Canada isn’t immune to financial scandals

There’s turmoil in the U.K. audit industry. The past year has seen calls to break up the big audit firms and to limit their scope and control in the hope of improving investor protection and public confidence.

The matter may seem remote to Canadian advisors, but there are close parallels between the U.K. and Canadian accounting industries. Further, financial reporting credibility is of paramount significance to equity analysis, stock prices and portfolio values.

Some U.K. lawmakers and regulators were never content with reforms in the aftermath of the financial crisis a decade ago, and have implemented improvements since. Recent major scandals have only added pressure to revamp oversight of the audit industry.

In January 2018, construction company Carillion plc became the largest publicly traded forced liquidation in U.K. history, with liabilities of £6.9 billion. In addition to directors and management, the auditors faced scrutiny for their role.

Carillion hid £400 to £500 million of financial debt on its balance sheet in the category of “other payables” through reverse factoring. The practice was approved by the company’s auditors, KPMG, over many years. The audit regulator, the Financial Reporting Council (FRC), launched an investigation into KPMG’s practices. The U.K. Secretary of State for Business, Energy and Industrial Strategy responded by announcing an inquiry into the FRC itself.

The report from inquiry head Sir John Kingman, issued in late December 2018, described the FRC as “a ramshackle house…built on weak foundations” that had fallen behind the standard set by the U.K.’s other financial regulators. Kingman proposed replacing the FRC with a new Audit Reporting and Governance Authority to address the weaknesses.

Parallel risks exist in Canada

The weaknesses that led to the U.K. audit failures and poor oversight also exist in Canada.

The FRC is not independently funded in the U.K. and relies on voluntary levies from market participants, leading to questions about the council’s independence. In Canada, the accounting regulators who set auditing rules are also funded by the accountants themselves, and not the public.

We also share with the U.K. the same accounting rules for companies, the International Financial Reporting Standards (IFRS), replete with the ideology that more leeway should be given to management to implement the vague rules to suit their specific needs. With such a weak framework, strong oversight from an independent regulator should exist, but doesn’t.

The Kingman report highlighted that the FRC did little to address long-running concerns, such as the audit expectations gap, competition among audit firms, auditor rotation and the conflict between audit and non-audit consulting work. In Canada, there is almost no public discussion of such issues, which threaten the veracity of financial reporting.

It was a long year for auditors in the U.K., with a May 2018 parliamentary report recommending a possible break-up of the big four audit firms, and other inquiries echoing the same. U.K. lawmakers have vowed to follow through on ending the self-regulatory model. The lack of similar questions in Canada is eerie.

Canada has had more than its fair share of major audit failures, including Valeant, Sino-Forest and Nortel, and many lesser-known collapses. The responses to shore up weaknesses in our regulatory framework seem wholly deficient compared to the responses from the U.K. and U.S., leading to serious under-appreciation of audit and accounting risk in Canada.

Advisors and their clients remain exposed in Canada, and those who appreciate the overall risk have some choices. Shifting portfolio allocations to more U.S.- and U.K.-regulated firms is one option, while tilting toward less complex Canadian holdings is another. We’ve noted before that greater accounting and audit risks exist for real estate and infrastructure assets, M&A deals, intangible assets and multi-year construction projects, to name a few.

Advisors should avoid the assumption that Canada is safer based simply on the relative silence of our lawmakers and regulators.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.