01 March 2019 by Peter Swabey
Updates from the CMA, in addition to Sir John Kingman’s review will impact the issues that we see in the audit market
In last month’s magazine, I outlined some of the principal points that we made in ICSA’s response to the Competition and Markets Authority (CMA) market study into the statutory audit market ‘to see if the market is working as well as it should.’
We now have an update from the CMA on their initial conclusions, as well as Sir John Kingman’s report following his independent review for the Government on the role and performance of the regulator, the Financial Reporting Council (FRC), to which ICSA responded in August. it seems appropriate to consider how far these initiatives will address the issues that we see in the market.
To start with Sir John Kingman’s review, I believe that this is, generally, a positive contribution. The review contains 83 recommendations for improvement, ranging from the replacement of the FRC with a new body, the Audit, Reporting and Governance Authority, with clear statutory powers and objectives, to the removal of responsibility for oversight of the actuarial profession or local government audit, and ranging also from the fundamental to the technically detailed. The majority of these recommendations make excellent sense although, naturally, there are some different emphases that I might have preferred to see.
One of the key challenges for the FRC in recent years has been that its role has changed incrementally over time since its creation following the Dearing report in 1988, but its powers have kept pace neither with its changed responsibilities nor, more importantly, with the expectations that politicians, the press and public have of its role. Sir John has recognised this, describing the FRC as ‘an institution constructed in a different era – a rather ramshackle house, cobbled together with all sorts of extensions over time. The house is – just – serviceable, up to a point, but it leaks and creaks, sometimes badly.
The inhabitants of the house have sought to patch and mend. But in the end, the house is built on weak foundations.’ Sir John states that ‘many of the FRC’s deficiencies are to some extent the product of its history and the limited hand it has been dealt by successive governments’. He goes on to explain that the ‘FRC still operates under a clear Direction from government, dating from 2016, requiring it to rely on delegation to industry bodies ‘to the maximum extent possible’.
This means, for instance, that the FRC has no direct regulatory purchase on the major audit firms…that some of the biggest and most important economic actors in the UK are still regulated not by an independent body but, in effect, by their trade association…[and in] a number of important areas, notably oversight of regulation of the actuarial profession and local authority audit, the FRC’s powers are limited or even non-existent, leaving it in the unfortunate situation of having been given responsibility without power’.
The fact that the new regulator will have statutory powers and clear terms of reference from the government is more important than that it is a new regulator or that it has a new name. One specific challenge for the FRC has been, as ICSA noted in its submission to Sir John ‘the tendency of governments of both complexions to deal with more complex issues through asking the FRC to change the Code rather than to legislate. To give just one recent example, the government’s desire to see increased recognition of stakeholder, especially employee, interests at board level has been translated into a Code requirement rather than imposed by legislation’.
I would have liked the report to make some clear recommendations about increased powers and effective sanctions, but it does say that the ‘Government, working with the FCA and the new regulator, should consider whether there is a case for strengthening qualitative regulation’. As we observed in the ICSA response to Sir John’s call for evidence, ‘The one concern that we have with the implementation of both the UK Corporate Governance Code and the Stewardship Code are the lack of sanctioning powers open to the FRC to enforce them’. We went on to suggest that the existing powers of the Financial Conduct Authority (FCA) might be better used to achieve this enforcement, ‘but would emphasise our view that responsibility for making judgements about compliance with
either of these codes should rest with the FRC as it, and not the FCA, has the competence to make
One area in which ICSA disagrees with the review is its criticism of the FRC’s ‘Guidance on Board Effectiveness, which includes guidance on such matters as succession planning for boards, ranging more widely into areas where the FRC is not expert and where it could be said to apply a rather bureaucratic mindset to business…These documents should only be issued if they are genuinely useful, and their utility clearly exceeds the considerable costs they impose through users having to read and check them’. In our view this guidance was useful, particularly for smaller companies, and our experience is that it was welcomed by users. It is difficult to see how Sir John could have formed the view that it did not meet the criteria he identifies.
Almost at the same time, the CMA has published an update paper on its market study of the statutory audit services market. Unfortunately, this is not as helpful. The study demonstrates a clear need for reform of the audit market, which I think comes as no surprise, and identifies six proposed remedies: regulatory scrutiny of audit committees; mandatory joint audit or market share cap; additional measures to remove barriers for challenger firms; market resilience; full structural or operational split; and peer review. But overall, the CMA’s unsurprising focus on competition addresses only one – albeit an important one – of the issues with this market. That is exacerbated by some flawed assumptions in the CMA paper and some over-reliance on the views of a small minority of respondents with their own particular views.
The CMA has focused on the competition issues in the audit market, addressing the issues of selection and oversight of auditors, to ensure that competition is focused on quality rather than price; of choice in the market, without undue barriers to entry and expansion for viable competitor firms; and of the structure of firms. It did not examine regulation as this is within the scope of Sir John Kingman’s review. Unfortunately, it has assumed that more regulation will help the market and that one of the major issues with audit is a result of the dominance of the ‘big four’ audit firms, hence proposals for mandating joint audits and encouraging the use of challenger firms. It may be that the CMA has sought and found a problem that suits a politically preferred solution.
Remedy 1: Regulatory scrutiny of Audit Committees
Auditor independence is critical to the quality of audit and, as we told the CMA in our response to their invitation to comment, ‘the appointment (and replacement) of the auditor is, together with ensuring the independence of the auditor, among the key responsibilities of the audit committee of the board’. The CMA seems, however, to have misunderstood the appointment process, stating that ‘Audit is a service for shareholders, but is commissioned by company management’.
In our experience, this is not the case: the audit committee of most larger corporates consists of independent non-executive directors who have been appointed by shareholders to address this ‘principal-agent problem’. The CMA states that ‘the evidence does not inspire confidence that Audit Committees consistently prioritise quality’, although reading the full report, little of that evidence seems first-hand and from those intimately involved in the process. The CMA did consider the establishment of an independent body to allocate auditors to companies but have moved away from this solution in the light of investor objections although – amazingly – ‘do not agree that the remedy would disenfranchise shareholders’. The CMA proposal is that the audit committee of all FTSE 350 companies should report directly to the regulator before, during and after a tender selection process, with a representative from the regulator possibly attending meetings as an observer; that it report directly to the regulator throughout the audit engagement; and that the regulator be able to issue public reprimands, or direct statements to shareholders in circumstances where it is not satisfied Audit Committees have followed proper procedures. This feels like an expensive and bureaucratic solution seeking a problem and a better approach would be for the regulator to be able to investigate on an exceptional basis should it believe such a review necessary.
The CMA is proposing that companies should be required to appoint two auditors, one of which should not be one of the Big Four, which would audit the company on an agreed joint or shared basis.
This remedy would involve imposing a market share cap on the Big Four firms, so that a given proportion of the market is reserved for challenger firms.
The aim of both these remedies is, quite openly, ‘to reduce the barriers to auditing large companies faced by the challenger firms’ which the CMA seems to regard as an end in itself. While this would undoubtedly lead to more – although perhaps not stronger - competition in the provision of audit, it is far from clear how this would lead to enhanced audit quality. They are both explicitly anti-competitive measures intended to allow challenger firms to achieve greater scale and experience by shielding them from competition with the Big Four. The fact that all parties agree that joint audit would increase costs and that these would potentially be disproportionate to any benefit are also ignored.
Widening the audit market may be a laudable aim, but it would surely be better to do this by addressing what the CMA invitation to comment described as ‘the unwillingness of larger corporates to appoint the mid-tier auditors’. They attributed this to the fact that ‘the majority of audit committee chairs for FTSE 350 companies would not consider a mid-tier firm to be a credible auditor for the scale and complexity of their businesses. In particular, for FTSE 350 or other large companies with significant international operations, there is a perception that only the Big Four have sufficiently developed international networks to service such accounts’. This is unfair insofar as it places responsibility on larger corporates alone – the perception also exists amongst investors and, I understand, some regulators.
The CMA is considering measures to reduce barriers to senior staff moving between firms, for example prohibition or limits on the length of non-compete clauses, and to promote sharing technology among audit firms, but are seeking suggestions as to how this might work in practice. In short, there is little evidence that it will or, indeed, that there is a problem in the market.
The CMA is proposing the development of a regulatory regime that will reduce the likelihood of the Big Four becoming the Big Three in the event of the failure of one of the major audit firms, for example by incentivising and/or mandating the movement of audit clients (and staff) to challenger firms or appointing a special administrator, who could take executive control over a failing firm. Again, there are no firm proposals at this stage.
This proposal moves beyond the existing restrictions that apply to the provision of non-audit services to audit clients by looking at ways in which the audit and non-audit businesses could be separated. The creation of audit-only firms might enhance a culture of independence and professional scepticism and might also reduce the potential for firms to be conflicted from tendering.
The CMA proposes the introduction of an independent ‘peer reviewer’, ‘a third party – not connected to the statutory auditor and not having recently audited the company’ appointed and paid by the regulator, and owing a duty of care only to the regulator. The argument is that this would improve audit quality by introducing an additional, independent quality check either for all companies or for specific companies chosen at random or by the regulator and the CMA suggests that it could be funded by ‘a levy on the audit fees of the FTSE 350 and large companies’.
On 18 December, the government announced a further review in the audit space. Sir Donald Brydon, the outgoing chairman of the London Stock Exchange has been tasked with ‘recommending what more can be done to ensure audits meet public, shareholder and investor expectations’. The terms of reference of this review are yet to be published, but it is intended that it will build on the work of the Kingman and CMA reports and will also, according to Greg Clark, Secretary of State for Business, Energy and Industrial Strategy, ‘consider audits as a product and what the future, standards and requirements should be for audits in the future’. He goes on to say that this explicitly includes ‘how far audit can and should evolve to meet the needs of investors and other stakeholders, putting the UK at the forefront’.
Also in December, Professor Prem Sikka of the Universities of Sheffield and Essex published an independent review of the auditing industry commissioned by the Shadow Chancellor of the Exchequer, John McDonnell MP. This is a more critical review of the profession, taking a position that the quality of audit services is poor with little incentive for improvement and making recommendations, for example, that auditors should act exclusively as auditors with their provision of non-audit services being a criminal offence; that a statutory state-backed auditor should be created; and that there should be an independent body created to appoint and remunerate auditors for all non-financial sector large companies.
Professor Sikka agrees with the CMA position that joint audits should be mandatory and that restrictions to the entry of new firms in the audit market should be removed. He also proposes increased auditor rotation, capping the market share of the ‘Big Four’ and increased auditor liability, not just to companies and their shareholders, but to all stakeholders. A number of these proposals were also considered by the CMA but discarded as they felt that the potential costs exceeded any likely benefits.
All these reviews add value, but the difficulty is that each of those published to date has focused on one particular aspect – be it competition, the FRC as regulator, or the perceived evils of the current system. I hope that Sir Donald Brydon’s review looks at the bigger picture. As we commented in our submission to the CMA, rather than focus on the need to break up the dominance of the ‘Big Four’ as if that will be some sort of panacea, the fundamental requirement is to improve the quality of the work done by the appointed auditor.
Various ‘solutions’ to the problem of audit quality have been proposed, but I am sceptical as to their effectiveness. For example, in many cases non-audit services are more remunerative for audit firms than audit services, particularly as we rightly see greater restrictions on the former. But the natural tendency within firms will, therefore, be for the ‘brightest and best’ to move towards the better remunerated consultancy roles and leave the basic audit work to others. I do not see how this will serve to improve the standards of auditing. There is some anecdotal evidence that partners in other areas of practice within Big Four firms are becoming irked by damage to the brand associated with the exposure of deficient audits and the need for them to defend audit scandals when they are pitching for business. Internal pressure of this kind brings a commercial imperative for audit firms to improve their own quality and this will be lost if the businesses are separated.
Similarly, the concept of joint audit has been suggested, but we have seen no independent evidence that joint audit is effective and are concerned that it may increase costs for companies, both financially and in terms of management time, and possibly create confusion. What if joint-auditors disagree about a particular treatment?
In my view the solution is threefold: education, training and trust.
• Education – clarification of the true role of audit as the political, press and public expectation of the role is markedly different from what an auditor would perceive it to be, and making changes to bring these views into line.
• Training – as a number of the ‘accounting scandals’ seen in recent years have at their heart questions of judgement. Whether particular value could, or should, be regarded as crystallised in the accounts should, in my view, be a question of fact rather than of opinion – either it is yours or it isn’t. It should not be possible for two different accountants to draw up the books for a period and have them audited against current accounting standards by different auditors and yet find many millions of pounds difference. Shareholders never benefit from such restatements. Training is required to foster a greater spirit of professional scepticism among auditors and accounting standards need to be revisited to give greater clarity on where judgement has been applied by both the preparer and auditor.
• Trust – the chief weakness of the audit market is the lack of confidence, not just on the part of companies, but on the part of investors and some regulators, in the ability of auditors outside the Big Four to provide an audit of an adequate standard for large, particularly multi-national, companies. The accuracy of this perception should be tested by an independent body. If it can be shown that mid-tier firms are up to auditing the very largest companies then we believe that companies, investors and regulators will welcome them with open arms. If it is shown that they are not, alternative solutions will be necessary.
Unless these issues are addressed before a decision is made, we risk creating solutions which fail to address the underlying problems of the audit market.