UK report reveals radical proposals for audit reform
New requirements for auditors and boards of directors
A broader duty of disclosure, more obligations to detect fraud, and comprehensive transparency regulations are just some of the recommendations made in the Brydon Report. British audit regulators are pushing for an operational separation of major auditors, thereby fueling the debate on the future of the auditing business.
Authors: Alessandro Miolo, Managing Partner Audit & Assurance; Chris Krämer, Partner Audit & Assurance
The British government responded to the company collapses in 2018 at department store chain BHS and construction company Carillion by commissioning three independent reviews of the current state of the audit market. The Brydon, report published shortly before Christmas 2019, is the last of the three reviews.
The two other reviews had already been published. The Kingman Review published in December 2018 dealt with the supervision of British audit companies; and the British Competition and Markets Authority (CMA) reported in April 2019 on the state of play with regard to competition in the British audit market. These reports proposed a number of sweeping changes in the audit market, including the creation of a new supervisory authority, joint audits, and a greater separation of auditing and consulting services in the Big Four.
The Brydon Report, containing personal recommendations by Sir Donald Brydon, former chair of the London Stock Exchange, focuses on audit quality and effectiveness and makes a total of 64 recommendations. Brydon is calling for nothing less than a realignment of the audit industry. The report deals exclusively with audit in the United Kingdom; however in view of the international focus of many companies and audit firms and the existence of international auditing standards, the recommendations in the report will have relevance to auditing in other countries of the world.
The report states that the purpose of auditing a company’s financial statements should be to help build and maintain trust in the company, its board of directors and the reporting process itself. However, Brydon recommends more extensive reporting and auditing of information. The report proposes measures that could be described as radical, with implications for both audit firms and the companies they audit, or rather their boards of directors. The recommendations include the following:
- More extensive reporting in respect of the going concern statement
Auditors already include within their audit strategy and planning an examination of early warning signals that a company’s going concern status might be under threat, both external signals such as a sharp fall in share price or sustained negative media coverage and internal signals, such as a downgraded credit rating or a breach of covenant in credit agreements. Brydon recommends that in future, auditors should report on any such signals they have identified, and the audit procedures that they have implemented.
- Detecting fraud as part of the audit
Brydon considers that one of the main reasons for the gap between the public perception of an auditor's role and what the auditor's legal responsibilities actually are arises from expectations about identifying and reporting on fraud n client companies. He therefore recommends that the relevant auditing standard (ISA 240) should be amended to state clearly that it is the auditor's responsibility to structure the audit in such a way that material fraud is detected. Auditors should be trained regularly and more extensively in forensic accounting to aid in the detection of fraud.
At the same time, the report recommends that the boards of directors of audited companies should report annually on the actions they have taken to prevent and detect material fraud, and that the information provided should be audited by the statutory auditor. The audit report should disclose what has been done to obtain assurance on the directors’ statement on material fraud, and what additional procedures have been taken to assess the effectiveness of relevant controls and detect material fraud.
- Greater transparency
The Brydon report recommends that auditing fees should be shown in the profit and loss statement of the audited company, instead of appearing only in the notes to the financial statements (as has hitherto been the case) and that the audit report should disclose details of the hours spent on each audit by each grade of staff within the audit team. Brydon also advocates that audit fees should not be a relevant factor when it comes to determining management compensation. Furthermore, the hours spent on each audit per employee level should be indicated in the reports.
Companies that report additional KPIs (known as Alternative Performance Measures) other than those required by accounting standards, or who use them to calculate management remuneration, should also have these metrics audited. Brydon also calls for a clear separation within the audit firm between the audit team and the team responsible for negotiating the audit fee. In addition, audit firms should be required to publish information about the profitability of their audit work and the remuneration earned by their senior statutory auditors, including the basis for calculating this remuneration.
Audit companies, audit clients and supervisory authorities are in agreement that changes to the auditing of financial statements are inevitable to ensure the continued relevance, quality and effectiveness of auditing. The UK government is expected to make recommendations over the coming months, but regulatory authorities are already driving forward with some of the suggested reforms. The focus here is on increasing the independence of the audit business – among other things by creating separate, independent boards of directors for the audit business and improving financial transparency between auditing and other activities. In the coming months, audit firms and their stakeholders in the United Kingdom and the rest of the world will have to discuss what additional measures they need to take to make sure they are ready for the future.