Newsflash: The Future of Audit – BEIS Committee issues final report

The Business, Energy and Industrial Strategy Committee has issued its final report and recommendations to the Government following an inquiry into the Future of Audit.

Stephen Griggs, Deloitte’s managing partner for audit, said:

“We have been consistent in our support for reform. We need to create a world-leading audit product that works in the public interest, supports the continuous improvement of audit quality and preserves the future success of one of the UK’s leading sectors and the attractiveness of the country as a place to invest.

“We welcome many of the recommendations, including extending the scope of the audit and better regulation of audit, but we have concerns about a potential structural split. This will be detrimental to audit quality and could materially damage the UK’s competitive position as a leading capital market.”

Stephen Griggs has published an article commenting on these developments and looking forward to the audit of the future in the Times, which is available here.

The key conclusions and recommendations are as follows:

The audit product

The Brydon Review - The Committee encourages Sir Donald Brydon to extend the scope of audit to cover the entire annual report (potentially with different levels of assurance and reporting) and to explore how to make audits more forward-looking.

Audit findings - There is a recommendation that the FRC should make graduated audit findings mandatory, i.e. asking for auditors to express an opinion on key management estimates and judgements in the accounts, describing them on a range from cautious to optimistic.

Investor engagement with audit matters - There are three recommendations to increase investor engagement:

• inclusion of a requirement in the new Stewardship Code for investors and asset owners to consider audit matters;
• auditors to present at the AGM; and
• the audit report to be published at the same time as results are announced.

Capital maintenance

Definition of realised profits - The Government and the FRC to produce a clear, simple and prudent definition of realised profits with the Committee expressing clear support for defining realised profits as those that are realised in cash or in assets that can readily be converted into cash.

Accounting of realised profits and distributable reserves - Auditors must be prepared to challenge management on their accounting of realised profits and distributable reserves. Government and the FRC should work together to produce simple and prudent guidance for companies and auditors to follow.

Valuation of goodwill - The Committee strongly supports the Government’s proposals to tighten one of the key capital maintenance rules known as the ‘net assets test’ and to require auditors to take a more critical look at the valuation of goodwill for the purpose of distributions.

Disclosures - It is recommended that companies disclose the balance of distributable reserves in the annual accounts and the break down of profits between realised and unrealised. In addition, it is recommended that directors must state that dividend payments will not make the company insolvent or create cash flow problems.
 

The role of directors

Regulatory scrutiny of the audit committee - The Committee fully supports the CMA’s proposed remedy on greater scrutiny and oversight of audit committees. If this remedy fails to improve the professional scepticism and independence of auditors then the Committee recommends that the potential independent appointment of auditors should be considered.

Accountability - The Committee supports the recommendation from the Kingman Review that all directors, including CEOs, CFOs, company chairs and audit committee chairs, should be held to account for true and fair accounts and compliant corporate reports.

Internal controls - The Committee also supports the Kingman recommendation that there should be a consultation on strengthening the framework around internal controls on a similar basis to the requirements in the US under the Sarbanes-Oxley Act.

The audit profession

Audit rotation - Auditor tenure should be reduced to seven-year non-renewable terms that can only be terminated in exceptional circumstances.

Cooling-off period - The CMA should consider the benefits of a cooling-off period of three years during which non-audit services could not be offered after an audit engagement had ended.

Separating audit from non-audit services - The Committee encourages the CMA to aim for full legal separation of audit and non-audit services (“structural separation”). It considers that the CMA should at the very least implement its proposed operational split of the firms in order to achieve the separation of economic interests.

Audit fees - There should be greater public reporting on audit fees, potentially including the disclosure of audit hours, staff mix, and rate per hour. Auditors should also report instances where they have performed additional procedures but have been unable to increase their fee correspondingly. The Committee also recommends that the FRC and its successor should be given more powers over audit fees.

Joint audits - The Committee recommends that joint audits should be piloted in the upper levels of the FTSE 100. Such audits should include a Big Four and a challenger firm – they should not include two Big Four firms.

Market caps - The CMA should draw up detailed proposals for introduction of a segmented market cap. This should be done on the basis that each firm should have an individual cap.

Bank audits - Due to their strategic importance, the Government should examine the auditing of banks to explore whether additional safeguards are required for that sector specifically.
 

Audit regulation

Leadership of the Audit, Reporting and Governance Authority (ARGA) - The current FRC board members should have no meaningful role in the reform process or management of the new organisation.

Whistleblowing - ARGA should ensure that it has effective procedures and policies in place to encourage whistle-blowers to come forward when they have serious concerns and to investigate them fully.

Market failure - The Government should introduce the necessary legislation in the next session of Parliament to give ARGA powers to intervene to prevent a significant market failure or lessen its impact if it cannot be averted.

Lessons learnt - Where there has been a major accounting and/or audit failure the new regulator should conduct and publish a swift but comprehensive review of what went wrong to share lessons with the wider audit market.
 

What happens now?

The Government undertakes to issue a formal response to a Select Committee report within two months of the publication of the report, when possible, but may seek the Committee’s agreement to a longer period.

Read the full BEIS Committee report