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Building a credible financial reporting system model

7 December 2020: As the transition to a new financial regulator continues apace, a leading academic says the time is ripe to pull apart the financial reporting system to better understand whether a more fundamental overhaul might be needed to prevent future corporate failings.

Mike Power FBA FCA, professor of accounting at the London School of Economics and Political Science, has written a paper that suggests a focus on individual events and scandals such as the collapse of Carillion often points the finger at systemic issues rather than the root cause. This typically results in knee-jerk regulatory reactions but fails to address fundamental weaknesses in the system. 

Speaking to Insights ahead of ICAEW’s Information for Better Markets conference 2020, Power said: “One of the big questions is, do we overreact to corporate failures by trying to fix everything and reform when failure is normal? Rather than create new bodies and new roles, we just have to run the present system properly.” To do that, Power says a credible model of the financial reporting system is needed to better understand interdependencies. 

A series of reviews over the last three years have all alluded to problems in auditing, accounting and financial systems that have contributed to corporate failures. They include the House of Commons review into the collapse of Carillion in 2018, the Kingman review into the functioning of the FRC in 2018 and this year’s Brydon review of the audit profession, which directly resulted in plans to replace the FRC with the Audit Reporting and Governance Authority (ARGA).

“It is vital to understand how systems work and how they self-regulate. Control is dispersed in self-regulating systems, so you have to think of the system as a whole with lots of interacting components, rather than being drawn to individual events such as company collapses,” Power says.

Power also touches on the political economy of the financial reporting system and how it embeds certain interests and may create barriers to change. “There are pockets of actors who carve out niches as intermediaries and when you try and change the system you are interfering with a lot of vested interests.” 

The paper also questions whether the significance of external auditors is overplayed. “It may be that auditors don’t contribute as much assurance as we imagine. Systems thinking might direct our attention to other aspects of the system that have been overlooked,” Power says. “When you see the system laid out, what becomes clear is how much resource and energy goes into standard setting and monitoring and how little relatively goes into enforcement.”

The paper hopes to prompt discussions about the role of a financial regulator, Power explains, and culminates in a series of questions aimed at a fictitious non-executive director sitting on the risk committee of future regulator AGRA. For example, where do we find early warning tools for fraud, earnings management and bankruptcy? Where are critical points of failure in the system, rather than failures of individual entities, and how much time would we have to fix them? And how can the financial system learn in the face of a blamist, adversarial operating environment? There are many more.

“They are absolutely the questions that the new proposed regulator ARGA should be asking,” Power says. But without a map of how the system works, they are almost impossible to answer, he warns. Having a system model would also be politically helpful for a new regulator because it would allow them to face up to politicians and say that actually the system is working very well, it’s just there was one bad event, Power says. “We know there are accounting standards setters, audit firms and regulators but we don’t have a more dynamic understanding of their co-dependency and where in that system the critical points of failure might be. If you don’t know that, you can’t be very smart as a regulator.” 

Professor Mike Power will present his paper at ICAEW’s Information for Better Markets conference 2020, taking place on 14 December 2020. For more information or to register click here.