The week immediately preceding Christmas proved to be a momentous one for the profession: we received the long-awaited report from Sir John Kingman on the Financial Reporting Council (FRC) and audit regulation going forward and the preliminary findings of the Competition and Markets Authority (CMA) on the audit market and competition, and the government announced a further inquiry, this time into the future of audit. Given this unprecedented level of interest in our profession and the changes we could be facing, I believe we should all be thinking seriously about what impact the recommendations and findings might have on us long term.
If we look at the proposals from the perspective of investors and those people who have investments, these reforms are intended to help with the issue that investors return to time and time again – audit quality. It is the single most important point that my discussions with investors continue to focus on. Now that doesn’t mean that investors by and large aren’t happy with audit quality but what they are concerned about, perhaps because they may not necessarily be deeply involved in the details, are suggestions that audit quality might be declining. This, for me, is top of the list of things that we have to get fixed.
I know from my discussions with them that investors would also really like auditors to tell them something that they don’t already know about the business that they are invested in. Whether this is likely to happen as a result of any of the proposed changes isn’t yet known but there is clearly a demand for more insight (however that is defined) to be gained from audits in future.
Another area of interest to investors will be the potential cost that might fall on them, either directly or indirectly, as a requirement of funding the Audit, Reporting and Governance Authority (ARGA) – the new FRC – and the additional cost that may be passed on in a more demanding regime for auditors.
Turning to ICAEW members who are on boards of directors and, specifically, on audit committees, the package of proposals announced pre-Christmas has a number of items which at a minimum should be food for thought, and perhaps at another level will change your role as audit committee members. Clearly, being a member of an audit committee, certainly of a FTSE 350 company, is going to involve far more work in future. There is a serious option on the table from the CMA that the FTSE 350 all become joint audits. Assuming that this will be planned over a period of time, audit committees will need to be arranging a tender process to find a joint auditor, which might prove easier for some sectors than others. Any appointment process is going to be more closely scrutinised by ARGA and audit committees will also be required in the course of an audit to report how they will be assessing its quality. This is something that members may have been doing already but it would appear that the new requirement will require an explicit report.
Members of audit committees who are not in professional bodies will find that there is a new liability regime under ARGA (which we welcome) but all audit committees and indeed boards of directors will need to reassess their own personal risk appetite in the light of the new rules. This is probably an important discussion to be conducted at a board level because directors should all be aware of their liability and we doubt the policy goal of the recommendation was to attract only those people who did not appreciate their personal liability.
It will also be apparent to anyone who has read the CMA report that the recommendation for joint audit is done in the full knowledge that there will be a cost implication – an increase in audit fees of between 20% and 50% seems to be the accepted benchmark. Higher fees are inevitable, given all the demands that are being made on the audit provider, and will need to be built into the governance planning of any FTSE 350 company.
Another potentially expensive recommendation, this time from Kingman, is the review of internal controls. The government, Sir John suggests, could consider moving the UK to a regime similar to the one introduced in the US under Sarbanes-Oxley. Such a change would have implications for management and the board of directors but would also end up costing any businesses – including a large number of the FTSE 350 – that don’t operate to the US standard. Their boards may feel that they need some external support as and when this happens.
As far as members in practice are concerned, the list of recommendations and preliminary findings that directly impact and working out the interdependencies is probably going to occupy many of you for weeks and months to come. The headlines from the CMA report indicate a ring-fencing arrangement of the public interest entity (PIE) audit activity, final details yet to be developed, but the implications of this for the Big Four and potentially the challenger firms could be significant in operational terms.
The second headline grabbing proposal relates to all FTSE 350 audits becoming joint ventures and this appears to be the preferred route over market caps. I believe that we should be looking at this with an open mind and not immediately turn to the default position of “We used to have joint audits in the UK and stopped doing them”. Frankly, 30 years have gone by since then and it’s time to take another look. Rather, we should be focusing on the practicalities of the recommendation, such as is there the risk appetite among the challenger firms to move into this space? If there is, good and over what timescale? If not, should we be looking at alternative remedies sooner rather than later? Needless to say, this is a significant business issue for those in PIE audit firms.
One of the pieces of work that will only start in 2019 but arguably is at the core of all the questions that have been asked about audit is what should its scope be and what does the future of audit look like? We welcome the appointment of outgoing chair of the London Stock Exchange, Sir Donald Brydon, to head up this review and look forward to giving input as required. We are excited about the possibilities of redefining the expectations gap, making the going concern opinion more robust, and exploring other areas where audit has often been challenged, like fraud or environmental, social and governance issues. These are areas where potentially all of you will have a view.
Having said all that, this note is not intended to fill you with dread about what is coming down the line. But I believe our members need to have their eyes open to the implications of these recommendations and preliminary findings. One thing that I can say with some certainty about 2019 though is that it is going to be interesting and probably more expensive!