Last year was something of a banner year for corporate reform. No fewer than three landmark reports arrived, aiming to tackle not only the growing concerns over Britain’s corporate governance rules and the competitive balance in the audit market but also, now, the way auditors work.
When Sir Donald Brydon’s report into the quality and effectiveness of audit was published just before the 2019 Christmas holiday period, it was met with a cautious welcome. “Sir Donald’s thorough report contains some bold proposals that could change the way the accountancy profession operates within the UK business landscape,” ICAEW CEO Michael Izza said at the time. “We agree that audit urgently needs to keep pace with the needs, not just of investors, but of wider stakeholders in society, and we are long-standing advocates of proportionate and practical change to restore public trust.”
That trust had been undermined by a series of high-profile corporate failures - including BHS, Carillion and Patisserie Valerie. Parliamentarians, such as Rachel Reeves MP and her Business Select Committee, have been quick to criticise what they saw as the role of audit in these collapses. The issue here is that the audit, even properly conducted, no longer meets the needs of shareholders and wider stakeholders - the so-called “expectation gap”.
Sir Donald’s proposals are set alongside two other significant landmark reports. Last March the government welcomed the recommendations of the Kingman Review into overhauling the accountancy watchdog, the Financial Reporting Council (FRC), announcing its intention to set up the Audit, Reporting and Governance Authority (ARGA). The new regulator, ministers said, would “have strategic direction and duties to protect the interests of customers and the public by setting high standards of statutory audit, corporate reporting and corporate governance”.
In quick succession, the Competition and Markets Authority (CMA) issued its findings on choice and resilience in the UK audit market. One of its headline recommendations was to require the Big Four firms to split their audit and non-auditing businesses, requiring, “Separate management, accounts and remuneration: a separate CEO and board for the audit arm; separate financial statements for the audit practice; an end to profit-sharing between audit and consultancy, and promotions and bonuses based on the quality of the audits”.
Three groundbreaking reports later, where is the UK audit market heading? Christopher Humphrey, Professor of Accounting in the Accounting and Finance Division of the Alliance Manchester Business School, says Sir Donald offers a chance to fundamentally rethink the purpose of audit – what it’s for, why it exists, who is being served, and who is accountable.
“I think Sir Donald is trying to say you’ve got to reinvigorate auditing because he’s clearly talked with a wide range of people, young and old, and I don’t think the view is massively positive,” says Humphrey, who also served on the Brydon Review advisory board.
Central to the report is the need for audit to become more integrated into the overall financial reporting landscape, less boxed off and more holistic. He also suggests that a rethink of audit should lead to it becoming something more than the statutory audit of financial statements. It should, he says, include more non-financial information as well as “original material” such as information generated by the auditors themselves.
Humphrey is optimistic that the report reflects Sir Donald’s positive view of audit’s role. “I think he is saying, “Well, I believe audit is vital. I believe it has a role to play” and I think the one thing that was really striking is that he said auditors are in a unique position; the level of access they have is unique, so they can do so much with that.”
The intention, Humphrey says, is for reform to create a situation where users of accounts have greater confidence in a company’s ability to serve the public interest, manage its risks and take better long-term decisions. “And some of that will come from audit but it won’t just come from the audit of financial statements as you’re currently doing it.”
Sir Donald clearly hopes his work will create a once-in-a-generation opportunity for genuine reform. However, Nigel Sleigh-Johnson, Director of ICAEW’s Technical Strategy Accountability Group, says implementing the recommendations won’t be a quick or simple process. “The best thing we can do now is to take some time to reflect on two things,” he says.
“First, we need to think about what the reform programme would involve; but also there are some really good ideas in there that we as an Institute and others could use to start to make some changes ourselves, either through hosting debates or developing guidance and thinking for our members, without necessarily waiting for the machinery of government to get in motion, which can be slow.”
There are fears that, despite the government’s acceptance of Kingman’s call for a new regulator, a regulatory vacuum may develop as the wheels turn slowly. “That’s why we want to see the formation of ARGA as the priority,” says Daniel Ellis, Policy and Public Affairs Manager at ICAEW. “It’s encouraging that it features in the Queen’s Speech because we need that new regulator to help restore investor confidence and public trust in audit. Beyond that, the focus has to fall on improving audit quality.”
But, as Ellis points out, while audit reform is vital, the wider issue that Sir Donald points towards is improving the UK’s corporate governance rules generally. “That’s a question of where audit fits into efforts to bolster internal controls, empower shareholders and hold directors to account.”
There’s no doubt that fundamental reform is overdue. From the practice perspective, Phil Shohet, Senior Consultant at Foulger Underwood, says that recent high-profile corporate failures and scandals have shown some large audits to be unfit for purpose. “If you look at some of those failures, what has been produced by the audit is not quite a waste of time – something’s better than nothing – but it’s almost incredibly misleading in many regards. Unless you can correct that, there’s no point in finding new auditors or shared auditors for some of the other projects if the end product is less than useful. And it’s got to get back to the end product.”
Shohet accepts that the audit profession alone cannot solve the problem. “Investors, regulators, politicians and bankers share some fault, not simply companies and accountants. They must all have a contribution to make for fixing this sector.”
Lisa Weaver, Associate Professor at Warwick Business School, says: “Auditors get it in the neck all the time for things they aren’t actually responsible for, so developing a better understanding of what auditors do is the key to it all. If the clearer wording that Sir Donald suggests, and the improved understanding, is effective, then the profession won’t get beaten with a big stick every time a company collapses.
“And that links to the liability issue which the industry is clearly concerned about,” Weaver says, pointing out that the number of firms doing audit work is shrinking slowly but surely every year.
Whatever the next step, ICAEW’s Ellis believes the opportunity for substantive change has to be grasped.
“Ultimately, we want to get it right – that has to be the overarching principle,” he says. “And no one – government, the profession or investors – wants to be having this debate in 10 years’ time. We want to get it right this time.”
Audit report: a timeline
January 2018: Carillion collapses. BEIS Select Committee launches joint inquiry alongside the Work and Pensions Select Committee. The joint inquiry takes oral evidence from the Financial Reporting Council (FRC) and the Insolvency Service.
April 2018: The Department for Business, Energy and Industrial Strategy launches an independent review into the FRC which will be led by Sir John Kingman, Chairman of Legal & General PLC and former Second Permanent Secretary to HM Treasury.
October 2018: The Competition and Markets Authority (CMA) announces a formal Market Study into the statutory audit sector and launches an invitation to comment. Alongside this, then-Business Secretary Greg Clark asks Sir John Kingman to extend his review to look at auditor procurement and remuneration. ICAEW submits written evidence to the CMA’s Market Study.
December 2018: Sir John Kingman publishes his review on the FRC and auditor procurement and remuneration. Professor Prem Sikka publishes his report on Reforming the Auditing Industry.
April 2019: The BEIS Select Committee issues its Future of Audit report on 2 April 2019. Rachel Reeves, BEIS Select Committee Chair, gives a keynote speech at ICAEW discussing the report and its recommendations.
July 2019: Greg Clark gives a speech on competition in which he announces a consultation on the CMA’s recommendations, and that Sir Jonathan Thompson will be the next CEO of the FRC.
December 2019: The government announces in the Queen’s Speech that audit reform will be part of a forthcoming Employment Bill. Sir Donald Brydon publishes his report on audit quality.
Brydon: the key points
“The purpose of an audit is to help establish and maintain deserved confidence in a company, in its directors and in the information for which they have responsibility to report, including the financial statements,” the report states. However, it says reformed audit should involve the need for auditors to provide decision-useful information to users of audit reports. Sir Donald suggests that information should sometimes include original information.
“ARGA should facilitate the establishment of a corporate auditing profession based on a core set of principles,” Sir Donald says in the report. “ARGA should be the statutory regulator of that profession. In doing so, I recommend that ARGA determines a framework for all corporate auditing, whether of financial statements or of other information.”
The report advocates building on the existing concept of professional scepticism, and calls for auditors to approach each audit with “professional suspicion”; that should, he suggests, help auditors to deliver “deserved confidence” in the company’s performance, leadership and controls.
Sir Donald also recommends that audit reports should include a new section in which the auditor states whether the director’s section 172 statement is based on “observed reality”, grounded in the auditor’s knowledge of the company and its processes. This would extend the concept of auditing to areas beyond financial statements.
Echoing Christopher Humphrey’s call for audit to be more of a joint venture between stakeholders, the report recommends setting a mechanism to give shareholders the opportunity to propose any issues they want to see covered by the audit. Sir Donald also suggests a standing item on audit at the company’s General Meeting, which he believes will encourage greater interaction and questioning of the Audit Committee Chair and the auditors.