This full structural separation goes a step further than the Competition and Market Authority’s (CMA’s) proposal of an operational split as it would better tackle conflicts of interest, the report said.
For its review into the “broken” audit market the BEIS committee called on all major stakeholders in the sector - including the Big Four, ICAEW, the Financial Reporting Council (FRC), FTSE 350 CFOs, investors and outside experts. It came up with more than 30 recommendations in total covering areas such as audit fees, competition, independence, regulation and quality.
The purpose of the inquiry was to ensure that results of both the CMA and Kingman reviews are acted on.
As well as the Big Four break-up, the committee proposes a segmented market cap and the use of joint audits on a pilot basis for more complex audits, as well as introducing more frequent audit rotations of seven-year non-renewable terms with a cooling-off period of three years, if there is an operational split.
It backs the Kingman Review and the government’s endorsement of the plan to replace the FRC with the Audit, Reporting and Governance Authority and its beefed-up powers.
However, it rejects the audit profession’s defence of an “expectation gap” – particularly, it says, from the Big Four and Grant Thornton, to “paint the crisis in audit as a perception problem”. It points out that 27% of audits reviewed for 2017/18 did not meet FRC quality standards and argues that there is instead a “delivery gap” and a “serious failure of audit to deliver on its own current terms”.
Following Grant Thornton CEO David Dunckley’s assertion in front of the committee that an auditor “is not looking for fraud” and that the system is “not set up for that”, it says that detection of material fraud must continue to be a priority. It recommends that in light of the failings at Patisserie Valerie, audits must state how they have investigated potential fraud, including by directors.
Chair of the BEIS committee Rachel Reeves MP said that change in the audit market is “long overdue” and “now we need action”. She suggests that the Big Four “may seek to undermine the case for reform” but that the UK must not “wait for the next corporate collapse”.
“The Big Four’s dominance has fostered a precarious market which shuts out challengers and delivers audits which investors and the public cannot rely on. Our report proposes a range of measures to boost competition, improve the audit product, and ensure that the UK continues to be a world leader in corporate governance. A segmented market-cap and the piloting of joint audits would help to break the stranglehold of the Big Four and deliver a healthier and more resilient audit market,” Reeves argued.
“For the big firms, audits seem too often to be the route to milking the cash-cow of consultancy business. The client relationship, and the conflicts of interest which abound, undermine the professional scepticism needed to deliver reliable, high-quality audits. Splitting audit from non-audit business would be a big step to boosting the culture of challenge needed to deliver high-quality audits,” she added.
To improve audit quality the report also proposes that the FRC should make graduated findings mandatory and that Sir Donald Brydon should consider extending the scope of audit to cover the entire annual report.
On capital maintenance it recommended that, “the FRC urgently reminds directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches. Most importantly, auditors must be prepared to challenge management on their accounting of realised profits and distributable reserves.” The committee added that it should “produce a clear, simple and prudent definition of what counts as realised profits” for the purpose of distributions.
ICAEW chief executive Michael Izza said, “We broadly welcome this very useful report and commend the committee on the thoroughness of its inquiry. We believe its rigorous focus on the twin objectives of improving the quality of audit and increasing its value to business and wider society set the right tone. Building on the recommendations so far from the Kingman Review and the [CMA], it makes many sensible suggestions across a wide range of topics, including better engagement between auditors and shareholders, and distributable profits and the capital maintenance regime.
“We very much support the committee’s objective of achieving greater choice in the market for FTSE 350 audits and we agree that a segmented market share cap would encourage more mid-tier firms to rise to the challenge.”
However, Izza warned that some of its ideas for reducing conflicts of interest, “such as the break-up of the largest multi-disciplinary firms, might prove counter-productive”.
He added, “This could both drive out incumbents and discourage new entrants and it would be unfortunate if an attempt to guarantee the independence of audit firms ended up undermining the resilience of the audit market.”
Hemione Hudson, head of assurance at PwC, said, “We recognise the need for reforms which will enhance audit quality; however, the report’s recommendation to break up the largest firms risks hampering, rather than enhancing, it. Arguing for ‘break-up’ sounds like action but actually it will reduce quality, weaken resilience and distract attention from more practical steps to ensure auditing keeps pace with society’s expectations.
“There are likely to be significant unintended consequences from breaking up the large professional services firms, with increased cost and disruption to the economy and businesses which would be damaging to the UK’s competitiveness. As business secretary Greg Clark MP told the BEIS select committee, ‘audit and other professional services in this country are widely admired around the world’, and it is important that the UK remains an attractive place to do business.”
Hudson added that PwC supports the report’s recommendation that Sir Donald should consider extending the scope of audit.
Stephen Griggs, Deloitte’s UK managing partner for audit, said, “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.”
EY felt that the vision for the UK the report outlines could best be delivered by "a multidisciplinary model of services".
"A multidisciplinary model provides the structure, breadth and depth of technical skills and industry expertise necessary to deliver high-quality audits for large and complex companies, both for today and the scope that the committee envisages for the future," the firm said."We, therefore, disagree with the proposals that call for an operational or structural split in the UK as this would undermine the multidisciplinary model and risk unintended consequences to audit quality."
However, it did give its backing to the possibility of introducing legislation in the UK similar to the US Sarbanes-Oxley. "Audit is a vital part of the UK’s corporate reporting and governance system. One of the measures proposed by the BEIS select committee is further investigation into a possible UK version of Sarbanes Oxley. We believe that such a framework would increase the accountability of management and directors of large listed and private businesses and further strengthen the UK’s corporate reporting system."
A spokesperson for KPMG said the report shows that “trust in audit is in urgent need of repair”.
“As a profession we need to focus relentlessly on audit quality and make the changes required to deliver what companies, shareholders and broader stakeholders need from our work. This is the number one priority for our firm.
“To address concerns about possible conflicts of interest, we have already stopped undertaking non-audit work for companies we audit in the FTSE 350. We are not accepting any new non-audit work for these companies, and we anticipate that the vast majority of existing projects will have concluded by the end of 2019.
“We are co-operating fully with the various inquiries currently under way, engaging actively with the reviews of the audit sector, and, where we can, we are moving ahead and taking action ourselves,” they continued.
“We are now 18 months into our Audit Quality Transformation Programme, and we are confident that we are making good progress. But it is absolutely essential that the [FRC], and our wider stakeholders, have confidence that our programme to upgrade the consistency of our quality is delivering the right outcomes. With this in mind, we welcome that the FRC has commenced an assessment of our audit practice.”
An FRC spokesperson said it shares a “number of the concerns expressed in the select committee’s report which are consistent with the evidence we submitted to its inquiry”.
“Long-term fundamental changes to the regulation of audit form part of the implementation programme we are developing with BEIS. We have noted the committee’s views on the need for change and are pleased to see their support for the transformation of the FRC into the new regulator, the Audit, Reporting and Governance Authority.”