Conclusions and recommendations
The audit product
1.Fraudulent reporting by directors is almost always material, by nature if not by size. The detection of material fraud is, and must continue to be, a priority within an audit. Audits must state how they have investigated potential fraud, including by directors. (Paragraph 31)
2.Auditors are required to look ahead. We support work to strengthen the audit of and reporting on the going concern assumption and the viability statement. But we encourage Sir Donald Brydon to go further and explore how to make audits more forward-looking. In particular, Sir Donald should consider how widening the role and scope of audit might give the auditor more opportunities to express forward-looking opinions. (Paragraph 35)
3.We recommend that the FRC make graduated findings mandatory. (Paragraph 41)
4.The broadening of the audit remit would improve the usefulness of the product and the value of the job. Auditors would acquire new skills, employ more of their professional judgement and communicate their views clearly and openly (Paragraph 44)
5.As part of his review, Sir Donald Brydon should consider extending the scope of audit to cover the entire annual report, albeit with different levels of assurance and reporting. Critical areas such as corporate governance and payment practices ought to be subject to a robust assurance process and meaningful reporting by the auditor. Auditors should be encouraged and empowered by the new regulator to speak their mind openly and clearly in audit reports, without fear or favour. They should call out poor management when they see it. If there are barriers to auditors taking on more responsibilities and reporting on them candidly (such as unlimited liability and skills issues), the Brydon Review should include proposals for removing these barriers. (Paragraph 45)
6.We believe that requiring auditors to present at the AGM is a good way to generate engagement. This direct dialogue with shareholders would also remind auditors who they are accountable to. It would require them to demonstrate their independence and evidence their willingness to challenge management to a wider audience than the Audit Committee. (Paragraph 51)
7.Our proposals to make audit more useful and transparent should also increase investor interest in audit matters. Interested investors will be more likely to engage and use their voice to push for continued improvements and greater transparency. But there is a long way to go. We have three recommendations to increase investor engagement. Combined with our proposals to make audits more transparent and useful, we believe that this package will lead to significant and positive engagement from investors. (Paragraph 52)
8.There should be a requirement in the new Stewardship Code for investors and asset owners to consider audit matters. (Paragraph 53)
9.Auditors should make a presentation at the AGM to show how they have challenged management and exercised professional scepticism to underpin their audit opinion, and to raise any major issues. (Paragraph 54)
10.In order to be useful, information must be timely. The FRC and its successor should consider requiring companies to publish the audit report at the same time as results are announced (instead of waiting for the full annual report to be published, which often happens a month later, even though the audit report is ready and signed off before results are announced). (Paragraph 55)
11.We support the work that Sir Donald is doing to understand “the origins and perceptions of the expectation gap”. Nevertheless, the expectation gap must not be allowed to mask the serious failure of audit to deliver on its own current terms. If auditors delivered on the existing regime reliably and well, the expectation gap would shrink greatly. The delivery gap is far wider than the expectation gap and that is what must be fixed as soon as possible. (Paragraph 56)
12.We also support the fundamental rethink of audit that Sir Donald has been tasked with. As a product, audit should be more useful and forward-looking. A revamped product will make a career in audit more varied, exciting and rewarding. Audit should be as attractive as consulting and be seen that way but should also be much more meaningful in its service to the public interest. (Paragraph 57)
Capital maintenance
13.Compliance with the capital maintenance regime is patchy at best and it is not adequately audited. We recommend that the FRC urgently reminds directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches. Most importantly, auditors must be prepared to challenge management on their accounting of realised profits and distributable reserves. (Paragraph 61)
14.We are alarmed and disappointed that the FRC has not provided clarity on these fundamental issues, given the potential and actual problems that have arisen. The Government and the FRC should work together to resolve these issues as soon as possible, and produce simple and prudent guidance for companies and auditors to follow. (Paragraph 78)
15.We recommend that the Government and the FRC urgently produce a clear, simple and prudent definition of what counts as realised profits for the purpose of distributions. We support defining realised profits as realised in cash or near cash. (Paragraph 79)
16.We reject any legislative change the aim of which is to adapt the law to the accounting standards. Instead, auditors and directors need to be reminded that compliance with the accounting standards does not fulfil all legal obligations, and that the law comes first. We regret that the FRC has failed to clarify this basic point with those it regulates. We recommend that the FRC and its successor vigorously enforce the revised capital maintenance regime. (Paragraph 80)
17.We strongly support the Government’s proposal to require companies and auditors to take a more critical look at the valuation of goodwill for the purpose of distributions. We recommend that the Government urgently take steps to tighten the net assets test. (Paragraph 86)
18.The Government cannot unilaterally change the international accounting standards, but it can seek to tighten the law. Stopping imprudent distributions makes companies more resilient and encourages management to think longer term and tackle problems earlier. The principle of prudence should be made explicit in the law and its interpretation. (Paragraph 90)
19.The Government and the FRC should lead international efforts to improve accounting standards. If the Government wants to achieve its ambitions of a Global Britain advancing UK influence and interests, then it should be prepared to spell out how it wants to lead international standards on key sectors such as accounting and audit. (Paragraph 91)
20.We recommend that companies be required to disclose the balance of distributable reserves in the annual accounts and break down profits between realised and unrealised. (Paragraph 93)
21.A solvency system should complement the revised capital maintenance regime that we recommend, not replace it. We recommend that the Government adopts a complementary solvency-based system in which directors must state that dividend payments will not make the company insolvent or create cashflow problems. (Paragraph 96)
Separating audit from non-audit
22.The opaque economics of audit undermine independence, erode trust and stifle competition. Audit can only be transparent and independent when it is fully priced. It will only be fully priced when it is no longer subsidised. Therefore, subsidies must end and audit must stand on its own two feet. We conclude that governance separation does not go far enough on the grounds that it fails to deliver independence and does not end cross-subsidies. (Paragraph 118)
23.An economic separation of audit and non-audit is highly desirable. We recommend that the CMA at the very least implements the proposed operational split to achieve the separation of economic interests. (Paragraph 122)
24.We believe that there is a strong case for independent audit firms. (Paragraph 124)
25.It is clear that there are well-functioning models of legal separation and audit-only firms. (Paragraph 136)
26.We agree with the CMA that “objections to full separation are overstated”. We found the objections against full legal separation to be very weak, as membership of the global network provides an effective avenue to pool resources, access staff and share technologies. We also found well-functioning examples of legal separation and audit-only firms. (Paragraph 139)
27.On the other side of the equation, legal separation offers benefits on multiple fronts: quality, independence, culture, transparency, trust and to some extent, choice. These benefits of separation are large, and in our judgement, worth incurring significant costs. (Paragraph 140)
28.We encourage the CMA to aim for full legal separation of audit and non-audit services. The CMA should look to the long term, and not let one-off, short-term implementation costs weigh too much in its calculations. If the operational split is chosen instead, the CMA and ARGA should conduct a review of the arrangements after three years to determine whether the split has ended cross-subsidies and improved culture, independence and transparency. If not, we recommend that the CMA then move to implement a full structural break-up of the Big Four into audit and non-audit businesses in the UK. (Paragraph 141)
Fees
29.We recommend that the FRC and its successor require greater reporting on audit fees, potentially including the disclosure of audit hours, staff mix, and rate per hour. Auditors should also report instances where they have performed additional procedures but have been unsuccessful at increasing their fee. (Paragraph 150)
30.We are not confident in relying solely on the integrity of auditors to do the right thing in the face of conflicting interests. We agree with Sir John Kingman that “economics shapes behaviour”, and auditors are no exception. The regulator should aim to align as much as possible the incentives that govern auditors’ behaviour with the delivery of quality. (Paragraph 151)
31.Audit must be properly resourced to deliver quality. We have argued that the audit product must improve too. We recognise that many of our recommendations in this report are likely to lead to higher audit prices. This is an acceptable consequence of securing better, more trusted audits. (Paragraph 152)
32.We recommend that the FRC and its successor be given more powers over audit fees. We support Sir John Kingman’s proposal that the regulator be given powers to intervene in the interests of quality. To do that well, the regulator needs to better understand the economics of audit. The regulator should also investigate whether the structure of fees is fit for purpose, with the aim of reducing or eliminating economic incentives that work against quality. (Paragraph 153)
Ensuring independence, challenge and professional scepticism
33.It is deeply concerning that many audit committees do not appear to be factoring professional scepticism and challenge into their criteria for selecting auditors and are instead using ‘cultural fit’ as a desirable attribute. Equally worrying is the finding that many audit committees are spending so little time on auditing matters. This questions whether many audit committees are committed to challenging management and to putting in the necessary time to ensure that auditors are as well. (Paragraph 161)
34.Because of our concerns about the independence of audit committees, their lack of attention to audit and the lack of emphasis they are placing on challenge, we fully support the CMA’s proposed remedy on greater scrutiny. We agree with the CMA and others that sharper oversight of audit committees would help ensure that audits are more independent, able to challenge management and address any bias in favour of the Big Four. It is for the regulator to decide how much intervention and oversight is required to deliver these objectives, both in general and in specific cases. (Paragraph 166)
35.If audit quality, choice, resilience and the professional scepticism and independence of auditors remain a problem despite the remedies proposed by the CMA, Sir John Kingman and Sir Donald Brydon, we believe that independent appointment becomes a viable option for reform. We recommend that the regulator and the CMA consider the potential independent appointment of auditors with a view to developing it as a viable remedy if other remedies and reforms fail. (Paragraph 176)
36.We believe that increasing the frequency of audit rotations will, especially if used alongside a market cap, also encourage challenger firms to enter the FTSE 350 audit market, which will increase choice, competition and resilience. We believe these benefits outweigh any possible increases in costs. We also maintain that ten years will allow an audit firm to gain a good understanding of the companies they audit and would contend that even with a twenty-year rotation, a new audit firm will be required to develop knowledge of the firms they audit and the sectors within which they operate. We recommend that the CMA should revisit increasing the frequency of audit rotations, which should be reduced to seven-year non-renewable terms that can only be terminated in exceptional circumstances. (Paragraph 179)
37.We are persuaded that a “cooling off” period during which non-audit services could not be sold after an audit engagement had ended would remove a major potential conflict of interest for auditors. It would help focus auditors’ minds on audit quality and remove any concern that challenging management or exercising professional scepticism would have adverse financial implications after an audit term ended. This would also be a good option if a full structural split of audit and non-audit services was not adopted. It would also most likely increase challenger firms’ non-audit work, which would allow them to build up experience, expertise and a fee base to develop and invest in audit work. On balance we think a cooling-off period of three years would be optimal in delivering audit independence. We recommend that the CMA seriously considers the benefits of a cooling-off period of three years across which non-audit services could not be offered after an audit engagement had ended. The CMA should see this is a viable option if it does not decide to proceed with a full structural split of audit and non-audit services. (Paragraph 182)
38.The amounts being spent by audit firms for prospective clients seem high and lack transparency, raising significant concerns about whether this undermines auditor independence. Auditors themselves said that part of the current crisis of trust in the audit profession is the perception of conflicts of interest. We are therefore concerned that since the FRC’s policy on hospitality was introduced in 2016 there have already been 35 breaches. We recommend that the regulator tightens the current rules and applies them also to prospective audit clients and requires audit companies to publish details of all hospitality in full. (Paragraph 188)
Competition, choice and resilience
39.The CMA thought further consideration could be given to the use of peer reviews to improve quality by introducing an additional, independent quality check. However, it did not see them as a mechanism to give challenger firms enough experience to become more competitive in tendering for the audits of large companies. We agree. (Paragraph 198)
40.We share the reservations of many about the utility and impact of joint audits but believe that they have a role to play in increasing the resilience of the market in the medium term. We recommend that joint audits should be piloted in the upper reaches of the FTSE 100 in conjunction with our preferred option of a market cap for the rest of the FTSE 350, which is discussed below. Such audits should include a Big Four and a challenger firm; it should not include two Big Four firms. The new regulator should recommend joint audits where it believes challengers have not yet developed the resources and skills to take on the most complex audits alone but where, working alongside a Big Four firm, they would not affect audit quality. The regulator should monitor the quality of these pilots carefully and draw lessons from them to inform debates on which mechanisms are the most likely to increase competition and choice without damaging quality. Finally, we recommend that if unlimited liability is a significant deterrent to the challenger firms auditing the largest and most complex companies, the CMA should consider how to remove this barrier. (Paragraph 205)
41.We recommend that because of their strategic importance the Government should examine the auditing of banks to explore whether additional safeguards are required in this sector. (Paragraph 206)
42.While acknowledging that there are short-term risks to introducing a market cap, we believe that on balance that they are outweighed by the long-term benefits of a more competitive and resilient audit market. We are confident that if the regulator designs, implements and monitors the market cap carefully these risks can be minimised. We recommend that the CMA draws up detailed proposals for the introduction of a segmented market cap offering challenger firms the chance to take up a proportion of audits across the FTSE 350. This should be done on the basis that each firm should have an individual cap to avoid one of the Big Four keeping all of its clients and remaining dominant. We recommend that the CMA develops this proposal together with a pilot of joint audits in the first instance to allow challenger firms to take on some of the more complex FTSE 100 audits. (Paragraph 213)
43.We recommend that the CMA works with the regulator to draw up proposals to mitigate the consequences of an audit market failure, especially if it involved one of the Big Four. However, we strongly believe that the CMA should prioritise remedies that enable more challenger firms to enter the FTSE 350 audit market and develop their ability to undertake the full range of audits. (Paragraph 217)
Regulation of audit
44.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. (Paragraph 226)
45.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. (Paragraph 234)
46.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. (Paragraph 235)
47.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. (Paragraph 238)
48.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. (Paragraph 242)
49.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. (Paragraph 244)
50.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. (Paragraph 248)
51.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. (Paragraph 252)
52.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. (Paragraph 255)
53.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. (Paragraph 256)
54.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. (Paragraph 259)
Published: 2 April 2019