Audit reform: a short-lived victory for economic sense

In September 2022, the IEA published my paper Accounts and Accountability, which argued that the government’s proposals for further regulating financial reporting and the audit industry were misguided. In the middle of this year, the government began to hint that the reforms might not find their way into the November King’s speech. And, indeed, they were absent from it.

I’ll count that as a win. I like to imagine Kemi Badenoch, the Secretary for Business and Trade, reading my paper (twice, because it’s so compelling) and getting straight on the phone to the Prime Minister: “Rishers!”, as I am sure she calls him, “this audit reform stuff is terrible. It’s gotta be nixed. We’re not doing it. No way, Suni boy!” The official position, that the government’s legislative agenda does not allow time for these reforms, is a mere cover.

Alas, it seems my victory will be brief. The likely future government remains determined to implement the proposed reforms. An article in the Financial Times quoted Jonathan Reynolds, the Shadow Business Secretary: “I cannot see an argument for it not progressing”.

Which goes to show that when you can’t see an argument, the reason may not be that it doesn’t exist but that you are not looking hard enough. If only Mr Reynolds subscribed to IEA publications, he would have seen an argument for not progressing. In fact, he would have seen several. So let me quickly rehearse the arguments in my paper, in the hope of making them more visible.

The government’s proposals, as they stood in September 2022, were based on recommendations from three inquiries launched in response to accounting scandals at BHS in 2016 and Carillion in 2018. Among other things, the government proposed to (1) dictate the content of companies’ financial reports, (2) oblige FTSE 350 companies to appoint two audit companies (including one that is not a Big Four firm), and (3) replace the Financial Reporting Council with an agency with greater powers. Before getting to the central mistake that lies behind these proposals, let me say where each individually goes wrong (for elaboration and justification, see my original paper):

  1. Companies have a commercial interest in supplying investors with any information those investors value more than the information costs to produce. The inquiries on which the government based its proposal failed to demonstrate any market failure in the production of financial information by companies.

  2. The proposal to reduce audit market concentration by forcing FTSE 350 firms to appoint at least one non-Big Four auditor fails to appreciate the genuine benefits of scale in auditors. Shoddy practice is more likely to be exposed at big firms with many clients than at small firms with few clients. The fact that big firms invest heavily in their brands also makes them more trustworthy, because exposure causes a large loss in the value of their brand. The “two auditors” mandate is an outrageous intervention in the decision-making of private enterprises and a state-mandated bung for second-tier auditing firms.

  3. An enlarged financial reporting regulator with stronger powers will increase legal uncertainty for businesses operating in the UK. Contrary to the advertised effect, such a regulator will make the UK a less attractive place in which to invest and do business.

Left-wing opponents of the government often complain about its slavish devotion to ‘the cult of the market’ or to ‘unfettered free markets’ or to ‘neoliberalism’. It is a bizarre complaint. This government has shown no confidence in the market mechanism whatsoever. They leap to regulate commerce even when there is no evidence of a market failure caused, for example, by externalities or asymmetric information. (I do not say that the existence of such sources of market failure is sufficient to justify state regulation but, for alleged believers in free markets, it is surely at least necessary.)

The accounting failures that contributed to the losses of investors in BHP and Carillion are not proof of a market failure, any more than getting a terrible meal from a restaurant is. Disappointment is an inevitable consequence of dealing with human beings, whatever the “system” they are working in. In a free market, poor performance is a source of discontent for customers and investors, yes. But it is also an opportunity for the competition – especially for new competitors with new ways of doing things. Entrepreneurs are always on the lookout for things that could be done better.

When the government intervenes and decrees “thou shalt do things THIS WAY!”, it stymies the efficient, innovative and adaptive market process. Things get done THIS WAY, even if doing things THIS WAY costs more than its worth to the intended beneficiaries and even if someone could have thought, or did think, of a better way of doing things. And things get done just this one way, even if things should be done in different ways to suit the different situations and preferences of those involved.

As I show in Accounts and Accountability, there is nothing peculiar about financial reporting and auditing. The government should no more dictate to companies how they report their financial performance or dictate to auditors how they go about their work than it should dictate to restaurants what to put on their menus or how to prepare the dishes.

Anyway, I shouldn’t be grumpy in this happy moment. It’s wonderful to see a Conservative government minister finally live up to the accusations levelled by leftist authoritarians.

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