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Will ARGA restore trust in audit?

A new mandate, new leadership and new powers: ARGA could be the vehicle to restore trust in audit and robust reporting. But, asks Alison Coleman, will it work?

Last December, having backed some of the key recommendations in the Independent Review of the Financial Reporting Council (FRC), led by Sir John Kingman, the UK government set the wheels in motion to replace the UK regulator with the Audit, Reporting and Governance Authority (ARGA), a new independent body with a new mandate, new leadership and stronger statutory powers. While the move has been broadly welcomed across the industry, it has prompted debate and raised some concerns about how ARGA’s remit will differ from that of the FRC, the extent of its role, and crucially, where the improvements will lie.

John Boulton, technical strategy manager at ICAEW, says: “We feel it is very important that the new regulator is set up so that it can be a success. There are strong expectations that it needs to be much more robust in helping to avoid disorderly corporate failure that is the result of having insufficient information.

People expect more transparency and clarity in the market, and that is an area where reporting can be said to have fallen down, so the new regulator needs to be more effective in helping to ensure that information is more robust. “However, we also think that the ambition and scope of ARGA should be very carefully defined so that it is in the best position to achieve that. The new regulator should not be overburdened, and careful thought is needed in terms of how this will be achieved.”

There is a widespread view across the industry that ARGA will be expected to be more interventionist than the FRC, and to take firm action in the event of default. Whether or not this is realistic is a different question, says Peter Swabey, policy and research director at ICSA: The Governance Institute. He believes that one of the challenges for those in the accounting profession is what has become known as the ‘expectation gap’; the difference between what the public, politicians and some elements of the media believe auditors can do and what an auditor would argue they are supposed to do.

Swabey says: “For me, the jury remains out on what ARGA will be able to do about that; some of the expectations will be very difficult to deliver. The area where I think they will be able to take firmer action is around what I call the ‘delivery gap’; the difference between what an auditor would say they are supposed to do and what in a small minority of cases the auditor seems actually to have done. To be fair, the FRC has been quite robust on these cases within the limit of its powers and so it is the question of the power to act that is most important here.”

Another issue that has been raised is the fact that so many of the proposed changes have come on the back of criticisms of audit. “It seems to be accepted that by having a more stringent regulator you will solve all audit problems,” says Nigel Hughes, former chair of ICAEW’s Practice Committee and owner of training and consultancy business Totteridge Associates. “The legal framework for audit was set out centuries ago, and so the sensible thing would be to deal with that first. We have the public consultation into the quality and effectiveness of audit led by Sir Donald Brydon underway. A rethought version of the audit; what it is and what it’s for, would clearly have implications for the profession, and, I suspect, for other work that people do.”

Hughes has also identified some inconsistency in Kingman’s findings. He says: “He complains about financial reporting not being brief enough and not understandable enough, and suggests that this comes from the reporting standards that were set. Yet he won’t do anything about the standard setting side of the FRC in moving it into ARGA. If there is a problem with the standards then the standards need changing, and just setting up a regulator on a more sensible foundation isn’t going to achieve that.”

One of the most significant recommendations is for the new regulator to have the power to investigate company directors. Currently the FRC only has jurisdiction over those with an accounting qualification. ARGA’s jurisdiction will extend to all CEOs, CFOs, chairs and audit committee chairs, regardless of their qualifications. Directors could become responsible for certifying the material accuracy of the financial statements. “It is absolutely right that ARGA has this remit if it improves governance,” says Boulton. “Directors have a series of duties under the Companies Act and it is absolutely crucial that those are effectively carried out. Giving the regulator powers to ensure that those duties are properly discharged has been part of the vision that John Kingman has set out and something that we support. “But there are some real issues to be tackled and everyone needs to work together, including ICAEW, as a regulator of professionals, to achieve that.”

However there are some unintended consequences of the regulator’s ability to call for the removal of board members, including the potential impact on share value and business growth, as Mark Freebairn, partner and head of the financial management practice of Odgers Berndtson, points out. He says: “You could argue that if you work in a capitalist model then you accept that you are going to allow greater risk for greater reward. But if you allow greater risk, you have to accept that there’s going to be failure. You can’t have risk without failure. If a business is too scared of the regulator, will they push the risk element hard enough to drive strongest growth? It is a challenge that needs to be thought about carefully. The last thing they want to do, at a time when things are difficult for business, is create an even more challenging environment for businesses to operate in.”

Matthew Howells, partner at accountancy firm Smith & Williamson, says that while it is right that advisers are held to account for genuine failures of professional behaviour and competence, corporate failures are seldom caused by poor auditing alone. “ARGA should continue the FRC’s work in providing positive examples of good practice and thinking about what works, as well as highlighting poor practice and what doesn’t work. The audit profession has come under intense scrutiny, and while no profession should be exempt from such scrutiny, those who regulate it should be mindful of the dangers of constant negativity.

“It risks making audit an unattractive profession to those already in it and those who might otherwise have considered entering it, and it would be disastrous if a downward spiral was started whereby firms cannot attract and retain the right talent to be able to perform high-quality audits. This is an opportunity for the profession to reset itself positively, and I believe it is important that the regulator shares that objective and mindset.” While corporate directors are understandably concerned about the implications of an expanded mandate from ARGA into their own performance and behaviour, Karthik Ramanna, professor of business and public policy and director of the Master of Public Policy Programme at the University of Oxford’s Blavatnik School of Government, believes that in particular it is non executive directors (NEDs) who have a special responsibility here.

“There is a perception that NEDs have played a relatively inactive role in UK corporate governance,” he says. “It’s true that NEDs in this country are paid substantially less than those in the US, so perhaps less is expected of them. If there is an expectation that NEDs should be playing a more active role and playing more of a governance role, which will be overseen by ARGA, we will need to see a fundamental re-evaluation of the way that NEDs are recruited in the UK and compensated.” ARGA is also set to be the guardian of the UK Corporate Governance Code, a move that some bodies disagree with and maintain there should be a separate commission for this role. ICAS’s Swabey argues that it is a good move because the FRC’s corporate governance team has developed significant expertise in this area and established close ties between governance and reporting.

He says: “For this reason I don’t agree with those who propose a separate ‘companies commission’. It would create additional bureaucracy and potentially create confusion between the different obligations. The only potential issue in my view is the degree of priority that governance has in the new regulator; it has sometimes seemed to attract a relatively small part of the FRC’s resources. It needs to be recognised at ARGA as both equally important to the accounting responsibilities but also different. The ‘comply or explain’ model needs to be protected.” The recommendation that ARGA should produce less guidance than the FRC has taken some by surprise. Those best placed to produce guidance must surely be those responsible for promulgating the requirements.

“Without such guidance, conflicting interpretations will inevitably develop,” says Matthew Howells. “This is sometimes, correctly, said to be what happens with the proper exercise of professional judgement, but the problem comes when firms are then criticised by the regulator for not coming to the same judgement as them. “If there is to be less guidance from ARGA, it will be more important than ever for them to communicate their expectations clearly to users, preparers and advisors alike.” His main concern, however, is the danger of ‘trickle down’ within the audit profession. He says: “Remedies that are appropriate at the larger end of the audit market, or for large listed companies, may well be disproportionate for the audits of less complex entities and audits carried out by small and medium practitioners.”

New head of ARGA

Sir Jon Thompson will leave his role as chief executive at HM Revenue and Customs (HMRC) this autumn to oversee the Audit, Reporting and Governance Authority’s transformation. After more than three years as chief executive at HMRC, Sir Jon said: “It’s been a tremendous privilege to lead HMRC so to leave now has not been an easy decision for me to make.” He added: “To have the opportunity to lead the Financial Reporting Council, as it turns into the Audit, Governance and Reporting Authority, and to promote public trust in doing business in the UK, at a point when we’re about to forge new alliances across the world, is too exciting to turn down.”

Sir Jon replaces Stephen Haddrill, who has been the FRC’s chief executive for the past 10 years. Michael Izza, ICAEW CEO, said: “I very much welcome the appointment of Sir Jon Thompson as chief executive of the Financial Reporting Council and, in due course, its successor, the Audit, Reporting and Governance Authority. He is an excellent choice and I have no doubt he will deliver on the vision of Sir John Kingman’s Review for a strong and credible new regulator. Together with the recent announcement of Simon Dingemans as the preferred candidate to be FRC chair and the launch of the public consultation on the Competition and Market Authority’s recommendations on choice and resilience in the statutory audit market, the government is now demonstrating real momentum in getting the process of reform under way.”

Originally published in Economia on 6 September 2019.