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Audit Reform Update

22 September 2020

The influx of high profile corporate collapses in recent years, including BHS, Carillion and Thomas Cook, has forced audit work firmly into the spotlight and culminated in multiple independent reviews into the sector. The consensus is overwhelmingly clear: audit work needs to be done better.

Significant (further) reform is inevitable, but what might the new audit landscape look like – and what are the possible risks that reform could pose for accountants and their insurers?

ARGA - a new Regulator?

Whilst Covid-19 and the political upheaval stemming from Brexit have delayed the timetable for audit reform, a significant amount of work has been done in this area, including three separate reviews which have produced a large number of recommendations. Last year the Financial Reporting Council ("FRC") was put on notice that it would be disbanded after the Government-backed Kingman report was released, which proposed the creation of a new regulator: the Audit, Reporting and Governance Authority ("ARGA"). The ARGA is set to be significantly more interventionist than its predecessor is and enforce a higher regulatory standard. This followed repeated criticism that the FRC had been too slow to respond to critical corporate collapses and the time it had taken to complete investigations. The creation of the new regulator was flagged in the Queen’s Speech last December, which stated that audit reform was prioritised, with the government committing to "develop proposals on company audit and corporate reporting, including a stronger regulator with all the powers necessary to reform the sector".

Auditors may look to their professional indemnity insurance to help to protect them against ARGA in the form of regulatory action, albeit such insurance will typically only indemnify costs incurred in defending or challenging regulatory or disciplinary action (up to a fixed sum) and will not (as a matter of public policy) cover fines or penalties that might be imposed as a result of a prosecution or regulatory action. However, auditors may face challenges in securing necessary cover, or risk premiums potentially increasing, as insurers seek to balance their own financial risks when issuing policies.

CMA Report – competition in a market dominated by 'the Big Four'

The Competition and Market Authority ("CMA") report, published last year, aimed to identify steps to promote competition in a market dominated by the Big Four accountancy firms following the catalogue of major corporate failures where the Big Four and mid-tier auditors were embroiled in investigations over their conduct and failure to identify going concern issues. It recommended enhanced regulatory oversight of audit committees, including ARGA mandating new minimum standards, monitoring their compliance and taking remedial action. If implemented, Audit Committees will be under pressure to ensure compliance with the new standards or face the regulatory consequences.

There could also be exposure to public scrutiny as the CMA recommends publishing any low-performing Audit Committees, generating reputational risks. The CMA report also endorses mandated joint audits of FTSE 350 companies. It is anticipated that this regime could result in increased costs, in excess of 25%, as a result of additional levels of work, leading to increased risks of errors and thereby exposing firms to increased risks of litigation. Further proposals include ensuring both firms be jointly and severally liable. Whilst this protects investors, it exposes one firm to liability for the other's work, a risk that cannot easily be controlled or managed. Challenger firms will need to ensure they have sufficient coverage, as auditing large entities requires greater levels of professional indemnity insurance. If premiums are not viable in the commercial market, it may push challenger firms down the route of self-insurance.

Sir Donald Brydon's Report on the quality and effectiveness of audit

Whilst the CMA has recommended operational splits between audit and non-audit practices of the Big Four to promote competition in the sector, Sir Donald Brydon, in his report into UK audit standards, has gone further. His report, published at the end of last year envisages a redefinition of audit altogether with the creation of an auditing profession in its own right. He maintains a vision of audit as a new independent profession, separate from accountancy, with its own governing Corporate Auditing Principles and a new regulator in the ARGA. If the Government accept his recommendations, the onus will be on auditors to act in the public interest, with the aim to support the expectations of the users of audit, and a focus on detecting fraud as well as ensuring companies can afford shareholder dividends. Sir Donald Brydon's hope is that the courts will consider any adherence to the governing principles in legal or regulatory actions. Again, auditors will need to ensure they make appropriate provision and employ safeguards to protect themselves in any such proceedings.

Comment

The Coronavirus should not be a reason to delay or slow reform of the audit sector. With the pandemic more likely to impact mid-tier challenger firms that do not have the resources of the Big Four to weather the current crisis, safeguarding the survival of challengers is critical to the viability of the industry as a whole.

In February 2020, Michael Izza, the CEO of the Institute of Chartered Accountants in England and Wales ("ICAEW"),  published the ICAEW's five goals for audit reform as a way of judging the potential effects of the reform programme, using them as an agenda against which individual suggestions for technical, regulatory and legislative change might be measured – and supported or criticised. These are:

  • Establish the ARGA;
  • Making audit a more inclusive profession by recruiting individuals from non-accountancy backgrounds and who possess the requisite technical, forensic, and cultural expertise;
  • The importance of having a more reliable core audit function with a strong system of internal controls which are subject to robust testing, focusing on the principle of going concern and the importance of having a reliable approach to fraudulent financial reporting;
  • "On-demand audit extras", which simply means additional checks being carried out by other stakeholders in the business to supplement the statutory audit; and
  • Reminding the Government to proceed with caution (and listen - very carefully - before it leaps) prior to implementing any proposals to extend auditors' mandate and intervening in the audit market.

Undoubtedly, it is a landmark time for audit in the UK. The spotlight has been refocused on the profession in light of instances such as EY's work in respect of Wirecard and Deloitte's audit of the UK software company, Autonomy. The aim of reform is to restore public confidence in the profession and increase the quality of audit for both our economy and society, with a focus on transparency. In what is a challenging balancing act for the Government, it will need to ensure that the benefits justify the potential cost impact on those in the audit market, including the significant risks associated with an increase in regulatory and legal action.

Authors: Jonathan Hyde, Rebecca Dymott and Zainab Bhadelia.

Further Reading

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