Newsflash: The future of audit and the FRC – three announcements

Three announcements were issued on 18 December 2018, regarding the future of audit and of the audit regulator, the Financial Reporting Council (FRC), in the UK:

• Sir John Kingman has published the report and recommendations arising from his review of the FRC, “Independent Review of the Financial Reporting Council” (the Kingman Review). 
• The Competition and Markets Authority (CMA) has published an update paper on its review of the audit market, “Statutory audit services market study”, putting six remedies out for consultation.
• The Department for Business, Energy & Industrial Strategy (BEIS) has announced a new independent review into the quality and effectiveness of the UK audit market as part of the Modern Industrial Strategy to build a Britain fit for the future through a stronger, fairer economy, to be chaired by Donald Brydon (the Brydon Review).

Among other responses, Rachel Reeves MP, Chair of the BEIS Select Committee, has noted that the Committee will be launching an inquiry into the future of audit early in 2019.

David Sproul, Senior Partner and Chief Executive of Deloitte North West Europe, said:

“We need a competitive, high quality audit sector that works for shareholders, wider society and businesses, and maintains the UK’s position as a leading capital market.

“It’s clear that trust and confidence in the role of the profession is not where it should be and we are supportive of change that enhances audit quality and maintains the competitive position of the UK as we prepare to leave the EU.

“This is a critical moment for the profession in the UK and internationally. The CMA provisional findings, the Kingman review and the announcement of the Brydon Review (formerly known as Project Flora) offer a unique opportunity to develop an audit market and structure that meets the needs of 21st century stakeholders.

“We will carefully analyse the detail within the CMA proposals and look forward to working with the CMA in conjunction with the findings of the other reviews to develop a world-leading profession in the UK.”

Read the Kingman Review

Read the CMA’s update paper

Read the BEIS announcement on the Brydon Review

Read the statement from the Chair of the BEIS Select Committee
 

The Kingman Review

The report on the FRC includes 83 recommendations. Many of these centre on replacing the FRC as it now stands with a new independent regulator called the Audit, Reporting and Governance Authority and the powers, objectives, duties, funding, staffing arrangements and governance structures of this new body.

Other key recommendations include:

• expanding the volume of corporate reporting review team (CRR) work, with powers to review the entire annual report including corporate governance, plus public reporting of CRR findings and related correspondence and the legal power to direct changes to accounts rather than going to court (Recommendations 24-26, 29);
• enhancing the enforcement regime over company directors, in particular with relation to the CEO, CFO, Chair and audit committee chair, enhancing the power to investigate directors (even those who are not accountants) and to refer cases to the Insolvency Service where disqualification may be warranted (Recommendations 36-38);
• a recommendation that the Government introduces a duty of alert for auditors to report viability or other serious concerns (Recommendation 45);
• recommendations for involvement with companies, including that the new regulator should be able to require rapid explanations from companies, to commission skilled person reviews in certain circumstances and to publish these if in the public interest, to require companies to procure additional assurance or independent evaluations, to order the removal of the auditor and, in the most serious cases, to issue a report to shareholders (Recommendations 46-50); and
• recommending that BEIS should consult on the case for a strengthened framework around internal controls in the UK, learning any relevant lessons from the operation of Sarbanes-Oxley in the US (Recommendation 51).

The final recommendation is that, as a priority, the FRC and the Government should work to identify and agree a set of measures and related timetable that can be implemented in the short term, in advance of tabling primary legislation.

The Review also strongly welcomes the proposal that a piece of independent work should be done to explore the issues arising from the audit expectation gap. This will be an area of focus of the Brydon Review.

The CMA remedies

The CMA’s update paper sets out its work so far along with six potential remedies and the comments received on those remedies to date. It asks 27 consultation questions and asks for responses no later than 5pm on 21 January 2019. Responses should be sent to statutoryauditmarket@cma.gov.uk.

In summary, the issues the CMA seeks to address are:

• selection and oversight of auditors;
• choice;
• firms’ structure; and
• regulation – although on regulation, the CMA cites and defers to the Kingman Review and its findings.

The CMA is likely to make recommendations to Government at the end of the market study, rather than to put in place its own order, because it believes that legislation would be likely to see the remedies implemented, monitored and enforced more effectively, and would enable a broader set of remedies. It also highlights the importance of Government involvement given the need to assess how other reforms under, for example, the Kingman Review, would work together with the CMA’s remedies.

The six potential remedies are:

1. Regulatory scrutiny of audit committees
   
   Audit Committees should be subject to specific regulatory requirements and obligations. The CMA’s current view is that this regulation should include:
   1. a requirement that Audit Committees report directly to the regulator before, during and after a tender selection process. The regulator would also have the ability to include an observer on all or a sample of Audit Committees
   2. a requirement that Audit Committees report directly to the regulator throughout the audit engagement; and
   3. the ability for the regulator to issue public reprimands or direct statements to shareholders.
      
      The CMA notes that this remedy should apply to at least all FTSE 350 Audit Committees
2. Mandatory joint audit
   
   The CMA’s provisional view is that joint audit would increase competition without risking audit quality:
   1. the main aim of this remedy is to reduce the barriers facing challenger firms (defined as a group of audit firms that are not the Big Four audit firms). The CMA’s preferred way of achieving this would be by mandating that at least one of the audit pair is a challenger firm;
   2. this remedy should at least apply to FTSE 350 companies – perhaps with some limited exceptions where the nature of the company would not sensibly justify a joint audit; and
   3. each joint auditor should have to be granted a significant proportion of the audit work. The minimum proportion to be assigned to any joint auditor might vary across the FTSE 350 companies and over time to allow challenger firms to build their capacity.
      
      The CMA notes that implementation of market caps may be an alternative answer if joint audits are not adopted.
3. Additional measures to reduce barriers to challenger firms
   
   The CMA favours prohibiting or limiting the length of non-compete clauses as these make it harder for audit partners and staff to switch firms. Partner switching is necessary for challenger firms to build their capacity.
   
   It notes that a number of other measures such as technology sharing warrant further consideration.
4. Resilience regime
   
   The CMA is concerned about further concentration in the market and wishes to develop an effective resilience regime to avoid further reduction in the number of the largest audit firms, “to avoid going from the Big Four to the Big Three”.
   
   This remedy should apply to at least the Big Four. It may also be appropriate for some large challenger firms to come within scope as they grow in relative size.
   
   It calls for views on design of such a regime as part of its consultation.
5. Full structural or operational split between audit and non-audit services
   
   The CMA identifies issues regarding profit pooling, decision-making based on non-audit services factors, underlying cultural concerns, and risks arising from a history of collaborative working between audit firm and company. It prefers a split between audit and non-audit services to further restrictions on non-audit services because of the impact further restrictions could have on choice.
   
   The CMA notes that full separation would be an effective remedy. However it has a view that an operational split could be manageable, for instance, a separation of audit from non-audit with respect to management and reporting. This is an area on which the CMA seeks feedback through its consultation.
   
   This remedy would apply to at least the Big Four and could be applied to challenger firms as well.
6. Peer review
   
   The CMA’s provisional view is that an important element of the regulator’s toolkit should be an independent peer reviewer to improve audit quality by introducing an additional, independent quality check.
   
   The regulator should have the ability to determine the scope of the peer review function, perhaps initially targeting this at companies that it considers high risk or which require additional scrutiny.
    

The Brydon Review

Donald Brydon, Chair of the Sage Group and outgoing Chair of the London Stock Exchange, has been appointed to lead a review into UK audit standards. This is part of the Modern Industrial Strategy to build a Britain fit for the future through a stronger, fairer economy. A detailed terms of reference and project plan for the Brydon Review will be published in the New Year.

The review will test the current model and ask how audit should be developed to better serve the public interest in the future. It will consider:

• how far audit can and should evolve to meet the needs of investors and other stakeholders, putting the UK at the forefront;
• how auditors verify information they are signing off;
• how to manage any residual gap between what audit can and should deliver; and
• what are the public’s expectations from audit.