What happens when you audit the auditors?

Root and branch reform of the UK’s audit and corporate governance regime is widely recognised as being long overdue. Such reform did come a step closer, after the government’s plans for audit and corporate governance reform appeared in the 2022 Queen’s Speech.

The drive for reform was prompted by a series of scandals, where inappropriate audits were seen as being linked to major corporate collapses, notably KPMG with Carillion and Deloitte with Autonomy.

These dramatic events, combined with the collapses of BHS and Patisserie Valerie, prompted three major reports into the sector, namely 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.

These reports informed a major 2021 consultation paper which incorporated more than 150 recommendations, drawn from these three reports. The scale of the proposed reforms amount to a genuine overhaul of UK corporate governance.

The proposals fell under six primary headings, namely directors’ accountability, the audit process, annual accounts, the audit market, executive pay and dividends. We will soon see if the eventual legalisation matches the level of ambition set out in the consultation paper.

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; and
  • keep the UK’s legal frameworks for major businesses at the forefront of international best practice.

In drafting the legislation, the government should keep these key objectives in mind. There is a real need to restore public and market confidence in the UK audit sector. The UK economy is moving into a time of serious economic uncertainty, caused by factors such as the coronavirus pandemic, inflation, Brexit and the war in Ukraine. Greater confidence in the UK’s audit regime will provide a welcome boost to investor confidence.

FRC replacement needs powers

A key issue is that the Financial Reporting Council (FRC) simply lacks the necessary powers to implement stricter controls which would make directors responsible for any lack of transparency.

We continue to await the detail of the UK’s proposed new auditing regulator, the Audit, Reporting and Governance Authority (ARGA), which is due to replace the FRC. The government intends ARGA to have more potent investigative and regulatory powers.

Mid-tier opportunity?

The government plans to break the market 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 that building capacity among smaller firms would take time. However, an increasing number of FRC investigations into mid-tier challenger audit firms has raised questions about this strategy.

While a more competitive market would be welcome, the most important thing is that a fresh regulatory approach is taken. This should provide clarity to companies, directors and auditors as to precisely what is required of them. It should also give regulators the powers and resources to ensure that the new standards are met.

Of course, a balance must struck between having effective regulatory control and allowing companies sufficient freedom to do business. Unduly light touch regulation can result in poor practice and even fraud.

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. However, unduly stringent regulation can hamper business activity and make the UK a less attractive location for international investors.

Many voices in the UK business sector are calling for more effective regulation. In response to rumours in late 2021 that the government’s proposal to create a UK equivalent of the US Sarbanes-Oxley Act was being dropped, 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 also said at the time that a Sarbanes-Oxley Act-style legislation would ‘underline its importance’ and help to improve compliance. We shall soon see whether this measure makes it into the legislation.

The UK’s audit reforms should be robust and well balanced. This is essential to boost confidence in the UK’s beleaguered audit sector. The ball is now in the government’s court to produce such legislation, which would ultimately also benefit the wider UK economy.