Scaling back audit reforms is a missed opportunity

High hopes were pinned on the audit reforms that were expected to restore trust in corporate governance and audit. So why is the government suddenly scaling back its planned and long-awaited corporate governance reforms?

Significant proposed reforms were set out in a government white paper just last March. These came in the wake of major corporate scandals such as Carillion and BHS. They followed the recommendations of three major independent reviews. Yet the Financial Times recently reported that, in the wake of a backlash from business, ‘officials are expected to rein in some of the most controversial plans in favour of a more ‘business friendly’ regime’. Executives have warned that additional costs would make it less attractive to establish and keep businesses in the UK in the wake of Brexit and the coronavirus pandemic. There is merit in this respect in the government’s dilemma in getting the balance right.

Most significantly, it was reported that ‘a proposal to use legislation to require directors to sign off on companies’ internal controls over financial reporting, modelled on the US’s Sarbanes-Oxley Act, is now expected to be dropped’. Instead, ‘a similar provision is expected to be included in the UK corporate governance code, according to people familiar with the revised proposals, which would carry less weight and be more difficult to enforce’.

This retreat is remarkable, since just this March, a government white paper sought ‘views on proposals to strengthen the UK’s framework for major companies and the way they are audited’. This stated that the 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; and
  • keep the UK’s legal frameworks for major businesses at the forefront of international best practice.

These proposals had been carefully framed in response to the recommendations made in three important independent reviews, which included Sir John Kingman’s Independent review of the Financial Reporting Council, the Competition and Market Authority’s statutory audit market study and Sir Donald Brydon’s independent review of the quality and effectiveness of audit.

Sarbanes-Oxley equivalent unlikely

Perhaps the most potent measure proposed was the adoption of a UK equivalent of the US Sarbanes-Oxley Act, which was implemented in 2002 requiring directors to sign off company internal controls over financial reporting. Sarbanes-Oxley is a well-run balancing tool in the US regulatory system, and it has proven to be very effective since its introduction. Both CFA UK and the Corporate Reporting Users’ Forum have backed such a measure.

The regulatory proposals are apparently being watered down in the interests of business. Yet not all business people are happy with these weakened proposals, given the significant economic damage that can be done by high profile business collapses.

A group of leading investors recently backed the stronger Sarbanes-Oxley measure, noting that ‘the cost — £2.3bn spread over 10 years — sounds high but is less than a tenth of a per cent of the £2.6tn market value of the FTSE All-Share. The annual ongoing cost would be less than 0.004% of the £5 trillion plus enterprise value of the index’.

The investors concluded by saying that they ‘support the government’s interest in fostering a healthy business environment and that is what the proposed reforms aim to do. So 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’.

Such sentiments were also recently echoed by John Wood, chief executive of the Chartered Institute of Internal Auditors, who wrote to business secretary Kwasi Kwarteng making the case for more stringent reforms, arguing that merely including the proposal in the corporate code ‘would not carry the same weight, opening up the possibility of evasion and make it more difficult for the audit regulator to enforce’.

He also made the vital point that ‘whether it is BHS, Carillion or Patisserie Valerie, the significant costs associated with corporate collapses linked to job losses, audit and corporate governance deficiencies cannot be overstated’.

The audit industry also has good reason to fear that the government’s reluctance to implement a robust Sarbanes-Oxley measure will result in auditors carrying the can in terms of liability in any future collapse.

The failure to reduce risk for auditors undermines the objectives set out in the 2019 in the Competition and Markets Authority (CMA) report on the UK’s audit market. This report called for smaller ‘challenger auditors to shake up the market and end the dominance of the Big Four’. Yet when the legal risks remain very high for auditors, only the Big Four have the financial heft and expertise to take on audit work for the largest UK companies.

Future of audit regulator

Furthermore, the market is still awaiting the finer details regarding the UK’s new auditing regulator, Audit, Reporting and Governance Authority (ARGA), which is due to replace Financial Reporting Council (FRC). It was touted as a more potent regulator, with enhanced regulatory and investigative powers. However, even before its launch, it is already becoming clear that ARGA will have authority over fewer companies than was initially envisaged.

The milder approach to governance now envisaged seems to be that company directors will merely be obliged to make an annual statement about the effectiveness of controls under the UK’s Corporate Governance Code. Such requirements may prove difficult to enforce, and it appears that companies will be able to opt-out and not comply, once they can satisfactorily explain why this is the case under comply and explain rules.

It seems bizarre, however, that only the premium listed companies will be required to comply, when these entities already have strong controls and governance in place. The government wants to include the oversight of large private companies within the new auditor’s remit. However, some of these businesses may well fall outside the scope of regulation.

This retreat from improving governance is a missed opportunity. The reality is that good corporate governance does not need to be unduly cumbersome or costly. In the long term, companies can seek to improve the accountability of internal control, rather than emphasising a reliance on external auditors. For now, those concerned with effective corporate regulation in the UK can only hope that the government will heed the many voices calling for it to implement a robust and effective regime.

Published in Accountancy Daily – 6 December 2021