The Future of Audit Contents

1Introduction

What are audits and why do they matter?

1.The origins of modern audit can be traced back to several corporate failures in the nineteenth century, such as the collapse of the City of Glasgow Bank in 1878, which identified the need for independent audits.1 An annual audit is now a statutory requirement for all listed and large companies.2 The purpose of the audit is to provide assurance to shareholders that the financial statements produced by the company’s management give a “true and fair view” of the company, including its assets, liabilities, financial position and profit or losses.3

2.Audits matter because they underpin confidence in financial reporting by companies.4 This in turn supports the orderly functioning of financial markets, where shareholders, investors and other stakeholders can form a view about an audited entity built on trustworthy and transparent information.5 If audits are not carried out properly and fail to detect significant problems in a company’s accounts, the consequences can be far-reaching not only for shareholders, but also for wider stakeholders such as employees, customers, suppliers and pensioners, who have a strong interest in the success and viability of the company.

Parliamentary interest in the UK audit market

3.Concerns about the audit industry arose during our joint inquiries with the Work and Pensions Committee on the collapse of Carillion,6 and BHS.7 The Secretary of State told us that the public were right to be concerned about these collapses.8 These were followed by the collapse of Patisserie Valerie,9 which went into administration in January 2019 after an accounting ‘black hole’ was discovered in the company’s books, estimated at £94 million.10 The pain inflicted by these failures runs deep and wide. In the case of BHS, 11,000 workers lost their jobs,11 and 19,000 current and future pensioners initially faced seeing their pensions cut.12 By May 2018, the collapse of Carillion had led to the loss of over 2,000 jobs, with over 27,000 pensioners facing reduced pensions, £2 billion owed to 30,000 suppliers,13 unfinished projects,14 and a cost to the tax payer of £148 million.15 The collapse of Patisserie Valerie into administration led to the closure of 71 stores and the loss of over 900 jobs.16

4.One of the key recommendations of our joint report on Carillion was that the Government should refer the statutory audit market to the Competition and Markets Authority (CMA).17 In October 2018, the Secretary of State wrote to the Chairman of the CMA and said he would welcome the CMA’s consideration of the operation of audit market for UK companies, citing his concerns about Carillion and BHS.18 Our interest in audit is also part of our continuing wider work on corporate governance.19

A crisis of trust in the auditing profession: key issues

5.The audit failures at BHS, Carillion and Patisserie Valerie are indicative of a wider crisis of trust in the audit industry. The Chief Executive of the Institute of Chartered Accountants in England and Wales noted that a “continual cycle of high-profile corporate failures” had produced a “palpable crisis in public trust” in the audit profession, which “required fundamental change if trust was to be regained”.20 The media has given prominent coverage to the multiple audit failures and commentators have raised serious questions about the role and quality of audit in the UK.21

6.The British origins of audit, and the fact that several of the world’s biggest audit companies were established in this country, means that the UK has a special responsibility to ensure that audit as an industry is robust and trusted. And, as several stakeholders and commentators have noted, the world is watching how the UK addresses the current crisis of trust in audit.22

Audit quality

7.Key to this crisis is a clear sense that audit quality has declined and from a low base. Along with Carillion, BHS and Patisserie Valerie, other recent auditing failures and audits currently under investigation include:23

In October 2018 the industry regulator—the Financial Reporting Council (FRC)—reported that there had been a decline in auditing standards since the previous year, with 27 per cent of audits not meeting its quality standards, up from 19 per cent the year before. In 2011/12, 44 per cent of audits had not met its quality standards.34 In June 2018, the FRC went as far as to say that KPMG’s audits had shown an “unacceptable deterioration”,35 while PwC, EY and Deloitte needed to reverse a decline.36 The Government have been clear that they are not satisfied with the current levels of audit quality.37

Competition, choice and resilience

8.There is also concern about the lack of competition and choice in the audit market for large listed companies. In 2016–17, EY, PwC, KPMG and Deloitte (the ‘Big Four’ audit firms) accounted for 97 per cent of FTSE 350 audits and 99 per cent of FTSE 100 audits.38 In 2016–17, only one FTSE 100 audit was carried out by a non-Big Four company.39 This concentration has increased in recent years;40 for instance, the Big Five became the Big Four when Arthur Andersen failed in 2002.41 This concentration has meant that many audit committees, especially those of the UK’s biggest firms, who are responsible for tendering and advising on the appointment of auditors, are often faced with a minimal number of audit firms from which to choose. Choice would all but disappear if one of the Big Four was to fail and was not replaced by one of the non-Big Four firms.

Conflicts of interest and the big four alumni

9.Critics have also questioned whether auditors are conflicted by their relationships with their clients. Several commentators have argued that audit firms are conflicted by the temptation to sell non-auditing services, which are more lucrative, and because they are auditing the very people they are being paid by and looking to be re-appointed by.42 Relationships between audit firms and clients can be further complicated by an ‘alumni effect’ with many members of audit committees, who run audit tenders, and chief financial officers formerly working for audit firms, especially the Big Four.43

Regulation and guidance on audit matters

10.The UK audit industry is currently regulated by the Financial Reporting Council (FRC). The FRC is an independent regulator in the UK and Ireland, responsible for regulating auditors, accountants and actuaries, and setting the UK’s Corporate Governance and Stewardship Codes. It seeks to promote transparency and integrity in business by aiming its work at investors and others who rely on company reports, audits and high-quality risk management. More detail on the FRC can be found in Chapter 8.

11.The FRC has received heavy criticism in recent years.44 This has centred on its perceived weakness in dealing with audit failures. For instance, it was heavily criticised for not investigating KPMG’s auditing of HBOS bank, which collapsed in 2008.45 The Treasury Select Committee called the decision not to investigate a “serious mistake”.46 Its subsequent decision, after finally investigating KPMG’s audit of HBOS, not to take any action was also questioned.47 It was similarly criticised for deciding not to pursue action against PwC for its auditing of Tesco, which had significantly overstated its profits.48 This led some critics to question the set-up of the FRC, especially its non-statutory basis and the fact that many former Big Four accountants sit on FRC panels and committees.49 The FRC’s ability to provide oversight of the audit profession was further thrown into doubt when it emerged that it had reviewed Grant Thornton’s audit of Patisserie Valerie, which failed to spot a £94 million discrepancy in the company’s accounts.50 It has been proposed that the FRC should be replaced by a more powerful regulator, the Audit, Reporting and Governance Authority (ARGA). This is covered in detail in Chapter 8.

Previous attempts to reform the audit industry

12.Previous attempts at reforming the audit industry have not been successful. Calls for reform of audit have invariably followed previous failures in the 1930s, 1970s and 1980s51 and more recent scandals such as Enron in 2002.52 In 1992, an Auditing Practices Board paper—the Future Development of Audit, began by stating that “the auditing profession needs to accept change” before pointing to issues such as independence, competition, governance and regulation and scope.53 These issues remain today.

13.The most recent major attempt to reform the UK audit industry was the Competition Commission’s statutory audit services market investigation. The Commission’s final report, published in October 2013,54 concluded that: “competition is restricted in the audit market due to factors which inhibit companies from switching auditors and by the incentives that auditors have to focus on satisfying management rather than shareholder needs”.55 Its implemented remedies included a requirement for FTSE 350 companies to put their statutory audit engagement out to tender at least every 10 years and measures to strengthen the accountability of the external auditor to the audit committee and reduce the influence of management.56 Subsequent EU audit reform, which came into force in 2016, required mandatory rotation of auditors (at least every 20 years), the prohibition of certain non-audit services to audit clients and the limiting of other non-audit services.57 However, the scandals of 2018 indicate that these reforms have not fixed audit yet.

The three reviews of audit

14.In response to the growing crisis in the UK statutory audit market, the Secretary of State and the CMA announced three separate reviews to look at different aspects of the market:

The Secretary of State told us said that he had decided to start the review of the FRC as quickly as possible, with relevant input from the Brydon Review as its recommendations were implemented.64 We comment on the output and remit of these reviews in the ensuing chapters.

Our inquiry

15.We launched our inquiry on the future of audit on 12 November 2018.65 The object of our inquiry was to examine how the three reviews announced would complement each other, given the links between the quality of the product, its regulation and the health of competition. We wanted to ensure that what emerges from these reviews is a coherent framework for auditing that could regain the confidence of investors and the public. We make a contribution on behalf of the public to the ongoing work of the CMA and Sir Donald Brydon, and call on the Government to implement the recommendations of the Kingman Review as a matter of priority.

16.We received 34 pieces of written evidence.66 In addition to a number of informal meetings with audit firms and investors, we held six oral evidence sessions between 15 January 2019 and 13 March 2019. We heard from academics, investors, audit committee Chairs, the Big Four and challenger audit firms, Sir John Kingman, Sir Donald Brydon, the FRC, professional audit bodies and the Secretary of State and officials. We would like to thank all those who appeared before the Committee and who submitted written evidence. We would particularly like to thank Federico Mor, from the House of Commons Library, for his work on the inquiry and Vinita Mithani from Middlesex University and Professors Stuart Turley and Brendan O’ Dwyer from the Alliance Manchester Business School for sharing their views with us.

1 See, for example: Derek Matthews (ed.), ‘A History of Auditing: The Changing Audit Process in Britain from the Nineteenth Century to the Present Day’, (2006).

2 The legal requirements for audits can be found in the Companies Act 2006, especially Part 16.

3 For an overview of the purpose of an audit, see: House of Commons Library, Company Audits: Problems and Solutions, (January 2019), pp 4–6; ICAEW Audit and Assurance Faculty, Audit Quality Fundamentals – Audit Purpose, (2006).

4 See: Financial Times, Audit has essential role in the wider economy, (21 December 2018).

5 For example, see: FRC, FRC finds good take-up of new auditor reporting requirements, (March 2015); European Commission, Auditing of companies’ financial statements, (accessed 18 February 2019). See also Public Company Accounting Oversight Board, The Importance of Auditing and Audit Regulation to the Capital Markets, (March 2014); FRC, ISA 200, June 2016, p2; House of Lords Economic Affairs Select Committee, Auditors: Market concentration and their role, (HL Paper 119; March 2011), p 5.

6 Business, Energy and Industrial Strategy and Work and Pensions Committees, Carillion, (HC 769; 16 May 2018). Carillion went into liquidation in January 2018. The joint inquiry found that KMPG had been paid £29 million to act as Carillion’s auditor for 19 years, in which time it did “not once qualify its audit opinion, complacently signing off the directors’ increasingly fantastical figures … failing to exercise professional scepticism towards Carillion’s accounting judgements over the course of its tenure as Carillion’s auditor, KPMG was complicit in them” (p 4).

7 Business, Energy and Industrial Strategy and Work and Pensions Committees, BHS, (HC 54; 5 July 2016), pp 29–30. BHS went into administration in April 2016. The Committee questioned the role of PwC’s auditor Steve Denison in signing off BHS’s accounts off just before it was sold without seriously questioning the BHS Director’s assessment that BHS remained a going concern. It later emerged that Steve Denison had only spent 2 hours working on the BHS audit (The Times, ‘BHS auditor Steve Denison ‘did two hours work on file’, (June 2018).

8 Q696 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).

9 The Committee became interested in the auditing of Patisserie Valerie as part of its inquiry into Small Businesses and Productivity. This initially focused on the company’s payment practices and whether its auditor, Grant Thornton, had checked compliance with payment practice reporting.

10 See: Financial Times, ‘Patisserie Valerie goes into administration after accounting fraud’, (22 January 2019); and: Times, ‘Patisserie accounting black hole is £94m, administrator reveals’, (16 March 2019).

11 See: BBC, Sir Philip sold BHS to dodge pension cost, says regulator, (June 2017).

12 See: Financial Times, ‘Philip Green pays £363m into stricken BHS pension fund’, (February 2017).

13 Business, Energy and Industrial Strategy and Work and Pensions Committees, Carillion, (HC 769; 16 May 2018), p 3.

14 For example, Carillion collapsed leaving two major hospitals unfished - the Royal Liverpool and Midland Metropolitan. See: Guardian, Carillion collapse further delays building at two major hospitals, (January 2018).

15 BBC News, Carillion collapse to cost taxpayers £148m, (June 2018).

16 Financial Times, ‘Luke Johnson made at least £20m from Patisserie Valerie’, (23 January 2019).

17 Business, Energy and Industrial Strategy and Work and Pensions Committees, Carillion, (HC 769; 16 May 2018), p 95.

18 Department for Business, Energy and Industrial Strategy, Operation of the audit market: letter from Rt Hon Greg Clark to Lord Tyrie, CMA Chair, (October 2018). Lord Tyrie’s response announced that the CMA would launch a market study into the statutory audit market and made reference to the Joint Committees’ report into Carillion.

19 See for example: BEIS Committee, Corporate Governance, (HC 702: 5 April 2017); BEIS Committee, Gender Pay Gap Reporting, (HC 928 2 August 2018); BEIS Committee, Executive rewards: paying for success, (HC HC 2018: 26 March 2019 ).

20 ICAEW, Michael Izza: Facing the Findings, (December 2018). See also: Institute of Chartered Accountants in England & Wales (FOA0015); CityAm, Audit must reclaim its Victorian roots to win back public trust, (15 January 2019); Financial Times, Whole audit profession accepts the need for change, (31 December 2018).

21 Financial Times, ‘The Big Flaw: Auditing in Crisis’, (August 2018); BBC, Why are accountants getting their sums wrong?, (4 February 2019); Accountancy Daily, 2019: trials and tribulations for accountants in the year ahead, (December 2018); The Times, Audit review: two inquiries, the same conclusion, (December 2018) CityAM, Audit sector faces huge shake-up as new reports make radical recommendations, (December 2018); Guardian, Audit sector faces inquiry as minister points to deficiencies, (September 2018); BBC, Carillion: The Audit industry’s existential question, (May 2018); Accountancy Age, FRC shout for independence, viability and higher quality in the UK audit market, (October 2018); The Economist, What is an audit for?, (May 2018). There has also been criticism that despite a series of scandals and audit failures, the profits of the Big Four and partners’ pay has continued to rise. See: Times, KPMG Profits Sing Despite Off-key Audits, (December 2018); Financial Times, KPMG UK revenues rise at fastest rate for decade despite audit criticism, (5 December 2018); Times, Deloitte’s bumper payout raises stakes for Big Four, (August 2018)..

22 See for example: Financial Times, UK auditing shake-up looks set to hit company directors, (21 March 2019); ICAS, UK audit debate: the world is watching, (November 2018); Daily Telegraph, We need long-term answers over the future of audit, (28 January 2019); Financial Times, Big four UK accountancy firms face radical shake-up, (December 2018); Financial Times, Breaking up the Big Four is not the answer to audit problems, (November 2018); Global Finance, Auditing the Auditors, (July 2018); Reuters, Breakingviews - UK audit reform leaves unfinished business, (May 2018).

23 A full list of enforcement outcomes since 2014 is provided in Letter from FRC to BEIS Committee Chair, (5 March 2019). Recent cases can also be found on the FRC website at: FRC, Recent Enforcement sanctions imposed against audit firms and Audit partners, (accessed 21 March 2019). The Times noted in December that the FRC was investigating PwC over its auditing of the Eurasian Natural Resources Corporation. See: Times, Watchdog to dig deep into PWC audits, (December 2018). The FRC singled KPMG’s audits out as “unacceptable”. See: Times, Carillion’s auditor KPMG is singled out for censure, (July 2018). In June 2018, the FRC announced that it was looking into Deloitte’s audits of SIG. See: Times, Financial Reporting Council orders investigation into Deloitte audits of SIG, (June 2018).

24 See: FRC, Investigation into the financial statements of Conviviality plc, (July 2018); Financial Times, Watchdog probes KPMG over Conviviality audit, (July 2018); BBC News, KPMG’s audit of collapsed drinks firm Conviviality faces probe, (July 2018); Guardian, Decline in quality’: auditors face scrutiny over string of scandals; In recent years, major audit firms have failed to spot key problems. We list the most prominent cases, (1 February 2019).

25 FRC, Sanctions against senior auditor and EY in relation to Tech Data Limited, (October 2017).

26 FRC, Deloitte LLP and John Clennett fined for Misconduct in relation to Aero Inventory Plc, (November 2016)

27 See: FRC, FRC launch investigation into KPMG in relation to the audit of the financial statements of Rolls-Royce Group, (May 2017); Guardian, Accounting watchdog to investigate KPMG over Rolls-Royce audit, (May 2017); ICAEW, KPMG’s Rolls-Royce audit under investigation, Economia, (May 2017).

28 See: FRC, FRC announcements in connection with Mitie Group plc’s 2016 annual report and accounts, (November 2017); BBC, Deloitte’s auditing of Mitie faces probe by watchdog, (July 2017): Telegraph, Accounting watchdog launches investigation into Deloitte over Mitie accounts, (July 2017).

29 See: Accountancy Age, FRC investigating Grant Thornton’s Sports Direct audits, (September 2018); Financial Times, ‘Sports Direct told to hand documents to UK watchdog’, (September 2018).

30 See: FRC, Sanctions against senior auditor and PwC in relation to RSM Tenon Group plc, (August 2017).

31 See: FRC, Sanctions against KPMG and Senior Statutory Auditor in relation to the audits of Ted Baker Plc, (August 2018); Independent, KPMG fined £3m over misconduct in Ted Baker audits, (August 2018).

32 See: Domino’s Pizza, Annual Report & Accounts 2016, p 71; Financial Times, ‘Trust in auditors will be elusive without an overhaul of priorities’, (17 February 2019); IPE, Accounting roundup: ‘illegal’ dividends, PIRC, FRC, s172, EFRAG, (6 February 2019).

33 See: FRC, Sanctions in relation to the audit of Quindell plc, (June 2018); Financial Times, ‘KPMG fined £3.2m over work with Quindell’, (June 2018); Guardian, KPMG fined more than £3m over Quindell audit, (June 2018).

34 FRC, Developments in Audit 2018, (July 2018).

35 The FRC found that 39 per cent of KPMG’s audits had fallen below its standards, which had increased from 35 per cent the year before. See: FRC, KPMG AUDIT PLC: AUDIT QUALITY INSPECTION, (June 2018), p 4.

36 See: FRC, Big Four Audit Quality Review results decline, (June 2018); BBC, KPMG’s audit work unacceptable, says watchdog, (June 2018). All of the FRC’s individual audit quality inspections for the top eight audit firms can be found here.

37 Q698 (Alex Chisholm, Permanent Secretary, Department for Business, Energy and Industrial Strategy).

38 FRC, Key Facts and Trends in the Accountancy Profession, (July 2018), p 50.

39 BDO was the only non-Big Four company to carry out an audit of FTSE 100 Company. See: FRC, Key Facts and Trends in the Accountancy Profession, (July 2018), p 47.

40 The concentration of the FTSE 350 audit market amongst the Big Four has been a feature of the market for some time. The Competition Commission’s market investigation into the audit market published in 2014, indicated that market concentration in the FTSE 350 audit market amongst the Big Four between 2002 and 2010 in terms of the annual share of audit fees was almost 100 per cent. See: Competition Commission, Statutory Audit Services Market Investigation: Descriptive Statistics, (2012), p 4.

41 Market concentration in the audit industry occurred mainly through mergers, especially in the 1980s and 1990s. Before the Big Five, there was a Big Eight, which included: Arthur Andersen; Coopers and Lybrand; Deloitte Haskins and Sells; Ernst and Whinney; Peat Marwick Mitchell; Price Waterhouse; Touche Ross; Arthur Young. See: House of Lords Economic Affairs Select Committee, Auditors: Market concentration and their role, (HL Paper 119; March 2011), pp 9–11.

42 See: Prem Sikka et al., REFORMING THE AUDITING INDUSTRY, (December 2018), p 3; Vinita Mithani, ‘More audit competition: who loses out?’, Economia, (November 2018);

43 See: Financial Times, ‘An illusion of choice: the conflicts that mire the audit world’, (August 2018); Accountancy Daily, Two thirds of FTSE 100 CFOs ex Big Four audit firms, (December 2018);

44 See: Times, The Financial Reporting Council: a watchdog that doesn’t bite, (October 2017).

45 See: Financial Times, ‘Watchdog admits it was slow to investigate HBOS audit’, (November 2017).

46 Treasury Select Committee, Review of the reports into the failure of HBOS, (HC 582; 26 July 2016), p 48.

47 See: Financial Times, ‘KPMG cleared over audit of HBOS before collapse’, (September 2017); ICAEW, ‘Profession defends audit in wake of HBOS decision’, Economia, (September 2017).

48 See: Financial Times, ‘PwC escapes censure over Tesco accounting scandal’, (June 2017).

49 See: Accountancy Daily, Big Four alumni: who’s working at the audit regulator?, (December 2018); Financial Times, ‘UK accountancy watchdog’s competence faces government probe’, (March 2018; Financial Times, ‘Britain’s accountancy watchdog has neither bark nor bite’, (October 2017); Sarasin & Partners et al., Investors require a robustly independent audit regulator, (October 2017); IPE, Accounting roundup: PIRC attack on FRC, watchdog funding changes, review work, (December 2016).

50 ICAEW, ‘FRC saw Patisserie audit before fraud detected’, Economia, (14 January 2019).

51 For example, the scandal surrounding the audit by Lord Kylsant and John Moreland of Royal Mail Steam Packet Company was a major case in 1931.While in the 1970s examples included London and County, while the 1980s and 1990s DeLorean, Barings, BCCI and various companies owned by Robert Maxwell. See: A Mitchell et al., ‘A Better Future for Auditing’, (1993); Derek Matthews (ed.), ‘A History of Auditing: The Changing Audit Process in Britain from the Nineteenth Century to the Present Day’, (2006).

52 See: Encyclopaedia Britannica, ‘Enron—What Happened?’, [accessed 18 March 2019].

53 The Auditing Practices Board, The Future Development of Auditing: A PAPER TO PROMOTE PUBLIC DEBATE, (November 1992).

54 Competition Commission, Statutory audit services for large companies market investigation, (October 2013).

55 Competition Commission, CMA finalises audit changes, (September 2014).

56 As above.

57 Europa, Audit reform in the EU, (accessed 10 March 2019).

58 BEIS, Independent Review of the Financial Reporting Council, Terms of Reference, (May 2018).

59 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018).

60 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019).

61 CMA, Market Study Notice Supply of Statutory Audit Services in the United Kingdom, (May 2018).

62 CMA, Statutory Audit Services Market Study: Update Paper, December 2018).

63 BEIS, Government takes next step in improving standards of UK audit market with new independent review into audit standards, (18 December 2018). The Terms of Reference for Sir Donald’s Review and details of his Advisory Board and Auditors’ Advisory Group can be accessed here.

64 Q647 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).

65 BEIS Select Committee, BEIS Committee examine the future of audit, (12 November 2018).

66 BEIS Select Committee, Future of Audit: Written Evidence, (accessed 13 March 2019).



Published: 2 April 2019