes if the AADB pushes ahead with percentage based sanctions it should be based on income after tax, and figures for the year of the misconduct not the year the fine is handed out.

Many also highlight that if a percentage based approach is needed that surely it should be based on revenues garnered from the service line at fault.

Fines should be used to cause “financial hurt” to a firm, said PKF, but, it should be based on profit not turnover and the largest firms may have much higher profits per partner than smaller firms.

Also in the conceding line the ICAEW points out firms structures are very complex, some are European LLPs and asks would the fine be based on the European figures or is the firm expected to come up with a UK only turnover?

ACCA raises the very important question that is also not clear how a tribunal and sanctions system would work if a company opts for a joint audit.

Also PwC said that it would like to see more action taken against those who perpetrate fraud if changes are to be introduced. However, it also highlighted that because an auditor failed to discover fraudulent behaviour it is not an audit failure.

“We are considering carefully the views expressed in the various consultation responses. We are aware of the audit firms‘ concerns on this matter which, in finalising the guidance to disciplinary tribunals, will be balanced against other responses and the need to ensure that sanctions are proportionate, serve the public interest and act as an appropriate deterrent against misconduct,” said an FRC spokesman.

“The consultation responses have been overwhelmingly supportive of the value of issuing sanctions guidance, the need for which was also underlined in a High Court judgement last year. The FRC will issue its response later in 2012.”

Overall the profession is worried about the damaging effects higher fines will cost to the reputation of audit in the UK, will it reduce the number of people entering the profession, will it reduce the renewing of membership figures, decrease competition or will it actually have any effect other than revenue raising as most cases involve human error. The AADB has made one thing clear, which all respondents have agreed, that change is needed but it must be aware to tread lightly, there are many large firms who will not go quietly.