In 2020, the Financial Reporting Council (FRC) — the UK audit industry watchdog — found that a third of the sampled audits needed improvement or significant improvement. The study included audits by the seven largest audit firms in the UK, including BDO, Deloitte, EY, Grant Thornton, KPMG, Mazars, and PwC. The FRC concluded in its report that “firms are still not consistently achieving the necessary level of audit quality”.
The FRC’s review of a sample of 2019/2020 UK audits concluded improvements are needed.
Together, these factors led the UK Government to commission three independent reviews over the past three years. The reviews covered the FRC, the Competition and Market Authority (CMA), and the quality and effectiveness of the audit industry in the UK.
Following the results of those reviews, on 18 March 2021, the UK Government announced its intention to overhaul the audit and corporate governance regime. It also launched a consultation process on proposed reforms to strengthen the audit profession and the way in which companies are audited, which closes in July 2021. The government is planning to bring these reforms forward quickly.
The reforms in their current draft form are expected to apply mainly to so-called public interest entities (“PIE”), which include c. 2,000 companies in the UK, to address the findings of the reviews and restore trust in audit and corporate governance. However, these proposed reforms, once implemented, will likely have an impact on foreign companies too, in three ways:
UK influence on other governance regimes
Foreign subsidiaries of UK PIEs: In several recent corporate PIE failures, the UK Group had operating subsidiaries and joint ventures abroad, including in the UAE. The proposal includes reforms that would impact subsidiaries of UK PIEs, too.
Changes required to the audit firms’ UK practices may spill over to their overseas practices.
The proposed reforms include changes concerning:
audits, auditors, and audit firms
directors’ duties
shareholders
the FRC
The UK Government announced on 18 March 2021 its intention to overhaul the audit and corporate governance regime, including changes to directors’ duties.
The Government concludes “the current framework/…/ is inadequate in holding directors/…/ to account in the rare but serious case that they neglect their reporting responsibilities.”
The FRC lacks the necessary powers to enforce directors’ duties. [i
Reporting and accountability is weak in relation to internal controls over financial reporting, dividend and capital maintenance decisions, and steps taken to strengthen a company’s resilience. [v]
“New reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning”
New powers granted to the FRC to hold directors of large businesses to account
The FRC has published ongoing findings of sub-standard work by UK auditors.
FRC has published ongoing findings of sub-standard work.
The consultation paper said FRC’s findings “have seriously called into question whether the statutory audit is performing the public interest function expected of it.”
There is a “lack of evolution of the audit process”, partly driven by a lack of effective competition and high concentration (97% of FTSE 350 audits are performed by the Big 4).
The Government challenges that those Big four firms “also compete to provide a wide range of other business services to the largest companies” (read: consulting).
There is a need for “a new auditor mindset and to strengthen the resilience and integrity of the audit market”.
Create a new independent, corporate audit profession, which would be separate from the professional accountancy bodies and have “a clear public interest focus.”
“New overarching principles for auditors, to reinforce good audit practice.”
Requirements for auditors to consider “a wide range of information” “in reaching audit judgments.”
“New obligations on both auditors and directors relating to the detection and prevention of material fraud”.
New regulatory measures to increase competition and reduce the potential for conflicts of interest by providing new opportunities for challenger audit firms and new requirements for audit firms to separate their audit and non-audit practices.
Separation of audit and non-audit arms of certain firms.
Regulator to be granted statutory powers for monitoring the audit market and its firm.
The FRC identified several issues concerning shareholders, and has proposed reforms accordingly.
“There are concerns/…/that asset managers and asset owners do not sufficiently prioritise audit as a stewardship issue of importance.”
There was poor stewardship by institutional shareholders in the period leading up to the collapses of large companies we’ve seen over the last few years.
Requirement for companies “to set out their approach to audit through the publication of an audit and assurance policy on which there would be an advisory shareholder vote.”
Opportunity for shareholders to propose areas of emphasis to the audit committee for consideration in the annual audit plan.
There’s a lack of clear statutory objectives of the audit regulator.
There are “inadequacies in its enforcement powers in key areas of audit supervision, reporting and directors’ accountability”.
The regulator has not been effective in fostering competition in the audit industry.
“New statutory objectives and functions along with a new statutory levy to replace the existing voluntary levy.”
The audit regulator shall be given “competition powers and new powers to strengthen its corporate reporting review function, its oversight of audit committees and to enforce the corporate reporting duties of directors.”
“Proposals for the regulator to have responsibility for deciding which individuals and firms should be approved to audit [Public Interest Entities].”