A Review of the Dept of Business Energy & Industrial Strategy’s White Paper on Restoring Trust in Audit and Corporate Governance (UK)
Introduction
The British government’s Department for Business, Energy and Industrial Strategy (BEIS) has recently released a White Paper entitled Restoring trust in audit and corporate governance. It calls for responses by early July of this year, which, presumably, will guide whatever proposals it eventually puts to parliament for approval.
Its stated purpose is explicit in the title, and it makes clear that three recent accounting scandals, BHS, Carillion and Patisserie Valerie, are the proximate drivers. The politicians have pounced on perceived public unhappiness with big business and want to be seen to be taking firm action. So their targets are, in turn, the directors, the auditors and the regulator. In the process, they question the current meaning and purpose of the audit, the quality of auditing generally, the meaningfulness of the corporate reporting and the working of the audit marketplace. On the way through, the shareholders also come in for criticism. The recommendations would significantly change the way audit and the accountancy profession operate, and the expressed belief is that the result would be significant improvements in the public’s trust in the direction of big business and corporate governance.
In this first part of the article, we summarise the four reviews leading up to the White Paper, and in the subsequent part we briefly revisit articles that we have previously written on the subject, and examine the White Paper and give our views on whether it is likely to fulfil its promises.
The director’s role can be summarised as: plan the future, while protecting the present. And this means looking holistically at the business and the interests of all the key stakeholders.
So how do the directors monitor their performance in fulfilling their duties under the Companies Act, and how do the stakeholders receive confirmation that their interests are, indeed, being properly looked after?
This is what Audit is for, and clearly, from the criticism of current arrangements by the public and various of the stakeholder groups at different times, coupled with periodic reorganising of the regulatory bodies and regular re-writing of regulation, the traditional approach isn’t working. So do the BEIS proposals address the fundamental problems, and if not, where do they fall down?
Let’s look briefly now at the four recently published official investigations.
House of Commons BEIS Committee Report March 2019
The Future of Audit
This parliamentary committee review was prompted by the scandals emerging from the collapse of BHS, Carillion and Patisserie Valerie.
Approach
- Sceptical, aggressive
- All the self-confidence of a group of politicians whose personal experience is limited and whose knowledge of the subject is surface-deep, but who want to make an impact
- Containing some grammatical errors and typos
Issues identified
- Auditors need to look ahead, broaden the scope of audit and issue “graduated findings” (ie from full agreement through partial agreement to disagreement) on matters in the published accounts
- Shareholders should take more of an interest in the audit
- Delivery gap is wider than the expectations gap
- Accounting standards don’t necessarily match requirements of Companies Act, eg re capital maintenance
- Audit fees too low – regulator ought to address this
- Criticism of regulatory capture by the Big Four viz the high number of board members with a background in one of the Big Four
Summary of Recommendations
- Companies should stop distributing unrealised profits
- Audit reports should include graduated findings and auditors should communicate better with shareholders
- Auditors’ other work for clients creates conflicts of interest
- Lack of competition should be addressed, and also the supplier resilience issue if a Big Four failure occurs
- Weak regulation justifies creating the new regulator, ARGA, as more powerful and accountable to parliament
- Support for a SarBox type regime for the UK
Kingman Review December 2018
Independent review of the Financial Reporting Council
Sir John Kingman’s review was prompted by the Carillion collapse, and intended as a root and branch review of the FRC, but excluding the Carillion debacle.
Approach
- Precise, detailed to a fault
- What one would expect from a former top ex-Treasury civil servant
Main conclusions
- Highly critical of the FRC organisation and effectiveness, for instance, dismissing the Stewardship Code as well-meaning but ineffectual
- Audit expectation gap needs addressing (not addressed by this review!)
Structure of proposals
- Replace FRC with ARGA, with statutory powers
- Focus on consumers of information, not producers
- Big focus on nature of audit and an end to self-regulation
- Extend scope of review of reports beyond financial to include corporate governance
- Report annually on compliance with Corporate Governance Code & Stewardship Code
- Engage more with investors
- Make audit forward-looking to anticipate emerging corporate governance, reporting, or audit risks
- Make robust use of market intelligence
CMA Report
Statutory audit services market study April 2019
This review by the Competition and Markets Authority was prompted by the recent perceived audit failures regarding big corporate collapses, and the reviews summarised above, coupled with other international reviews in the EU and USA.
Approach
- Sprawling, doesn’t seem to really understand the way the industry works
- Critics might describe it as a load of naïve waffle!
Findings
- Widespread poor performance in audit…
- ….leading to lack of trust
Issues
- Audit committees don’t focus on quality
- Lack of choice due to lack of competition at highest level and entry barriers for smaller firms
- Impact on quality incentives of huge ratio of more profitable non-audit work (75-80%) to less profitable audit work
Recommendations
- Objectives
- Increase effectiveness of audit committees
- Increase choice of auditor
- Improve quality by addressing effect of non-audit work
- Through
- Audit committee scrutiny
- Mandatory joint audit and peer review
- Mitigating effects of potential failure of Big Four firm
- Mandating split between audit & non-audit for Big Four
- 5 year review of progress by regulator
Brydon Report
Report of the independent review into the quality and effectiveness of audit December 2019
Donald Brydon’s review was prompted by the Carillion and Patisserie Valerie failures and the perception that audit has lost its way
Approach
- Precise, confident
- Focused on caution
- What one might expect from a Scottish banker
Main conclusions and recommendations
- Expectation gap needs to be addressed
- Redefine audit
- Audit is too important to be an adjunct to accounting
- Need to establish a new profession – corporate auditing
- Reporting is not clear enough
- Directors should release an audit & assurance policy statement and a meaningful resilience statement and public interest statement
- Shareholders ought to take more interest in the audit process
- Standard AGM Agenda item for auditor to report to shareholders
- Consideration of other stakeholders
- Directors to take employees’ views into consideration and Auditor to report specifically on directors’ performance in regard to S 172 of the Companies Act
- Whistleblowers’ protection
- Auditors to be included in list of Prescribed Persons to whom they can communicate safely
- Improving fraud detection
- Specific training for auditors
- Kingman and other reviews: approval of:
- Annual attestation re effectiveness of internal controls
- Reassurance re affordability of dividends regarding resilience & capital maintenance
- Alternative company performance measures to be subject to audit scrutiny
Department for business, energy and industrial strategy March 2021
White Paper on restoring trust in Audit and Corporate Governance
Official response prompted by public worries about corporate wrongdoing eg failure of Carillion etc
Declared concerns
- Audit
- Corporate reporting
- Corporate governance
Background: three reviews in these areas
- Audit regulator (FRC) – Kingman
- Audit market – CMA
- Audit quality – Brydon
Declared purpose
- holding directors to account
- improving shareholder stewardship
- improving effectiveness of regulation
Approach
- holding directors to account
- holding auditors…
- holding shareholders…
- holding regulator….
- contains grammatical errors & typos
Structure of proposals
- attack directors’ responsibilities
- attack audit process & auditor firms who should catch wrongdoing
- attack regulator for not regulating effectively
- also have a go at shareholders (NB apparently misunderstanding the legalities, saying “shareholders don’t run the company, the directors do”, NO – the management does; but directors have a responsibility for the long-term success of their investors’ funds through the performance of the investee company on whose board they sit)
Framework of report and proposals
- Public Interest Entities (PIEs)
- Broaden definition to include large private companies
- Directors’ accountability for internal controls, capital maintenance
- Require directors’ statements about effectiveness of controls and adequacy of resources
- Additions to corporate reporting
- Introduce resilience statement and audit and assurance policy
- Increased regulator role in reporting
- ARGA empowered to direct changes in reports and remit extended to the whole of the report
- Directors’ wrongful behaviour
- Stronger malus and clawback provisions and powers for ARGA to pursue
- Auditors
- Create new corporate auditing profession with new overarching principles
- Audit committee role
- ARGA to set additional tasks for audit committees and facilitate shareholder engagement re audit matters
- Competition in the audit market
- Regulator-managed shared audit and operational separation of audit and non-audit work with powers for ARGA to monitor the market and act against individual firms
- Audit quality reviews
- Regulator, rather than professional bodies, to approve audits of PIEs
- Replacing the FRC
- ARGA as a strengthened regulator with more powers, including supervision of accountants and actuaries
The end result of all this interviewing, surveying, receiving detailed submissions and reviewing the input, is a set of proposals summarised above, which the Department of BEIS has published to gain reactions from affected parties. Depending on the responses, it will tweak its proposals and roll them out into draft legislation for Parliament to approve, following which they will become law.
In the second part of our article, we will set out our own views about the failings of the audit process and of the proposed regulatory approach to audit and corporate governance, which the BEIS Paper purports to address.
