Caroline Biebuyck 7 Mar 2019 06:02pm

Will audit face a watershed moment?

Might landmark reviews into the audit market and its regulation herald a watershed moment for the profession? Caroline Biebuyck reports on the fallout from the Kingman and CMA investigations

Will audit face a watershed moment? 630
Caption: Image from Getty Images

The audit market is under scrutiny. Whats new, you may ask. The cycle of scandals since financial deregulation in the 1980s has tended to follow a familiar path. First come the corporate failures, followed swiftly by calls for something to be done and a review or two to assess the options. Some change is enacted, then everything settles down until the next time.

But could the response to corporate failures at Carillion and BHS, and accounting scandals such as Patisserie Valerie, mark a watershed? For the first time in decades there is a sense of substantial change in the air, and studies commissioned by the government last year recommended radical reforms to address the effectiveness of the audit market and its regulation.

Theres a feeling that this time reform will be radical, says Robert Hodgkinson, executive director, technical, at ICAEW. The sense is we should be doing something more dramatic: having a new regulatory body and taking measures to disrupt the audit market.

The two reports send a loud and clear message that the status quo is not an option, says David Herbinet, UK head of PIE and global head of audit at Mazars. Now its up to the audit profession to take on the challenge and respond to the findings in an appropriate way.

Increasing competition

The government commissioned a series of reviews into aspects of audit last year. Of the two which reported back in mid-December, the one carried out by the Competition and Markets Authority (CMA) looked at long-standing problems with competition and conflicts of interest in the audit sector.

The lack of competition hit the headlines last April when Grant Thornton, then the UKs fifth largest audit firm, decided to stop bidding for FTSE 350 audits, saying the lack of a level playing field made it extremely difficult to penetrate the audit market for the UKs largest listed companies. The CMAs response to the limited choice is to propose that FTSE 350 audits be carried out by at least two firms, one of which is non-Big Four.

This would remove the barriers to entry that challenger firms currently face, giving them access to audits of the largest firms while building up credibility. Herbinet has long been a proponent of joint audits, having seen them in action in France.

Joint audit brings more challenge and another pair of eyes to critical issues. It gives more power to the audit: when two auditors discuss and agree on an issue this carries more weight with management, he says. The CMA should be commended on a proposal that makes a lot of sense: it is practical, realistic and achievable. There has been some muttering at the largest firms about whether the next tier firms will need their hands held as they learn how to do the largest audits.

Herbinet has little time for this. Its time that some people got off their high horse and realised the quality of the challenger firms. The main reason they are not currently active in the FTSE 350 audit market is more due to institutional prejudice and not because they lack the ability and capacity. Dominant firms in any market will argue that they are better, more capable, and so on. But the wheel is turning and these same stories we have heard for the last 20 years or so need to change.

Another concern is whether a joint audit would cost more. A recent review carried out by Audit Analytics looked at the audit costs of the 120 largest French listed companies, many of which require a joint audit, and those of the FTSE 100, none of which do. The review found that the audit fee per 1m revenue was broadly the same for the largest 25% of all the companies surveyed, regardless of whether they had a single auditor or joint audit; however, joint audit fees were between 10% and 28% higher than single audit fees for the remaining 75%.

Spotlighting cost misses the point, says Steve Gale, head of audit at Crowe.

The focus seems somewhat curious given the reason the remedy is being proposed in the first place. If the mantra quality comes at a price is true, and there is a perception that quality needs to increase, then the increased cost becomes something of a necessity. For all but a handful of companies, the audit fee, when looked at in the context of the business as a whole, is highly immaterial. Any increase, while not insignificant, should be considered in that light.

Splitting service arms

The CMA report looked into conflicts of interest within multi-disciplinary firms. Reading about this induces a sense of dj vu: the same problem caused consulting arms to split from their accounting firms in the immediate-post-Enron environment, while the EU audit reforms of 2016 set limits for the amount and type of non-audit services that auditors of public interest entities can carry out.

We have been here before, agrees Tim Bush, head of governance and financial analysis at independent corporate governance and shareholder advisory consultancy PIRC. In the past hiving consultancy off from audit firms has been a bit like chopping a bit off a starfish: it grows back. Whatever happens, they have to make sure that the starfish effect doesnt happen again.

The CMA felt that breaking up the firms into audit and non-audit arms would be a non-starter, given all the large players are part of international networks. Instead, it has taken a leaf from banking reforms to suggest ringfencing audit and consultancy services into separate operating entities. The rewards system and management for each segment would sit firmly within the part of the business it relates to, with the CMA envisaging that the separation would allow auditors to give the accounts the scrutiny they need without being distracted by cross-selling other lucrative services.

Stephen Griggs, managing partner of Deloitte, appreciates the need to rebuild trust and confidence in audits, and generally supports change that improves audit quality. Not surprisingly, he says Deloitte opposes a split between audit and advisory work.

We strongly believe that an essential element for delivering audit quality is the ability to draw on a wide range of skills within a multi-disciplinary firm, he says. Instead, the firm feels the answer lies in reviewing the way audit practices are overseen. We believe a stronger, fully accountable governance structure around the audit practice will address perceptions relating to incentives and conflicts, says Griggs.

Tackling regulation

The other review to make its recommendations public last year was the Kingman report into audit regulation. Its headline proposal is to scrap the Financial Reporting Council (FRC) in favour of a new regulator, the Audit, Reporting and Governance Authority (ARGA) to give audit regulation a fresh start with different staff, objectives, status and leadership. Kingman makes many recommendations in his report, so it is easy to get lost in the detail.

Hodgkinson thinks it is important to concentrate on the bigger picture arising from Kingmans well-thought out recommendations. As a profession, we want to have a strong, credible, well-resourced, expertly staffed regulator that is focused on the quality of information issued. Theres a big emphasis in Kingman on whether information is understandable and useable, which is quite impressive, as its that overall purpose that everyone has to sign up to, he says.

Bush says the Kingman proposals deliver what people have been wanting for a long time: a statutory basis for audit regulation. Weve had this muddle where the FRC has been acting as a private body when in fact it has been a public body. Weve had a body whose function includes setting corporate guidelines for companies, which has highly questionable governance itself. The FRC has not been getting the law right, has not been getting its status right, isnt getting its recruitment right they arent getting anything right. This is why we fully support the Kingman recommendations.

A question of responsibility

Much of the public anger over the pension scheme at BHS and failure of contractors after Carillions demise came from the lack of accountability of boards and auditors to anyone other than the shareholders. The Kingman report acknowledges this by pointing out that the new regulators duty should be to promote the interests of consumers of financial information.

Responsibilities in law are one thing, says Hodgkinson, but Kingmans approach appears to be to widen the vista to broader responsibilities. This is part of the rather refreshing, rigorous approach to reform. He could have framed the whole exercise in terms of looking at the nature of the corporation, or of the audit. But that doesnt get to the fact that we need to respond to the reality of public concern and the problems that people face.

Meanwhile Kingmans comments on extending responsibility across boards reflect the third of the main issues that the CMA identified: relationships. Companies have always chosen their own auditors and this has led to cosy connections building up between management and their auditors. UK implementation of the EU audit reforms partly addressed this by making public companies put their audits out to tender at least every decade, an auditor at least every 20 years. The CMA goes further, suggesting that regulators scrutinise audit appointments and management to make sure that the choice has been made for the right reasons. This should make sure those appointing auditors are held to account and independent enough to choose the most challenging audit firm, rather than for example the cheapest, states the CMA. Herbinet is in favour of this.

Regulatory scrutiny of the work of the audit committee is a good and needed development, he says. The Kingman and CMA reports, which came out in December 2018, mark the start of what could be a long process in seeing real reform. Donald Brydon is currently chairing a review into the quality and effectiveness of the audit market, building on the findings of the Kingman and CMA reviews, while the Business, Energy & Industrial Strategy Select Committee is conducting its own enquiry into the two reports findings.

In a separate exercise, Sir John Kingman is looking at ways of removing conflicts of interest, including considering whether a public body should appoint auditors. Meanwhile Labour commissioned its own report into the audit sector, which was carried out by long-standing critic of the accounting profession Professor Prem Sikka of the University of Sheffield, and was also issued late last year. This is clearly the start of something major, says Hodgkinson, a revolution which the accounting profession wants to see work.

There will be some hard choices and we at ICAEW want to actively contribute to how those choices are made. We want this to be successful. And we want to make sure the profession is seen as attractive and worthwhile for future generations. This is a longterm issue and we need to reflect that future set of interests as well as those of current auditors.