There is widespread consensus that the audit sector is not fulfilling its potential, and that previous attempts at reform have been ineffective. As the impact of high quality audit goes far beyond the boardroom, when pension funds rely on audited financial statements for their capital allocation decisions, it is ultimately their individual members’ capital that is at risk.
• Public confidence in the UK auditing industry remains low
• The FRC is set to become the Audit, Reporting & Governance Authority
• Implementing industry reform is reliant on fresh legislation
If there is something that most of us can agree on, the recent litany of audit failures in the UK – for which the 2018 liquidation of Carillion, a construction and facilities management services company, has become a byword – it is that the audit profession has failed to meet expectations and that attempts at improving audit quality have failed.
While evidence of change might be slight, there has been no shortage of audit-quality initiatives over the past three years. In fact, the UK audit profession, together with the UK’s audit and corporate governance watchdog, the Financial Reporting Council (FRC), have been the subject of three external reviews:
• Sir John Kingman’s reviews into the FRC;
• Competition and Markets Authority’s (CMA) study into audit; and
• Sir Donald Brydon’s review into UK audit standards.
In terms of their scope, the Kingman review examined regulation, including the role and structure of the FRC. The CMA inquiry focused on audit resilience, while the later Brydon review, led by former London Stock Exchange Group chairman Sir Donald Brydon, looked into the nature and scope of audit.
Although the Brydon Review was the last review to emerge, thanks to COVID-19, it has been overlooked as more pressing matters took hold. Even so, it would be a mistake for investors to ignore it.
While Brydon disappointed with his headline conclusion – audit is not broken, but its participants have lost their way – it would be a mistake for investors to overlook his conclusions.
“I was also rather underwhelmed during the review by the interest in audit shown by some of the portfolio managers with whom I spoke,” Brydon wrote. “Few appeared to read the audit report thoroughly and several took the view that it was enough to know whether or not the auditor had given an unmodified opinion.” The message was clear: however much investors might like to accuse the audit profession, reliance on audit is the responsibility of everyone with an interest in financial statements.
Others, such as Tim Bush from Pensions & Investment Research Consultants, however, are less generous about the audit’s shortcomings. “Confusion from the Big Four audit firms has been legion,” he says. “They are practiced at throwing up red herrings such as artificial intelligence and drone technology, and there is now, curiously enough, a consultation from the FRC on the use of technology in audit.
“I would make two comments here. One, technology is hardly new. It used to be called computer audit. Second, if the program is wrongly set up, you have garbage in, garbage out. In other words, if you are following the wrong objectives, it doesn’t matter whether you have programmed your staff, so to speak, to do the wrong thing or programmed a computer to do it wrong, you still get the wrong answer.”
Bush’s conclusion is that the audit profession has disconnected audit from the fundamentals of cash transactions and is now auditing irrelevant abstractions such as discounted liabilities and intangibles.
And as if three inquiries weren’t enough, the UK Parliament’s Business, Energy and Industrial Strategy (BEIS) Select Committee is leading a follow-up inquiry into the future of audit. Meanwhile, academic Prof Prem Sikka is conducting a fifth review on reforming the audit industry.
The FRC at least has grasped the need for reform of its own structure and processes, as well as of the wider audit market. The watchdog’s 2020-21 strategy document from last March explains: “We have fully embraced the need to change recommended by [Kingman, the CMA and Brydon].”
“We will see fairly cosmetic change. Lots has been promised but little has been delivered” - Prem Sikka
The document notes that by the end of 2019 and the start of last year, the watchdog had fully implemented more than 20 of Kingman’s 83 recommendations and had started to implement over 35 more along the way to transforming itself into the Audit, Reporting & Governance Authority. Those further reforms, the strategy report suggests, will require the UK government to legislate – once it has decided how it wishes to take Kingman’s findings forward, not to mention the CMA’s conclusions, as well as those in the Brydon report.
That said, the intrusion of COVID-19 has hampered progress. Evidence submitted to the BEIS Select Committee by the FRC last November explains that while the audit watchdog is “making progress in implementing many recommendations in order to deliver all the recommendations [it needs] legislation.”
It concludes with a stark warning that: “Without legislation, there can be no new regulator, with new powers or obligations to act in the public interest in a timely way, with appropriate levers and transparency to build the deserved confidence of our stakeholders.”
When that process of reform does eventually fire into life, Sikka suspects, it will end with another missed opportunity.
“There is no silver bullet to deal with the many problems we have with audit,” he argues. “Liability laws exert no real pressure on auditors to improve quality, there is poor public accountability, not to mention barriers to entry to the audit market.
“I feel that the audit industry should not be setting its own performance benchmarks, which is what it has effectively done under the FRC because the big firms have simply colonised the regulator. As a starting point, you need to have lay people in a majority. None of the reviews that we have seen so far have really addressed that.”
The issue of auditor independence was to the fore last month with the FRC report into Hewlett Packard’s abortive acquisition of software firm Autonomy. This report followed the FRC’s September 2020 ruling to fine Deloitte £15m (€16.5m) and suspend its senior audit partner Richard Knights from the Institute of Chartered Accountants of England and Wales for five years for their roles. At the heart of the report was the damming finding that auditors were reluctant to exercise proper professional scepticism.
This, Sikka says, is because auditors are conflicted. “The crux of the matter is that auditors should not be able to cross-sell services, and nor should management appoint and remunerate the auditors. The outsourcing of audit functions is another major issue and here, again, we have a worrying lack of transparency.”
His conclusion is that not only has the audit profession failed, but that it will continue to fail. He says: “We need alternatives to accounting firms and that probably means to have a state body conduct statutory audits of the 7,000 or so companies that the Companies Act defines as large companies. That would fundamentally change the relationship. The state body is the principle and any audit firm would act as an agent.
“However, too many of these issues have not been addressed by any of the inquiries that we have seen recently. I suspect we will see fairly cosmetic change. Lots has been promised but little has been delivered. I fear that they have engineered meaningful change off the agenda. Ultimately, this will see a continued erosion of public confidence in audit. I think we will still be talking about the same problems in a decade’s time.”