Summary
Concerns about the audit industry arose during Committee inquiries into Carillion and BHS and have deepened through a series of further high-profile audit failures. Questions around competition, resilience, conflicts of interest, regulatory weakness and the nature of audit itself have contributed to a crisis of trust in the industry. None of these problems are new; but previous attempts at reform have not delivered necessary improvements. The Government commissioned two independent reviews to look at regulation (Kingman) and the effectiveness of audit (Brydon), while the Competition and Markets Authority (CMA) has looked primarily at competition and resilience. Our recommendations feed into these reviews and indicate how reforms can be implemented in a coherent and timely manner.
The effectiveness of audit
We examined one of the core reporting and audit failures that brought down Carillion—the imprudent payment of dividends out of optimistically booked, and in hindsight unrealised, profits. We recommend that the Government and the Financial Reporting Council urgently produce a clear, simple and prudent definition of what counts as realised profits, and make further recommendations to tighten the UK dividend regime. To make audits more transparent and useful, we recommend the use of graduated findings and several measures to improve engagement with shareholders. We are clear that the detection of fraud should be a priority within an audit and audits must demonstrate how potential fraud has been investigated. We fully support the fundamental rethink of audit that Sir Donald Brydon is undertaking. We encourage him to consider how the scope of audit might be widened to give the auditor more opportunities to express forward-looking opinions and to report on more issues affecting stakeholders such as suppliers, employees and pension holders. This will make audit a more useful, informative product and a more varied, interesting career.
Conflicts of interest and auditor independence
There are still fears that auditors are conflicted by the commercial culture in which they operate. The culture of advisory services does not sit easily with the culture of challenge required by audit. We recommend that the CMA aims for a structural split or at the very least implements its proposed operational split between audit and non-audit. If operational separation does not end cross-subsidies and fails to produce improvements in culture, independence and transparency, we recommend that the CMA implements a full structural break-up of the Big Four into audit and non-audit businesses.
Many audit committees are placing an auditors’ ‘cultural fit’ and ‘chemistry’ above their professional scepticism and some committees are spending too little time on audit. We welcome the CMA’s proposal to increase regulatory oversight of audit committees to ensure that audits are independent, robust and free of bias towards the Big Four. We recommend that if this does not work, independent appointment of auditors by the regulator should be considered.
Competition and resilience
The Big Four dominate the FTSE 100 and FTSE 250 audit markets. The obstacles facing challenger firms have led to a lack of competition and choice for some of our most important companies when they change auditors. Choice would all but disappear if one of the Big Four failed. This precarious situation must be addressed before it is too late. To improve resilience and choice, the challengers need to gain a secure foothold in FTSE 350 audits. We therefore recommend a segmented market cap and the use of joint audits, on a pilot basis, for the most complex audits to enable the challengers to step up.
Regulation
The Financial Reporting Council’s (FRC) weak response to several audit scandals contributed to the current crisis of trust in audit. We agree with the Kingman Review and the Government that the FRC, with its voluntary base, needs replacing with a new statutory body, the Audit, Reporting and Governance Authority (ARGA). We also agree it needs more powers. We welcome the decision to replace the FRC’s leadership and recommend that the Government introduces the necessary legislation to establish ARGA in the next session of Parliament. We also recommend stronger audit quality reviews to be published in full, greater responsibility for non-financial directors for financial reporting and further consideration to be given regarding greater internal controls and enhanced audit checks for banks.
We believe that the package of measures we recommend will improve the quality and usefulness of audits, promote independence and challenge among auditors and, in time, deliver a more competitive and resilient audit market for FTSE 350 companies.
Published: 2 April 2019