Overdue audit and corporate governance reforms on the horizon

Just before the Queen’s Speech was delivered, rumours had been circulating that the long-awaited audit and corporate governance reforms had been unceremoniously dropped. Thankfully, it seems that the call from the chairman of the Commons Business Select Committee not to delay these much needed reforms were heeded by Downing Street.

Serious reform of the UK’s audit and corporate governance regime is widely recognised as being long overdue. However, such reform is finally on the horizon, in the wake of a string of major audit disasters, notably KPMG with Carillion and Deloitte with Autonomy. These scandals, along with the collapses of BHS and Patisserie Valerie, underscored the need for urgent reform across the UK audit sector.

Such major corporate failures prompted three major reports into the sector, namely Sir John Kingman’s Independent review of the Financial Reporting Council (FRC), the Competition and Market Authority’s statutory audit market study and Sir Donald Brydon’s independent review of the quality and effectiveness of audit. These reports in turn informed a major 2021 consultation paper. That consultation incorporated more than 150 recommendations, which were drawn from these three reports.

The reforms proposed by the government consultation are not minor tweaks. They amount to a genuinely meaningful reform of corporate governance in the UK. The consultation’s proposals fell under six primary headings, namely directors’ accountability, the audit process, annual accounts, the audit market, executive pay and dividends.

A vast amount of work and thought has already gone into preparing for these reforms. We must now wait and see if the eventual legalisation proves adequate to fulfil the government’s stated aims.

In March 2021, the government’s white paper said that the fundamental objectives of the reforms were to:

  • Restore public trust in the way that the UK’s largest companies are run and scrutinised
  • Ensure that the UK’s most significant corporate entities are governed responsibly
  • Empower investors, creditors, workers, and other stakeholders by giving them access to reliable and meaningful information on a company’s performance
  • Keep the UK’s legal frameworks for major businesses at the forefront of international best practice

Genuinely prioritising these key objectives is needed to restore wider public and market confidence in the UK audit sector. As the UK economy navigates through increasingly uncertain economic waters – buffeted the coronavirus pandemic, inflation, Brexit and the war in Ukraine – enhancing confidence in the UK’s audit regime will help to boost investor confidence.

As matters stand, the Financial Reporting Council (FRC) simply lacks the necessary powers to implement effective measure for stricter controls that would make the directors responsible for any lack of transparency. The FRC should either be given these powers or else it should be replaced by a body with increased means and remit.

We continue to await the fine print relating to the UK’s proposed new auditing regulator, Audit, Reporting and Governance Authority (ARGA), which is due to replace the FRC. This new body is supposed to be a more powerful regulator, which will wield more potent investigative and regulatory tools than the FRC.

The government has also pledged to break up the dominance of the Big Four audit firms: KPMG, EY, Deloitte and PwC. A 2019 Competition and Markets Authority (CMA)  report on the UK’s audit market called for smaller “challenger auditors to shake up the market and end the dominance of the Big Four”.

However, the CMA report also acknowledged building the capacity of smaller firms would take time.

The FRC’s recently increasing number of investigations into mid-tier challenger audit firms has caused some to question this strategy, however. For example, the FRC is investigating the 2020 audit of French Connection by mid-tier accountancy firm Mazars – which is just one amongst a number of other investigations into mid-tier audit firms. While a market shake up may be welcome, it’s clear that a fresh regulatory approach is required. This should give real clarity to companies and audit firms as to what is expected of them, while also giving regulator both the powers and the resources to ensure that these standards are met.

Of course, a balance must be carefully struck between having effective regulatory control and allowing companies sufficient freedom to do business. However, weighting the scales too far towards the latter consideration can open the gates for those lacking responsibility and integrity, as we have seen. This can ultimately damage business confidence across the economy, since business people and investors need to have confidence in the UK’s audit regime, before they can have the confidence to rely on those very audits when investing in companies.

The audit sector itself is crying out for improved regulation. The strength of feeling in the sector was made clear by the strident reaction to rumours late last year that the government was about to weaken the proposed audit reforms, particularly by dropping a proposed requirement that directors sign off on companies’ internal controls. This proposal was to essentially create a UK equivalent of the US Sarbanes-Oxley Act.

In response to these rumours, a joint letter by CFA UK, Corporate Reporting Users’ Forum, UK Shareholders’ Association and ShareSoc asked, “why water down measures that would reduce the risk of fraud and misstatements? As usual, however, the UK seems likely to fall back on the corporate governance code, which the good follow and the bad neglect”. The Chief Executive of the Chartered Institute of Internal Auditors said a Sarbanes-Oxley Act-style legislation would “underline its importance” and help to improve compliance. We shall soon see whether such measures make it into the legislation.

The UK’s audit reforms must be sufficiently robust and along the lines of those proposed in the government’s 2021 consultation documents. Any failure to implement the necessary reforms in a timely fashion would leave a festering lack of confidence in the UK’s audit sector. The ball is now in the government’s court to finally come up with meaningful and effective regulation which restores confidence in the UK’s audit sector. If it succeeds, it will also increase confidence in the UK’s corporate sector more widely.

Published in Accountancy Age – 18 May 2022