You could be forgiven for thinking that audit reform has a lot in common with online shopping: knowing what you want is the easy part – it is fulfilment that is the let-down.
- The UK government has launched a four-month consultation on the audit and corporate governance landscape
- The proposals are in response to high-profile corporate failures
- Directors, shareholders, auditors face increased scrutiny and oversight
Because, after no fewer than four probes and inquiries into the state of the UK audit market and its regulation, the government has responded with.… another consultation. To recap, those three probes comprise Sir John Kingman’s review of the Financial Reporting Council (FRC) the Brydon review into the quality and effectiveness of audit, and the Competition and Market Authority’s (CMA’s) statutory audit services market study. In addition, the UK parliament, through the Business, Energy and Industrial Strategy Committee, has pressed for reform.
And so in March, the UK’s business minister Kwasi Kwarteng heralded the arrival of proposals for a wide-ranging reform of the UK’s audit and corporate governance landscape. He said: “I am determined to reinforce the UK’s position in the wake of large corporate failures that have led to job losses and uncertainty among small businesses and local communities.”
Because the proposals, if adopted following a four-month public consultation that runs until July, could see companies face restrictions on dividend payments to shareholders and bonus payments to management. And company directors could face sanctions if they fail to take adequate steps to safeguard against misstatement or fraud.
In addition, the government has outlined the steps it says it needs to take to replace its audit watchdog, the FRC, with a new regulator, a proposed Audit, Reporting and Governance Authority (ARGA), with a specific and broader remit defined in law.
The impact of this shake-up will be felt most keenly by so-called public interest entities (PIEs). Traditionally, this group has tended to be listed companies. However back in 2016, EU audit reforms expanded the definition of PIEs to capture unlisted banking and insurance entities. At its broadest, these proposals could well see the definition of PIEs extended yet further.
Broadly speaking, the proposals in the consultation document will affect four groups and interests: shareholders, auditors, company directors and, last but not least, the FRC itself.
At the moment, the FRC has no powers to enforce director duties. The only exception is where a director is also a member of a professional accounting body such as the Institute of Chartered Accountants of England and Wales. The government has identified three areas of concern: internal controls over financial reporting, decisions about dividends and capital maintenance, and, finally, the steps directors take to strengthen the company’s future resilience.
That the government also has shareholders in its sights might seem surprising – until you consider that engagement is a key component of the success of the UK investment environment. After all, who else but shareholders vote on director appointments, give the green light to dividend payments, approve the appointment of auditors and have the final say on executive pay? Moreover, the larger the investor, the government’s argument goes, the more clout they have on stewardship. As such, the consultation document explains, shareholders should have “a strong interest in his quality, accuracy and reliability because it provides a basis for informed investment decisions and efficient allocation of investment capital across the economy”.
But what about the audit process? Well, auditors enjoy a unique vantage point over a company’s affairs. The audit team has privileged access to a company’s senior management, is privy to confidential information and has insights into its processes. Moreover, these responsibilities are enshrined in company law.
But with this bird’s eye view comes responsibility given that investors and the audience for corporate reporting depend on the auditor wielding its powers effectively. As the consultation document notes, a solid audit function “should be an ally of good business behaviour and despair to directors to meet their legal obligations to shareholders, creditors and other stakeholders, which ultimately serves the public interest.”
But, as the government is aware, this has not been the experience of recent years. Indeed, recent high-profile corporate reporting woes in the UK – such as British Home Stores, Carillion and Patisserie Valerie – and beyond – Wirecard in Germany – have only served to underscore this point. As if the depressing tally of corporate failings were not enough, the FRC’s own monitoring of audit quality suggests there is room for improvement.
The consultation’s diagnosis is that the audit product has remained static while the world has moved on. In short, audit is a prisoner of time given that financial transactions have increased in complexity over the past 50 years while the audit function has in many ways, its critics say, remained static. Something else that has remained static is the starkly restrictive concentration of the major firms in the supply of audit services: the startling reality is that just four firms have cornered some 97% of the FTSE 350 market.
But it is arguably in relation to the oversight of the statutory audit function that the new proposals will bite hardest. The 2018 Kingman review highlighted weaknesses, as the consultation document calls them, with the FRC’s oversight of the audit function.
One of the most glaring, the review found, was the lack of any statutory basis for the FRC‘s work. This was in addition to the lack of any legally sound objective for its work. On top of this, Kingman noted inadequacies in the watchdog’s enforcement powers in audit supervision. As if that were not enough, Kingman highlighted that the FRC has little ability to promote competition within the market.
All of this could change. Among the proposed measures in the consultation is a new statutory objective and function for the watchdog together with a formal statutory levy to replace the existing voluntary arrangement. The government also wants the ARGA to play a greater role in fostering competition in the market for audit services.
In addition, it will have new powers to strengthen its corporate reporting review activities, oversee audit committees and enforce the corporate reporting duties that directors are under. Finally, the consultation proposes giving the new regulator responsibility for deciding which individuals and firms should be approved to audit the PIEs that are at the heart of this consultation.
In practical terms, the proposals could give the ARGA the power to:
• Force companies to make changes to their accounts without needing to go to court for an order compelling them to do so;
• Bring greater transparency to the FRC’s work, and;
• Extend the FRC’s powers of review to cover the entire annual report.
But have investors got the message? Chris Cummings, chief executive of the Investment Association, says so. “Investment managers have an important role to play in holding companies to account on their audit quality,” he says, “and our members are committed to playing their part to drive up standards and improve transparency from auditors and companies.”
Failed audits have in recent years given rise to almost as much rage as any courier’s inept attempt at delivery. This time, however, the government appears to have eventually got the message.