UK Developments
It may seem that Brexit is the only public policy issue currently being debated in the United Kingdom. But there is a surprising runner-up for governmental attention: the regulation and operation of audits.
Multiple governmental inquiries have been undertaken, prompted in large part by the failure of the Carillion Company in 2018, and they could lead to far-reaching changes in the regulation of the UK audit profession, the staffing of the audit, and the structure of the audit firms, among other things. These efforts are reminiscent of numerous studies and regulatory initiatives in the United States over the past several decades that have undertaken full-throttle reviews of the audit function—most recently, the Treasury Department Advisory Committee on the Auditing Profession (in 2008), and the PCAOB’s consideration of mandatory audit firm rotation (in 2011/2012).
Two of the reviews were commissioned by the UK government. The first, a December 2018 review called “Independent Review of the Financial Reporting Council”, also known as the Kingman Review, recommends replacing the UK Financial Reporting Council with a new body called the Audit, Reporting, and Governance Authority, or ARGA. The new regulator would have a much wider range of powers, with greater enforcement authority, than does the FRC, including, in several respects, powers that are similar to those of the PCAOB or SEC. One item of note to public company directors: while the FRC has jurisdiction only over persons with an accounting qualification, ARGA’s jurisdiction would extend to CEOs, CFOs, and committee chairs.
The other commissioned review, called “Independent Review into the Quality and Effectiveness of Audit,” also known as the Brydon Review, was issued on April 10, 2019. It is a “Call for Views” (similar in some respects to what an SEC Concept Release looks like), with a comment period open through June 7, 2019. It examines issues that have been discussed on many prior occasions, such as the “expectation gap,” the “scope and purpose of audit,” audit quality, and auditor liability; as to each of these subject areas the review poses questions and asks for comment.
On April 2, 2019, the Business, Energy and Industrial Strategy Committee of the House of Commons issued its own report, “The Future of Audit,” stating that it endorsed the recommendation to replace the “ineffective FRC” with the ARGA, which would have “increased powers and a more proactive approach.” More dramatically, the Committee endorsed a “full legal separation of audit and non-audit services,” in other words the establishment of “audit-only” firms. The report said such a “structural break-up” would “prove more effective in tackling conflicts of interest and providing the professional skepticism needed to deliver high-quality audits.”
Shortly thereafter, on April 18, another UK governmental body, the UK’s Competition and Markets Authority (CMA), issued its own report, “Statutory audit services market study.” It describes the “deep-seated problems” in the market for audit services: “audit committees are only a partial solution to the problem that companies select their own auditors; high concentration among four big audit firms, resulting in limited choice and a market that is not resilient; audits being carried out by firms whose main business in not in audit.” The report goes on to make two main recommendations. First, it addressed the BEIS’s recommendation of audit-only firms and concluded that “an immediate full structural split” would “carry too many risks.” Instead, it recommended an “operational split”, for the Big Four firms, between audit and consultancy services. This would keep the firms “structurally intact” but would prohibit profit-sharing between the audit and non-audit practice, require separate financial statements for the two arms and separate CEOs and governing boards, and other changes; according to the report authors, this would reduce the “distracting interest” in non-audit work. Second, the CMA would mandate joint audits, where a Big Four firm would be required to work with at least one smaller firm, for audits of most of the UK’s large companies. In addition, the CMA recommended that the newly-constituted ARGA regulator should place audit committees “under greater scrutiny” to make sure that they adequately oversee audit quality.
Comment: Far-reaching changes in the structure of the audit firms and the audit function need to rest on solid empirical evidence that the resulting audits would improve. But there isn’t much, if any, solid evidence that joint audits (which currently are required in some countries, such as France) can improve audit quality or that the break-up of the firms would do likewise. As for the proposal to replace the FRC with a more effective body, this is long overdue and seems likely to move forward. But the most significant element of the reports may be the expectation gap issue, discussed most extensively in the Brydon Review. Changes can be made in how audits are delivered (addressed in the CMA and the BEIS reports) and how they are regulated (addressed in the Kingman Review), but if the product is unchanged and stakeholders expect that auditors will going forward be able to prevent all instances of financial fraud they are likely to be disappointed.
