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September 02, 2020 12:04 PM

Toothless Watchdogs

Posted by ARC Team

By Ferdinand Elfers and Jochen Pierk

While Big Four auditing firm EY is facing legal action over the 1.9 billion EUR accounting fraud that has led to the collapse of its client, Munich-based payments firm Wirecard, the scandal has also turned the spotlight on an apparent failure of the responsible supervisory authorities. Indeed, the German government did not hesitate to terminate its contract with the Financial Reporting Enforcement Panel (FREP), a private-sector body that was commissioned by the German securities market regulator BaFin to enforce accounting regulations for publicly listed companies in Germany. But while the FREP might come as a convenient scapegoat for politicians, it is questionable whether it could – and should – have detected Wirecard’s illicit accounting practices. The real problem is in the current design of public accounting enforcement in Europe, which is not just a German problem.

Accounting enforcement has been institutionalized in the European Union only since the mandatory introduction of International Financial Reporting Standards (IFRS) for publicly listed firms in 2005. Where the corresponding EU directive broadly asked member states “to take appropriate measures to ensure compliance” with IFRS, there is substantial variation in the institutional design of national enforcement activities. Some countries have set up dedicated enforcement agencies more or less comparable to Germany (e.g., Austria and Sweden), while for others, enforcement tasks are subsumed by the national securities market regulator or the central bank, or even individual industry supervisors. Among these, the European Securities and Markets Authority (ESMA), which was set up in 2014, takes only a broad coordinating role, but doesn’t engage in enforcement activities in its own right. In practice, its most important task in this regard is the determination of specific technical accounting topics that supervisors are recommended to emphasize in their financial statements reviews. Other than that, national agencies differ a lot, for instance, regarding the number of financial statement reviews (mostly between 10% to 30% of all listed firms per year), the scope of their enforcement activities, and their legal authority to impose penalties. The latter, by the way, are typically very modest. In 2019, European enforcers required restatements of financial statements in only four cases. Most of the time, firms get away with publishing a corrective note or adjusting their future financial statements.

One aspect that is, however, very common among the European enforcement agencies is their sometimes blatant underfunding. The FREP, which was in charge of supervising more than 400  publicly listed firms in Germany, has around 15 employees and a yearly budget of EUR 5.5 million. To put this in perspective, the average audit fees for a DAX 30 company in 2019 were EUR 12.6 Million, and Deutsche Bank alone had to pay more than EUR 60 million. It is not technically wrong that the FREP ‘failed’ to uncover Wirecard’s fraudulent accounting. But the idea that a single FREP employee could do what EY’s audit team couldn’t do for years, seems a little ambitious. The situation doesn’t look much better in other countries. For instance, the Swedish Council for Financial Reporting Supervision employs five reviewers responsible for 381 firms, and the Austrian Financial Reporting Panel employs seven reviewers for 85 firms.

Overall, the current system of accounting enforcement in Europe simply isn’t designed to prevent serious fraud cases. Even more than auditors, the European enforcement agencies focus on the correct application of accounting rules, and not on the verification of the underlying economics. However, even against this backdrop, they appear to be understaffed and hardly capable to manage complex accounting cases. In addition, 15 years after the introduction of IFRS, which was supposed to foster the harmonization of European capital markets, the lack of a stringent European approach to accounting oversight and the co-existence of intransparent local players are an unnecessary source of uncertainty for investors, and likely provides firms with opportunities for regulatory arbitrage.

Instead of blaming individual supervisors of predictably failing to do what they are not equipped for (and suppressing an expectable Schadenfreude about this German fiasco), European legislators can use the Wirecard affair to reform what is currently an intransparent and arguably inefficient European enforcement system. Pooling local resources under the umbrella of the ESMA would establish a uniform enforcement strategy that conforms the idea of harmonized accounting standards. At the same time, it would allow more specialization among employees and more flexibility to respond quickly to particularly relevant cases. And while public enforcement certainly is no panacea, increased funding can be a quick fix while solving the structural problems in the market for external audits. Overall, a stronger, more efficient European enforcement system would increase investors’ trust and the competitiveness of the European capital market.

 

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