8Regulation of audit
218.The regulation of audit is currently overseen by the Financial Reporting Council (FRC). Sir John Kingman’s independent review of the FRC identified significant weaknesses in the regulator and proposed reforms designed to ensure that the new regulator has sufficient powers and reach and is constituted on a statutory basis. This Chapter considers Sir John’s recommendations relating to audit, in the context of the Government’s response, published in March 2019.
The Financial Reporting Council
219.The non-statutory FRC regulates auditors, accountants and actuaries, and produces the UK’s Corporate Governance and Stewardship Codes. It aims to “promote transparency and integrity in business” and states that its work is “aimed at investors and others who rely on company reports, audit and high-quality risk management.”411 It publishes guidance on auditing and ethical standards,412 including on such issues as professional scepticism and audit independence.413 The FRC’s enforcement regime includes investigations where there appears to be misconduct or a breach of the relevant professional standards.414 To help enforcement, it possesses a range of possible sanctions, including temporary or permanent bans for auditors and financial penalties for audit firms.415
Sir John Kingman’s Independent Review of the FRC
220.The Independent Review, led by Sir John Kingman, was appointed in April 2018 with a remit to conduct a root and branch review of the FRC. Following a consultation, it published its report in December 2018.416
221.The Review acknowledged that the FRC had some strengths, such as its effective custodianship of the UK Corporate Governance Code, and that at times it had gone beyond limited statutory powers, for instance, to enhance monitoring of the six biggest audit firms.417 However, overall it was very critical, describing the FRC as “a rather ramshackle house, … built on weak foundations”.418 It identified several key weaknesses:
- Powers - the FRC’s powers were described as “clearly deficient” while its leadership had failed to make the case for greater powers and to shape the debate around audit;419
- Sanctions and Enforcement - while it had a range of sanctions available to it, the FRC took “an excessively consensual approach to its work”;420
- Independence - the FRC lacked independence because it was not on a statutory footing and lacked direct regulatory oversight over the firms who voluntarily funded it, meaning it was more akin to a trade body than a regulator;421
- Appointments - there were flaws in its appointment processes, which meant that its Board and Council were “largely self-perpetuating”, and often reliant “on the alumni networks of the largest audit firms” and “inappropriately informal” recruitment methods422
222.The Review’s verdict on FRC resonates with our view and the many views of our witnesses, some of whom thought that it had “gone off the rails”,423 or had dented public confidence.424 The majority agreed that it needed to be replaced by a stronger, independent and more accountable statutory regulator.425 The Secretary of State agreed that a “tougher regulator” was required.426
223.Our predecessor Committee pressed for the FRC to be given more powers to hold company directors to account and for it to be more interventionist.427 We have found it to be far too timid in exercising the powers and influence that it does possess. For instance, it failed to follow up on concerns it identified in Carillion’s accounts in 2015, three years before the company went into liquidation.428 It initially did not investigate the auditing of HBOS, and when it did, it decided to take no action even though it concluded that KPMG’s audit “raised questions about the adequacy of the nature and extent of some of the audit procedures”.429 In recent years the FRC has applied higher fines - £17.96 million in 2017/18 and £14.59 million in 2016/17, with a record fine of £5.1 million for PwC in 2017,430 although this may in part be a reaction to escalating criticism of its earlier timidity. Even these larger fines are a small fraction of the Big Four’s revenue. The FRC’s leadership half-hearted approach to acquiring greater powers was exemplified by its Chief Executive telling us that he had done so “from time to time” and “not necessarily on a constant basis”, even though he accepted that such powers were needed.431 Despite asking the FRC for evidence of it asking for more powers, we were not provided with any such examples of formal requests to the Secretary of State.432
224.We have also raised questions about the FRC’s transparency and accountability. In January 2018, it emerged that the FRC had reviewed the quality of the audit of Patisserie Valerie’s accounts by Grant Thornton, six months before a £40 million fraud was discovered in these accounts.433 These reviews are not published. The FRC is currently reviewing its own review of the Grant Thornton audit. Whilst a review is clearly needed, under current arrangements the regulator is, in effect, marking its own homework.434
225.The longstanding criticisms of the FRC’s lack of independence and “capture” by the very profession it is supposed to regulate are given credence by the dominance of the Big Four alumni within its ranks. For instance, in October 2017, it was reported that 34 out of 109 members of the FRC Board and Committees were current or former partners of the Big Four.435 When the FRC decided not to take action over PwC’s audit of Tesco, three out of 15 directors who sat on the main FRC board were former PwC partners, while another seven sat on other FRC committees.436 This led to one critic to argue that the organisation was “fatally flawed in the way it was set up and has been operating … based on trade association relationships”.437 Even the FRC’s Financial Reporting Lab, praised as an example of innovation, lost some credibility when one of its reports on the disclosure of dividends highlighted Carillion as an example of “good practice”.438
226.We agree with the Kingman Review that the Financial Reporting Council has for too long been a weak and ineffective regulator. Though in recent years it has begun to apply higher penalties for audit failures, we believe that it is too late to repair its reputation and credibility. It seemed unwilling to explore major audit failures, such as at HBOS, and reluctant to use sanctions even when it found substandard audits. It was ineffective in seeking the additional powers, statutory underpinning and funding it required to make it truly independent of the industry it was regulating. Its leadership also showed a degree of naivety in not acting on perceptions that it was captured by the Big Four, a suspicion fuelled by its self-perpetuating recruitment processes. On balance, the FRC has contributed to the current crisis of trust in audit and now lacks the credibility to address it.
The Independent Review’s key proposals and the Government’s response
227.The Review made 83 recommendations on how to deliver a new regulator, with a new mandate, purpose, leadership and powers. The Government’s response stated that most of the conclusions and recommendations of the Review spoke for themselves and could be implemented straight away; this included 48 recommendations it committed to working on with the FRC.439 However, it also noted that some recommendations would require legislation, while others would need to take into account the CMA’s final recommendations and the work of Sir Donald Brydon.440 However, the Secretary was clear that the Government would proceed “at pace with reforming” the FRC.441
228.The Secretary of State told us that reform of the FRC was important because it would enhance the UK’s “reputation as a good place to do business”.442 The Permanent Secretary at BEIS, said that it would make improvements to protect a profession that makes “a very important contribution to economic life as a whole in the UK” as it was “a huge source of gross value added that employs hundreds of thousands of people”.443
A new regulator: The Audit, Reporting and Governance Authority
229.The Review’s central recommendation was that the FRC should be replaced by a new independent regulator with statutory powers and objectives, to be named the Audit, Reporting and Governance Authority (ARGA). The Government accepted the recommendations on setting up ARGA, its funding, recruitment and ensuring greater transparency. It also announced that it was recruiting new leadership for the FRC, ahead of ARGA being set up.
230.In common with the vast majority of witnesses, we welcome the proposal that ARGA be accountable to Parliament through its Chair and CEO being subject to pre-appointment hearings with this Committee and the requirement to submit annual reports.444 The Department has subsequently launched a public appointments competition for a new Chair of the FRC without consulting the Committee or making reference to a pre-appointment hearing in the job description.445 The appointment is expected to be made for a period of four years, well beyond the period by which ARGA should be fully established.446
231.Similarly, we welcome, the recommendation to place ARGA on a statutory footing.447 This is essential if the regulator is to become independent and work in the wider public interest and not, as the FRC was perceived, as a “private company with a slightly disparate set of powers pursuing what is a vital national interest”.448 We are pleased that the Review did not ask for the taxpayer to fund ARGA and that it has replaced voluntary funding with a mandatory industry levy. This will help protect the regulator from perceptions of it being dependent on special interests within the audit industry. Sir John told us that ARGA would cost more than the FRC.449 However, we believe that this is necessary if ARGA is to be effective and address the shortcomings of the current regulator. We are reassured that the Review recommended that ARGA’s budget should be set by BEIS, after consultation with ARGA and stakeholders, which should mean that its funding will be proportionate but sufficient.450
232.We also support the Review’s recommendations on open and transparent recruitment processes and the decision to make board members public appointments. We believe this will help underpin ARGA’s credibility and ensure that staff are recruited on objective criteria. We similarly welcome other recommendations to help ensure that ARGA is more transparent than the FRC, for example, by ensuring full compliance with the Freedom of Information Act,451 and better information on the handling of complaints and leaks.452
233.In addition, the Review recommended that once every Parliament, ARGA should produce a report on the overall state of financial reporting and financial information, its usefulness, and make recommendations where it could be improved.453 We welcome the Government’s agreement to implement this recommendation.454
234.We welcome the Government’s commitment to accept the Kingman Review’s recommendations to establish ARGA and its steps to start implementing those recommendations that do not require legislation. We are particularly pleased that the Government has accepted Sir John’s recommendation that ARGA should be fully funded by a compulsory levy on the industry. We also welcome the Government’s decision to replace the FRC’s current leadership. They have lost our confidence and clearly that of the Government and the majority of audit stakeholders. We recommend that current FRC board members should have no meaningful role in the reform process or management of the new organisation. Given concerns about the independence and effectiveness of the FRC, we expect that the Government’s preferred candidate will not be appointed until they have appeared before this Committee and we have reported to the House our opinion.
Whistle-blowers
235.One of the additional roles of the FRC is investigating the complaints of whistle-blowers, for example, in the case of the HBOS scandal, for which it has been criticised.455 The FRC told us that since 2009 they have investigated 25 whistle-blowing cases.456 Of these, only three so far have resulted in companies making additional disclosures in their accounts or providing undertakings following FRC intervention. Nine investigations are still ongoing. We are surprised that in ten years only 25 whistle-blowers have seen their concerns investigated and that only three cases led to any sanction by the FRC, none of which could be regarded as punitive. Considering the number of corporate failures and scandals that have occurred since 2009, we would have expected there to have been many more cases. We recommend that ARGA ensures that it has effective procedures and policies in place to encourage whistle-blowers to come forward when they have serious concerns and investigates them fully.
ARGA’s new powers
236.Sir John Kingman told us that duties and powers of the FRC were “clearly deficient”,457 a view shared by the current Chief Executive of the FRC,458 and the Government in its reply to the Review.459 This includes the inability of the FRC to go into a company to test the quality of an audit or its financial reporting, or the powers to appoint somebody to review them.460 The Review recommended several new powers for the regulator to intervene in companies where serious problems are found. These include:
- directing companies to change accounts if they had been badly prepared or contained misstatements, so corrections could be communicated more quickly to the market;461
- when necessary, requiring companies to produce additional assurance on its financial reporting and viability statements, and an evaluation of particular areas of concern;
- giving the regulator the power, when deemed necessary, to commission, at the company’s expense a “skilled person review” to protect the interests of investors and the wider public;
- enabling the regulator, when in the public interest, to publish the report of the skilled person;462
- requiring the company to respond to the skilled person’s report;
- in the most serious cases, allowing the regulator to:
- order the removal of an auditor or undertake immediate retendering;
- Issue a report to the company’s shareholders suggesting that the company’s dividend policy should be reviewed or that they consider changing the CEO, CFO, Chair or Audit Committee Chair.463
237.Sir John Kingman told us that these powers would, for the first time, allow the regulator to “to go in and have a look” when it was concerned about the running of a company.464 We agree that the regulator should have the powers to intervene in a company if it has serious concerns about the preparation of their financial accounts or the quality of the auditing. This might, if carried out early enough, help avoid a company failure, or at least enable steps to be taken to mitigate some of the worst consequences of such a failure. The powers to commission a skilled person’s report, which might be published, and remove an auditor or retender, should provide powerful incentives to concentrate minds on audit quality. We also consider that the publication of such reports, especially if undertaken shortly after a company failure, will allow key lessons to be learned so that similar failure can be avoided in the future. Similarly, we believe that the ability to recommend to shareholders that they consider removing the CEO, CFO, Chair and Audit Committee Chair, will act as a deterrent to poor financial reporting and financial oversight.
238.We welcome the Government’s acceptance of the Kingman Review’s proposals for wider powers to intervene to prevent a significant market failure or lessen its impact if it cannot be averted. We recommend that the Government introduces the necessary legislation in the next session of Parliament. We further recommend that when there has been a major accounting and/or audit failure the new regulator should conduct and publish a swift but comprehensive review of what went wrong to share lessons with the wider audit market.
ARGA’s proactive remit
239.The Review concluded that the FRC had not been proactive enough, which had led to its inability to shape the agenda around audit and respond to risks as they emerged. It also thought that auditors and audit firms could do more to highlight key problems before, or as they emerged, so that they could be addressed as quickly as possible. In terms of the regulator shaping the audit agenda and being proactive, the Review recommended that it should:
- be forward looking and proactive in acting on emerging corporate governance or audit risks;
- promote competition in statutory audit services; and, advance innovation and quality improvements;
- to do this, it should develop new teams, including analysts, investment experts, economists, and corporate lawyers.465
240.In terms of audit firms, it recommended that they should have a “duty of alert” to report viability or other concerns firstly to the company board, then to shareholders and ultimately to ARGA.466 The Government welcomed the Review’s proposed objectives, duties and functions for the new regulator, such as enhanced competition and market review duties.467 It noted that primary legislation would be required and that the FRC had agreed in the interim that it would adopt the new objective, duties and functions as quickly as possible.468
241.We agree that ARGA should be much more proactive than its predecessor and equipped with the tools to identify early warning signs of companies or sectors under stress,469 including a full market intelligence function, which we understand that the FRC is beginning to develop.470 If the FRC had had the deeper market intelligence suggested by the Review it might have spotted some problems earlier, such as those concerning Carillion.471 It is regrettable that auditors do not already have a duty to report concerns to the board, and ultimately to the regulator. We believe that the risks cited by some stakeholders that such reporting could become “self-fulfilling” are outweighed by the benefits to be derived from early warnings.472 It is essential that the regulator and others can intervene at the earliest opportunity when a company is in trouble to avoid collapse or mitigate its consequences.
242.We welcome the Government’s positive response to the Kingman Review’s recommendations on ARGA’s objectives, functions and its more proactive role. This should enable ARGA to become the strong, credible regulator the audit industry needs.
Enforcement processes
243.The Review examined the FRC’s enforcement processes. It noted that the FRC acknowledged that it had to speed up its investigations and had set a target of concluding investigations within two years. However, the Review still found that “significant delays appear to remain”, though it accepted it was inevitably hard to judge, case-by-case, the extent to which such delays were genuinely avoidable.473 The Review recommended, that in the first instance, the FRC’s Board and the Government should continue to monitor enforcement performance, while ARGA should report on it in its Annual Report and be held to account by the BEIS Select Committee.474 The Government said that the FRC would take this forward immediately.475 Stephen Haddrill accepted that the FRC had been slow in conducting investigations but said that the FRC was now addressing this.476 However, he told us that the whole process could still take well over two years.477
244.We are deeply concerned that investigations into audit failures are still taking two years and longer. We therefore welcome the Government’s commitment to implement immediately the Kingman Review’s recommendation that the FRC and the Government should closely monitor performance in this area and that ARGA should make this a priority. This will be a key area in which we will hold ARGA to account.
Sanctions
245.The FRC already has a wide range of available sanctions. Individual auditors can face temporary or permanent bans and financial penalties and be subject to declarations for poor audit quality. They can also face a ban as a director of a Public Interest Entity (PIE),478 and exclusion from relevant professional bodies.479 Audit firms can be prohibited from carrying out statutory audits and/or signing audit reports.480 Financial penalties for audit firms for seriously poor audits are unlimited.481 The Kingman Review found that there was no “shortfall in the severity of sanctions available to the FRC”.482
246.However, as the Review noted, the main problem with the sanctions regime has been the FRC’s reluctance to use them.483 In several high-profile cases, it has been accused of being ‘toothless’,484 feeding a suspicion that an “occasional rebuke or fine from the regulator is merely seen as the cost of doing business.”485 For example, it decided not to impose any sanctions at all in relation to the 2007–2008 financial crisis.486 The Treasury Select Committee described this as a “serious mistake”.487 It was similarly criticised when it decided to close a subsequent investigation into HBOS because it deemed that the audit “did not fall significantly short of the standards reasonably to be expected”.488 It also faced questions over its decisions to not take action against PwC for its audits of Tesco and Barclays.489 In the case of Tesco, it was argued that the FRC had not provided a sufficient explanation of why it had decided not to take action.490
247.We acknowledge that there is a balance between effective sanctions and encouraging more entrants into the FTSE 350 audit market. As noted above, the CMA saw the threat of severe financial penalties and reputational damage from high-profile audit failures as a barrier to challenger firms bidding for FTSE 350 audits. Several challenger firms told us that this could be avoided by using financial penalties that were proportionate to the size of the audit firm,491 and where possible, applying non-financial sanctions that encouraged improvement.492 We agree that the use of sanctions should take into account the facts of the case and the turnover of the business.493 However, if we are to reduce the number of major audit failings, and concentrate minds on audit quality, there must be serious consequences for delivering poor audit work.494 We therefore believe that the Review got the balance right by recommending that though ARGA should “use all the available levers it has—including robust enforcement and the powerful deterrent effect this can create—to maximise self-reinforcing incentives to pursue quality and best practice.”495
248.We welcome the Kingman Review’s conclusion that ARGA should not be a ‘soft regulator’ and the recommendation that ARGA, unlike the FRC, should make full use of the range of sanctions it has at its disposal. We recommend that while ARGA should be proportionate, in the worst cases it should not be shy of imposing tough sanctions, including large fines.
Monitoring audit quality: Audit Quality Reviews
249.The FRC currently conducts Audit Quality Reviews (AQRs) of audit firms, on a voluntary basis. These reviews examine a sample of audits and related procedures supporting audit quality. AQRs are carried out annually for the larger audit firms. They focus on key audit judgments and the sufficiency and appropriateness of the audit evidence obtained, and also review an audit firm’s procedures and culture. Each year the FRC publishes a selection of individual firm and thematic AQRs,496 while all AQRs, many of which are confidential, contribute to the FRC’s annual report on audit quality.497
250.The Kingman Review recommended that AQRs should be a statutory requirement,498 and that ARGA should work towards publishing individual AQRs, including gradings, in full, with a first step the publication of AQR reports on an anonymised basis.499 The Government agreed that AQRs should be put on a statutory basis and that AQRs should be published in full on an anonymous basis immediately, with further consideration to be given to future publication in full.500
251.We were surprised to find that AQRs were conducted on a voluntary basis, a further reflection of the opacity of current audit regulation. We believe that AQRs should be more robust and focus on the key commercial judgements made by auditors.501 AQRs must also focus on the technology and processes being used by audit firms to conduct audit: we heard that at Carillion, electronic files had been ‘augmented’ after the completion of the audit.502 It is clearly imperative that audit evidence cannot be retrofitted to camouflage poor audit judgements. Audit firms might not be in favour of publishing de-anonymised AQRs,503 but transparency will allow audit clients to make more informed decisions about audit quality and provide an added incentive for audit firms to make audit quality a priority.
252.We welcome the Government’s decision to take forward the Kingman Review’s recommendation that AQRs should be a statutory requirement and be published in full. However, we recommend that AQRs should not be anonymised, even in the first instance. We recommend that AQRs should move beyond process-driven box ticking and offer a robust appraisal of the opinions offered in audits and on the quality of the analysis and evidence used to drive those opinions. This should include reviewing what steps an audit had taken to identify fraud. We also recommend ARGA should as a matter of routine inspect audit firms’ software that records audit files and ensure that it is sound and that the audit trail cannot be tampered with.
A UK Sarbanes-Oxley and the wider reporting eco-system
253.The Review recommended that serious consideration should be given to introducing a Sarbanes-Oxley (SOX) regime in the UK,504 and that the Government should consult early on its possible introduction.505 This would require the CEOs and CFOs of public companies to report on the effectiveness of a company’s financial reporting and internal controls, with the board and management having clear responsibility for the accuracy of reporting and robustness of controls. The Review accepted that such a move might impose significant initial costs, though recurring costs would be lower, and costs might be justified if it led to improvements in both reporting and internal controls.506 The Government said it would consider a strengthened framework around internal controls on a similar basis to the SOX and bring forward a detailed consultation in due course.507
254.We found a lot of support from a range of stakeholders for the introduction of a UK SOX regime,508 who argued that it would help improve financial reporting, upon which audits depended and, by placing more responsibility on CEOs and CFOs, improve the overall reliability of the eco-reporting system. We accept that there are key differences between the US and UK regulatory systems that would need to be addressed.509 We also note counter arguments that SOX could make management less ready to disclose weaknesses and mistakes for fear of being sued in the future,510 and that it might stifle innovation in financial reporting511 However, we believe that if a UK SOX system was introduced carefully and monitored to avoid these unintended consequences, it could contribute to a more robust financial reporting system.
255.We welcome the Government’s commitment to consider and consult on the possible introduction of a strengthened framework around internal controls on a similar basis to Sarbanes-Oxley. If adapted to the UK regulatory system, a UK equivalent could make a significant contribution to improving the reliability of financial reporting.
256.The previous Committee supported the FRC’s desire to be able to hold all directors to account, not just those who happen to be members of the professional bodies which come within the remit of the FRC.512 Indeed, we have been told informally that several directors have resigned membership of a professional body precisely to avoid the risk of being subject to FRC sanctions. This is clearly unacceptable. The Kingman Review recommended that the Government, working alongside ARGA, should develop detailed proposals that would hold all directors, including CEOs, CFOs, company chairs and audit committee chairs, to account for true and fair accounts and compliant corporate reports.513 The Government welcomed the proposals to review and enhance the sanctions regime for directors, noting that legislation would be required.514 We welcome the Government’s acceptance that all company directors, regardless of their professional qualification, should be accountable for their performance and liable to the regulator’s sanctions, including if company reporting falls short of the required standards.
Registration of auditors by Recognised Supervisory Bodies (RSBs)
257.In the UK there are four recognised supervisory bodies (RSBs),515 such as ICAEW, to which the FRC has delegated specific regulatory tasks, including the registration and de-registering of auditors. The Review recommended that this task should be reclaimed by the regulator from the RSBs, and that the Government should work with the regulator to develop and consult on the detail of how this regime would work, including developing a range of sanctions.516 The Government welcomed the Review’s recommendation and stated that it would consult without delay on what additional sanctions short of deregistering audit firms could be used by the regulator.517
258.We agree with the Review and others518 that it is inappropriate for regulatory powers, such as registering statutory audit firms, to be delegated to a professional body. It is further evidence of the unsatisfactory voluntary approach of the current regulatory regime. By removing the registering of auditors from professional accountancy bodies, there is also the possibility that it can allow non-accountants to enter the audit market, who could bring other skills, such as IT technology.519 Though audit quality is paramount, and opinions cannot be replaced by technology,520 such as AI, allowing more entrants into a properly regulated audit market could in time help address the competition, choice and resilience issues highlighted in Chapter 7.
259.We welcome the Government’s decision to return the registration of auditors to the industry regulator. We recommend that the Government and the regulator explore whether non-accountancy entrants, such as technology firms, could also play a role in the statutory audit market, if audit quality can be assured by rigorous registration, monitoring and enforcement policies. We believe that this could help address competition, innovation and resilience issues.
411 FRC, About the FRC, (accessed 25 February 2019).
412 See: FRC, 2016 Auditing Standards, (accessed 25 February 2019). These standards include: quality control of audits; the objectives of an audit; agreeing terms of audit engagements; consideration of laws and regulations in an audit of financial statements; identifying material misstatements; assessing risks; assessing audit evidence; audit sampling; auditing accounting estimates and fair value accounting estimates and related disclosures; auditor responsibilities relating to fraud in an audit of financial statement; determining whether auditing of financial statements indicate that a company is a “going concern”; forming an opinion and reporting on financial statements; communicating key audit matters in the independent audit report.
413 FRC, Briefing Paper: Professional Scepticism, (March 2012). FRC, Guidance on Audit Committees, (April 2016). This includes guidance on: the establishment and effectiveness of audit committees, relationships with management; oversight of internals controls, internal audit and management systems; tendering for and appointment of external auditors; oversight of external audits; audit and non-audit services; and relationships with shareholders.
414 FRC, Enforcement Division, (accessed 25 February 2019). The FRC’s enforcement procedures are set out in full in FRC, Audit Enforcement Procedure, (June 2016). An abbreviated version can be found at: FRC, Enforcement Procedures, (accessed 25 February 2019).
415 See: FRC, Sanctions Policy (Audit Enforcement Procedure), (April 2018)..
416 BEIS, Independent review of the Financial Reporting Council (FRC) launches report, (18 December 2018).
417 As above, p 6. The Financial Reporting Lab was launched in 2011 to provide an environment where investors and companies could come together to develop new reporting formats.
418 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (18 December 2018), p 5.
419 As above, p 8.
420 As above, p 8.
421 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (18 December 2018), pp 6–7.
422 As above, pp 7–8.
425 See: Q157 (Margaret Ewing, Nomination, Audit and Risk Chair, ITV); Q158 (Steve Barber, Audit Committee Chair, AA plc); Grant Thornton(FOA0029); RSM(FOA0030); PwC LLP Grant Thornton (FOA0029); Rathbone Brothers PLC(FOA0026); Rathbone Brothers PLC(FOA0026); Mazars LLP Mazars LLP (FOA0025); Sarasin & Partners LLP(FOA0024); Aberdeen Standard Investments (FOA0023); Association of Chartered Certified Accountants (FOA0021); ICAS (FOA0019); Deloitte (FOA0017); Chartered Accountants in England & Wales (FOA0015); Investment Association (FOA0014); Chartered Institute Of Internal Auditors (FOA0013); Crowe U.K. LLP (FOA0010); KPMG LLP (FOA0009); PIRC (FOA0007); UKSA & ShareSoc (FOA0005); Vinita Mithani, Lecturer at Middlesex University (FOA0016); Association of Investment Companies (FOA0034). See also: Financial Times, EY Chair calls for more powers for audit watchdog, (October 2018).
426 Q649 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).
427 See: BEIS, Corporate Governance, (HC 702; April 2017), p 21.
428 See: Business, Energy and Industrial Strategy and Work and Pensions Committees, Carillion, (HC 769; May 2018), p 77–78..
429 Financial Times, Watchdog admits it was slow to investigate HBOS audit, (November 2017).
430 Accountancy Age, FRC fines reach record high after 24 per cent increase this year, (July 2019).
432 The evidence which the FRC provided, consisted of oral and written evidence to Parliamentary Select Committees and responses to the Government’s Green Paper on Corporate Governance Reform and to the Kingman Review. See: Letter from FRC to BEIS Committee Chair, (5 March 2019).
433 This was later found to be £94 million. See: Financial Times, Patisserie Valerie overstated total financial position by £94m, (16 March 2–19) and Times, Patisserie Valerie revealed £40m fraud after FRC cleared audit, (14 January 2019).
434 The Times, Patisserie Valerie revealed £40m fraud after FRC cleared audit, (14 January 2019). Similarly, in 2013, the FRC approved the quality of KPMG’s audit of the Co-Operative Bank during an annual review shortly before it was discovered that there was a £1.5 billion capital shortfall at the lender.
435 The Times, The Financial Reporting Council: a watchdog that doesn’t bite, (October 2017).
436 As above.
437 IPE, Former MEP says ‘fatally flawed’ FRC should be shut down, (June 2018).
438 Financial Reporting Lab, Lab implementation study: Disclosure of dividends – policy and practice, (December 2016), p 10.
439 BEIS, Audit regime in the UK to be transformed with new regulator, (11 March 2019).
440 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL Initial consultation on the recommendations, (11 March 2019), p 10–12.
441 Q647 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy). He told us that the Government had responded quickly, with a short consultation, so it could legislate as quickly as possible where needed. (Q648). He was confident that until the current leadership was replaced, it could be trusted to implement those recommendations that did not require legislation or further consultation (Q655).
442 Q665 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).
443 Q701 (Alex Chisholm, Permanent Secretary, Department for Business, Energy and Industrial Strategy). See also: Q701 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).
444 See: Grant Thornton (FOA0029); RSM (FOA0030); Grant Thornton (FOA0029); Rathbone Brothers Plc (FOA0026); Mazars LLP (FOA0025); Sarasin & Partners LLP (FOA0024); Aberdeen Standard Investments (FOA0023); Association of Chartered Certified Accountants (FOA0021); ICAS (FOA0019) Deloitte (FOA0017); Institute of Chartered Accountants in England & Wales (FOA0015); Investment Association (FOA0014); Chartered Institute Of Internal Auditors (FOA0013); Crowe U.K. LLP (FOA0010); KPMG LLP (FOA0009); PIRC (FOA0007); UKSA & ShareSoc (FOA0005); Vinita Mithani (FOA0016); Association of Investment Companies (FOA0034).
445 We were told that the Government hoped to have the new Chair and Deputy in place by the Summer of 2019. Q656 (Alex Chisholm, Permanent Secretary, Department for Business, Energy and Industrial Strategy). It hoped to have a CEO in place by the end of 2019. Q657 (Rt Hon Greg Clark MP, Secretary of State, Department for Business, Energy and Industrial Strategy).
446 Cabinet Office/HM Government Public Appointments, Financial Reporting Council – Chair (accessed 20 March 2019). The Secretary of State told us that the present leadership of the FRC was necessary to ensure continuity but that the Government wanted the new leadership in place as soon as possible because ARGA would represent a significant change from the current FRC (Q650). He also said that the new leadership team should be independent and able to “make often difficult judgements … given the interest of people and organisations that are quite powerful”. (Q652).
447 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 3.
449 Q169 (Sir John Kingman, Chair of the Independent Review of the Financial Reporting Council). Sir John said that he did not want to “put a number” on how much more ARGA would cost (Q170). See also: Mr Malcolm Bacchus (FOA0006) he argued that the increased costs had not been subject to a cost/benefit analysis.
450 We were told by BEIS that this would address the “peculiar, to say the least” situation were a “regulator should charge a voluntary levy to the bodies it regulates”. Q664 (Alex Chisholm, Permanent Secretary, Department for Business, Energy and Industrial Strategy).
451 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 57. The Review said that FOI provisions should apply in full to ARGA functions and governance.
452 As above, pp 55–58. The Review was critical of how the FRC handled complaints. It called for ARGA to be more transparent, with better guidance on how it managed complaints including the publication of trend data on the nature and outcome of complaints and the speed with which they were dealt with. It also said that ARGA should be more proactive in managing complaints against the professional bodies. The Review found the FRC had a problem with leaks and that ARGA should be robust and effective in investigating them and ensuring that sharing of information avoided this.
453 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 34.
454 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL Initial consultation on the recommendations, (11 March 2019), p 20.
455 See: Financial Times, FRC accused of ignoring HBOS whistleblower, (7 February 2019) CityAM, Audit watchdog ‘whitewashed’ HBOS evidence, (7 February 2019); Times, City regulator denies failings after leaking whistleblower’s complaints, (28 January 2019).
456 The FRC told us that they referred 44 other cases to other regulators, professional bodies and the police. See supplementary evidence from FRC, letter from Stephen Haddrill, 22 March 2019.
459 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 3.
461 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 35. The Review stated that currently the FRC might have to take companies to court which could delay or defer corrections.
462 As above, p 49.
463 As above, p 50.
465 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 48 and p 61.
466 As above, p 48. The Review listed a number of issues to justify a skilled person review: concerns about the accounting treatment of key areas of audit judgement; evidence of significant investor concern; concerns about the credibility of a company’s viability or going concern statement or the methodologies used to underpin the statements; concerns that corporate governance explanations are seriously misleading or inaccurate; grounds to believe that important aspects of corporate governance are seriously deficient; indications that internal controls or risk management are seriously inadequate; where a dividend has been announced that appears rash or unaffordable and incompatible with the UK’s capital maintenance rules; indications that a company might not be financially viable, and the company is not acting responsibly in dealing with these risks; intelligence that an audit committee is not doing its job effectively or is unduly influenced by executive directors.
467 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 32.
468 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 14.
469 See Institute of Chartered Accountants in England & Wales (FOA0015); Grant Thornton (FOA0029); Mazars LLP (FOA0025).
473 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 39.
474 As above, pp 39–40.
475 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 21.
478 Public interest entity.
479 FRC, Sanctions Policy (Audit Enforcement Procedure), (April 2018). The FRC sanctions can include a combination of sanctions. For examples of recent sanctions imposed on audit partners see: FRC, Recent Enforcement sanctions imposed against Audit firms and Audit partners, (accessed 25 February 2018). For example, in June 2018 the FRC announced that Stephen Denison, an audit engagement partner at PwC, was fined £500,000 (reduced to £325,000 on early payment) and prohibited from carrying out audit work for 15 years because of key failings in the audit of Taveta Group (which included BHS Limited).
480 FRC, Sanctions Policy (Audit Enforcement Procedure), (April 2018), p 12.
481 As above, p 10. The calculation of financial penalties can also take into account the level of profitability per partner, market share, the number of audit and non-audit clients and the respective size of those clients, and the number of partners and registered individuals. For example, in May 2018, KMPG was fined £4.5m (reduced to £3.1 m after early settlement), because its audit of Quindell Plc did not obtain reasonable assurance that the financial statements as a whole were free from material misstatement, failed to obtain sufficient audit evidence and exercise sufficient professional scepticism. See: FRC, Sanctions in relation to the audit of Quindell Plc, (June 2018). A review of the FRC’s sanctions in 2017, recommended that fines of £10m or more could be appropriate for cases involving seriously poor audit work, carried out by a Big Four firm. The Review’s recommendations which took effect in June 2018, also included the greater use of non-financial sanctions. See: Financial Reporting Council’s Enforcement Procedures Sanctions, Review Panel Report, (October 2017).
482 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 40.
483 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 21.
484 See: Financial Times, Too close for comfort: the incestuous ties that bind auditors and watchdogs, (August 2018).The article noted that FRC fines “pale in comparison” to the penalties issued to banks and other financial services companies by other financial regulators.
485 The Times, The Financial Reporting Council: a watchdog that doesn’t bite, (October 2017).
486 See: Prem Sikka et al, Regulatory Architecture to enhance democracy and business accountability, (January 2019), p 69. The authors note that in some cases banks collapsed with days or weeks of receiving unqualified audit reports.
487 Treasury Select Committee, Review of the reports into the failure of HBOS, (HC 582; July 2016), p 55. See also: Prem Sikka et al, Regulatory Architecture to enhance democracy and business accountability, (January 2019), pp 67–68; Independent, Will HBOS mea culpa from the Financial Reporting Council see it getting tough with auditors?, Independent, (November 2017); The Telegraph, HBOS audit investigation delayed again; (June 2016). Sir John Kingman also noted that the decision not to investigate KPMG’s audit of HBOS, had “unquestionably damaged confidence in the regulator as well as the integrity and reliability of the regulatory process” (Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (18 December 2018), p 52.
488 Financial Times, KPMG cleared over audit of HBOS before collapse, (September 2017).
489 See Financial Times, Britain’s accountancy watchdog has neither bark nor bite, (October 2017); Financial Times, UK audit watchdog drops probe of PwC’s work for Barclays, (October 2017); The Times, PWC cleared of misconduct over Barclays but fears grow, (October 2017); The Independent, Tesco fraud: Questions left unanswered as Financial Reporting Council quietly cans investigation into auditors, (June 2017).
490 See: Prem Sikka et al, Regulatory Architecture to enhance democracy and business accountability, (January 2019), p 61. The report noted that the FRC decided not take action despite the FCA concluding that there was some evidence of concern which resulted in its levying a fine of £129 m.
491 See: Q302 (David Dunckley, Chief Executive Officer, Grant Thornton); Mazars LLP (FOA0025); Crowe U.K. LLP (FOA0010) This was also
492 Mazars LLP (FOA0025) Q302 (David Dunckley, Chief Executive Officer, Grant Thornton); Crowe U.K. LLP (FOA0010) Grant Thornton (FOA0029).
494 Q96 (Margaret Ewing, Nomination, Audit and Risk Chair, ITV); Q96 (Steve Barber, Audit Committee Chair, AA plc).
495 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 22.
496 For example, for 2017/18 the FRC published AQRs for Deloitte, PwC, EY, KPMG, BDO, Grant Thornton, Moore Stephens, Mazars. In terms of thematic reviews, the FRC have published reports on Audit Culture (May 2018); Materiality (December 2017) which look at how several audit firms have approached these areas. For example, the thematic review of audit culture looked at BDO, Deloiite, EY, Grant Thornton, KPMG, Mazars, PwC and RSM UK Audit.
497 See: FRC, Development in Audit 2018, (October 2018). For previous editions: FRC, Report on Developments in Audit, (accessed 25 February 2019). These reports include analysis of the audit quality of the top six audit firms, stakeholder confidence in audits and a summary of resolved breaches of audit quality and live investigations.
498 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 32. The Review noted that AQRs were currently carried out on a voluntary basis.
499 As above.
500 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 18.
502 Qq459–460 (Bill Michael, UK Chairman and Senior Partner, KPMG). See also: Times, KPMG partner suspended over Carillion audit, (19 January 2019).
503 Crowe U.K. LLP (FOA0010) Grant Thornton thought that AQRs should be in the first instance published anonymously (FOA0029)
504 The Sarbanes-Oxley (SOX) Act was introduced in the US in July 2002, following several high-profile financial scandals such as Enron and Worldcom. The Act inter alia sought to: enhance auditor independence; ensure that senior company executives took individual responsibility for the accuracy and completeness of corporate financial reports; increase financial disclosures and more timely reporting of material changes to a company’s financial position; introduce specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations; provide certain protections for whistle-blowers. For an overview of SOX see: House of Commons Library, Sarbanes-Oxley Act, (2003); ISACA, What is Sarbanes-Oxley (SOX) and what is its impact on audit?, (2019); AccountingToday, Voices Sarbanes-Oxley: 15 years of successes and challenges, (September 2017).
505 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 75.
506 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (18 December 2018), pp 5--51.
507 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 24–25.
508 See: Q84 (Leon Kamhi, Head of Responsible Investment, Hermes Investment Management); Q84 (Liz Murrall, Director, Stewardship and Reporting, The Investment Association); Q84 (Euan Stirling, Global Head of Stewardship & ESG Investment, Aberdeen Standard Investments); Q97 (Margaret Ewing, Nomination, Audit and Risk Chair, ITV); Q98 (Steve Barber, Audit Committee Chair, AA plc); Q480 (Steve Varley, Chairman, EY UK); Q528 (Maggie McGhee, Executive Director, Governance, Association of Chartered Certified Accountants); BDO LLP (FOA0020); KPMG LLP (FOA0009); EY (FOA0022); ISACA (FOA0002); Deloitte (FOA0017); Grant Thornton (FOA0029).
509 See: Q31 (Ilias Basioudis, Senior Lecturer in Financial Accounting and Auditing, Aston University Business School); Q31 (Professor Christopher Humphrey, Professor of Accounting, Alliance Manchester Business School); Mazars LLP (FOA0025).
510 Q31 (Vinita Mithani, Lecturer in Accounting, Department of Accounting and Finance, Middlesex University).
511 Q533 (Sir Donald Brydon, Chair of the Independent Review of the Quality and Effectiveness of Audit).
513 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), pp 43–44. The Review also recommended that the regime for non-member directors should follow the principles of the Audit Enforcement Procedure, with the same threshold for action to be taken, and a graduated range of sanctions. To achieve this, the Review stated that ARGA should set out relevant requirements or statements of responsibilities in relation to auditing and corporate reporting in order that directors are individually accountable for their roles. It thought that though ARGA should be free to impose a range of sanctions, the disqualification of Directors should remain with the Insolvency Service and that ARGA should liaise closely with the latter when investigating Directors.
514 BEIS, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 21. This Kingman proposals were supported by a number of witnesses. See: CIMA (FOA0033); Crowe U.K. LLP (FOA0010); Chartered Institute Of Internal Auditors (FOA0013); Investment Association (FOA0014); Institute of Chartered Accountants in England & Wales (FOA0015); Deloitte (FOA0017); ICAS (FOA0019); Sarasin & Partners LLP (FOA0024); Mazars LLP (FOA0025); PwC LLP (FAO0029); Grant Thornton (FOA0029). See also: Financial Times, Investors to target tarnished directors over audit failures, (24 March 2019); Financial Times, UK auditing shake-up looks set to hit company directors, (21 March 2019).
515 The four RSBs are: Association of Chartered Certified Accountants (ACCA); Chartered Accountants Ireland (CAI); Institute of Chartered Accountants in England and Wales (ICAEW); Institute of Chartered Accountants of Scotland (ICAS).
516 Independent Review of the Financial Reporting Council, Independent Review of the Financial Reporting Council, (December 2018), p 29.
517 BIES, INDEPENDENT REVIEW OF THE FINANCIAL REPORTING COUNCIL: Initial consultation on the recommendations, (11 March 2019), p 17.
518 Q82 (Natasha Landell-Mills, Head of Stewardship, Sarasin & Partners); Q83 (Euan Stirling, Global Head of Stewardship & ESG Investment, Aberdeen Standard Investments).
519 See: Q29 (Professor Karthik Ramanna, University of Oxford); Q83 (Euan Stirling, Global Head of Stewardship & ESG Investment, Aberdeen Standard Investments).
520 See PwC, The Future of Audit: A framework for Debate, (February 2019), p 15. They note that despite the introduction of transformational audit technology, “much of audit remains a human endeavour”. Though it was reported3 in March 2019 that a Dublin-based firm was offering an “audit automation” service. See: Times, Audit automation gets go-ahead, (22 March 2019).
Published: 2 April 2019