Our response to Government audit reform proposals

We summarise below the key messages in our response to the Government consultation on Restoring trust in audit and corporate governance which closed on the 8 July.

Overall comments

We are genuinely excited by the opportunities that the proposed reforms present to the audit profession and all stakeholders interested in high-quality financial reporting. The package of reforms is unprecedented in its breadth. It represents a tremendous opportunity for all parties to work together for the public benefit and to truly restore trust in financial reporting in the UK. However, it is important to ensure that a balance is struck between ever-increasing regulations and the need for British businesses to remain competitive as they recover from the joint shocks of COVID-19 and Brexit.

In our view, it is essential that all parties involved in the Financial Reporting Ecosystem are fully engaged to ensure successful implementation of reform. Only by all parties (audit and financial reporting standard setters, regulators, auditors, shareholders and companies/directors) actively engaging in these reforms can we truly restore trust in audit and corporate governance.

In that context, we are particularly pleased that this consultation is about much more than simply audit reform. We are fully supportive of the need to undertake reforms to restore trust in our profession, which has been discussed for some time. Reforms of aspects of Corporate Governance, along with an enhanced and engaged regulator, are also critically important to successfully restoring trust in financial reporting. We are also pleased to see proposals to give the regulator enhanced powers over Audit Committees and Company Directors. We believe that a greater emphasis on the role of directors and company boards, along with enhanced requirements on auditors and the introduction of internal control reporting and assurance, have the potential to bring about real change.

However, whilst we understand the need to focus on trust in financial reporting for Public Interest Entities, and the emphasis of the Government’s proposals on the largest entities on the FTSE market, it is disappointing to see that the interests of SMEs, which form the bedrock of the UK economy and in many ways are of just as much public interest, are not addressed in the proposed reforms. Furthermore, the needs of public sector and not for profit entity auditors are not considered, other than in the context of identifying potential entities to be included in the broader PIE definition. We are particularly concerned that the development of auditing standards and other requirements relating to the corporate auditing profession will focus solely on Public Interest Entities and we fear that this may lead to the exaggeration of a “two tier” audit profession in the UK, which would be a huge missed opportunity.

Our responses to some of the key areas covered in the consultation include:

  • Expanding the Public Interest Entity (PIE) definition – A global review of the PIE definition is underway and includes more qualitative factors like the important of an entity to its sector and the potential impact of a company’s failure, neither of which are addressed by the Government proposals. Any changes made the UK definition should be made with the global revision in mind. Furthermore, we do not support the inclusion of large third sector bodies (e.g. large charities and universities) in the PIE definition as it is not clear that the proposals in the consultation and the associated benefits are proportionate for such entities.
  • Internal controls frameworkWe believe that introducing a form of “UK-Sox” would be a step forward in enhancing trust in corporate governance and reporting, helping to ensure that Directors fully and properly consider the entity’s internal control environment and whether it is appropriate and effective. In our view, to be effective, the proposals should include a Directors’ attestation following their assessment of internal controls supported by a formal audit opinion, as set out in the Government’s option 3. We do question, however, the benefits of such a regime for all PIEs given the proposals to expand the PIE definition.
  • Regulator powers over company directorsWe are pleased that the proposals include greater powers for ARGA over company directors, particularly in relation to corporate reporting and audit, and that these powers apply to all directors rather than just those directors who happen to be members of professional bodies. Furthermore, we support the proposals for the oversight of audit committees.
  • Scope of the auditThe wider scope of the audit, and regulation, is in line with our own vision for the future of audit of all entities, not just PIEs, where audited entities should be able to, and be encouraged to, obtain the assurance they need over their areas of risk rather than be constrained by a financial statements audit carried out in accordance with international auditing standards. As with much of the consultation, however, the devil will be in the detail of how the reforms will be implemented.
    • The new “Corporate Auditing Profession” appears attractive instinctively, but without clarity as to its scope and remit, it is difficult to conclude if it is appropriate. For example, we believe that it is important to avoid a two-tier audit profession where there is the “Corporate Audit Profession” for the largest PIEs but a different profession/professional bodies for auditors of the rest of UK plc, as well as the third and public sectors.
    • It is important that the regulator’s powers and, in particular, the quality inspection regime must be expanded to cover the wider auditing services proposed and to all providers of “corporate audit” services, including new providers not currently subject to regulation and quality inspection.
    • We broadly agree with the principles of corporate auditing and we consider that the proposals are broadly similar to existing informal principles and underlying behaviours in auditors today. To that end, we do not believe the establishing these principles will make much difference in practice, other than perhaps in public perception. These principles should apply to all corporate auditors, not just existing audit firms.
  • Tackling fraud – The reform package in general, and in particular relating to fraud, needs to ensure an appropriate balance of responsibilities between Directors, auditors and regulators to avoid just making more work that adds little value. We are concerned, however, that the fraud proposals are an area where unrealistic expectations may be raised given the relatively restricted changes proposed. As with the recent FRC proposals to revise ISA 240, we believe that the changes proposed won’t really make a significant difference to what auditors and companies do in reality; the risk then lies in the extent to which these changes are trumpeted as being a big change. We are fearful that these proposals will be put forward as, and/or may be perceived to be, the solution to the sort of corporate failures we have seen in recent years, and we do not believe that this will be borne out in reality.  Auditors are already doing more on fraud, through enhanced training, better use of advanced technology etc. and raising expectations further may not be beneficial.
  • Audit of alternative performance measures and KPIs – Although there are inherent challenges around the consistency of such information produced by companies, given that they should reflect those matters of interest to each individual entity, we believe that this is an area which would benefit from assurance. We are disappointed that there aren’t more requirements in the proposals relating to this issue.
  • Auditor liability – the consultation focusses on the impact of legal liability on audit firms and whether it restricts audit innovation. However, the proposals fail to recognise the regulatory liability which is a key factor in restricting innovation and choice in the PIE audit market.
  • New professional body for corporate auditors – In principle it is easy to see why a distinct professional body for corporate auditors might be an attractive solution to any issues with audit quality. However, the Brydon review and these proposals show a lack of clarity as to how such a professional body should be established and how it would deal with the different requirements of statutory auditors and other corporate auditors. Unfortunately, this lack of clarity in the proposals makes it impossible to conclude whether or not such a professional body would indeed drive better audit.
  • Shareholder engagement with the audit several of the proposals are intended to drive greater shareholder engagement with the audit. We are sceptical, however, as to whether there is a great deal of appetite from the investor community to engage effectively with the audit.
  • Managed Shared Audit – Our preference is for sole appointment of a challenger firm to FTSE 350 entities where this is feasible, rather than a managed shared or joint audit. We have experience of successfully delivering audits to FTSE 250 entities, although we acknowledge that this is not always realistic, especially for the more complex international groups.  Regarding the proposals:
    • We are strongly of the view that managed shared audit is preferable to joint audit in the UK legal and regulatory framework and we are pleased to see joint audit has been dropped from these proposals. There are many reasons, in addition to the often-quoted auditor liability issues, why joint audit wouldn’t work in the UK legal and regulatory framework without other fundamental changes to company law and regulations.
    • Shared audits are already successfully delivered in cases where challenger firms undertake the audit of significant components of larger listed entities which are audited by the big 4 (e.g. Ford, Goldman Sachs, JP Morgan). The new element in these proposals relates to the “Managed” aspect of shared audits and it is important that the introduction of arrangements to manage shared audits doesn’t stifle existing arrangements and innovation. However, as currently set out in the consultation there is a lack of detail which makes fully supporting managed shared audit as the solution difficult at this stage. It is clear whether managed shared audit would:
      • be attractive to challenger firms,
      • make a difference to competition in the market, or
      • be achievable in reality.
    • It is unclear whether the introduction of managed shared audit in and of itself will be sufficient to drive the changes in the market which the Government desires. (See our comments/concerns set out above). As a result it possible, if not likely, that a market share cap may be needed in the future, and we agree that it is appropriate for proposals for a managed market share cap to be set out here.

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If you would like further guidance or to discuss in more detail these new audit requirements, please contact your local MHA member firm.