Ben Hubble KC and Miles Harris of 4 New Square Chambers look at the potential impact of reforms suggested by the Kingman Review and the Competition & Market Authority’s Update Paper on the audit sector.
The days before Christmas 2018 saw the publication of two very important documents for the future of financial reporting. First, Sir John Kingman submitted his review of the Financial Reporting Council (FRC). Second, the Competition & Market Authority (“CMA”) published its Update Paper on its review of the audit sector.
Taken individually, the reforms proposed in each document are far reaching. However, their combined impact would reshape the face of financial reporting and its regulation.
The Kingman Review
The Review recommends the replacement of the FRC with a new, better resourced independent regulator focused on the interests of consumers of financial information and with significantly expanded powers and objectives. It is suggested this new regulator be named the Audit, Reporting and Governance Authority (ARGA) and be capable of inspiring respect in those who depend on its work and fear among those it regulates. The Review recommends that ARGA should:
- Introduce a regime for the approval and registration of audit firms conducting Public Interest Entity (“PIE”) audits, supported by a range of sanctions;
- Carry out compulsory monitoring of audit work;
- Work towards publishing all individual audit quality inspection reports, including gradings, upon completion of Audit Quality Reviews (AQRs);
- Increase the volume and extent of Corporate Reporting Review (CRR) work carried out by the FRC and be given stronger powers to require documents or information for a CRR and to compel changes to accounts promptly without having to go to Court;
- Have a new power to investigate concerns relevant to its strategic objective by using ‘skilled person’ reviews, publishing their findings where appropriate;
- Have the ability to take a range of pre-emptive actions appropriate to the circumstances, ranging from notifying the company of its views of the risks and requiring the company to make a rapid formal response, to (in the most serious cases) recommending to shareholders that they consider a change of CEO, CFO, chair or audit committee chair, or reconsider the payment of dividends;
- Introduce a duty to alert, obliging auditors to report viability or other concerns relating to audit; and
- Help develop detailed proposals for an effective enforcement regime in relation to PIEs pursuant to which it will hold to account and if necessary sanction all relevant directors (CEOs, CFOs, Chairs and Audit Chairs) personally for any failure to discharge their duties to prepare and approve true and fair corporate reports and to deal openly and honestly with auditors, whether or not those directors happen to be accountants.
The CMA’s Update Paper
The changes proposed by the CMA are fewer but arguably more significant for the audit market and the future of financial reporting. Most notably, from the perspective of those involved in regulatory disputes, the CMA suggests that:
- Audit committees should be required to report directly to the ARGA before, during and after a tender selection process and to report directly to the regulator throughout the audit engagement. This would be to enable ARGA to utilise a new ability to include an observer on audit committees and to issue public reprimands or direct statements to shareholders where appropriate;
- There should be mandatory joint audits, at least as regards the FTSE 350 (perhaps with some limited exceptions), with one of the pair of auditors to be a ‘challenger firm’ not from the Big Four;
- There should be a structural or (the CMA’s preference) an operational split of firms’ audit and non-audit functions. It is to consult on this as on whether any split should be applied to challenger firms as well as the Big Four; and
- There should be peer reviews of overall financials coupled with shadow audits of risky areas with a view to keeping the statutory auditors ‘on their toes’. Like Kingman the CMA suggested that it ARGA should target companies considered high risk or deserving more scrutiny.
Notably, the CMA did not favour breaking the Big Four into smaller audit firms.
Click here for a fuller summary of the Review and the Update Paper and their effects.
What is the future for regulatory disputes if, as seems likely, the proposals in Kingman and the CMA are largely implemented?
A new and bulked-up regulator will inevitably find more work for itself and may feel the need to be more aggressive in order to justify its existence (and show mettle to its own stakeholders). This is particularly likely given Kingman’s criticism of the FRC’s approach. In addition, the volume and variety of regulatory action and disputes will also increase for other reasons.
The CMA’s proposed reforms to the audit market would see firms grappling with new challenges in a more heavily regulated environment. To take on the increasing role the CMA hopes they will have, challenger firms would need to increase their capacity significantly and such expansion often strains internal systems for ensuring quality of work. Similarly, although mandatory joint audits would provide an opportunity for challenger firms, one can foresee these posing risks. Where tasks are split, there is a greater risk of the overall picture being missed or warning signs falling into the gap between the two spheres of responsibility. Further, although an operational split within accountancy firms between audit and non-audit work may be preferable to a structural split, creating and maintaining an organisational split within firms will not be straightforward, especially as one of the reasons for adopting that approach is to ensure that firms have access to non-audit expertise where necessary.
All that said, even if the market were to remain structurally unchanged, the proposed enlargement of the scope of the ARGA’s involvement in financial reporting is dramatic.
If the ARGA is to fulfil the aim of being more forward-looking and pre-emptive then new disputes are likely to arise between it, auditors, companies and company officers:
- If the ARGA can impose a range of sanctions on firms tendering for audit work short of de-registration, then one would expect it to be more likely to be prepared generally to impose a sanction, with less concern about a sanction being disproportionate;
- If AQRs are to be published, either as a matter of routine or where the ARGA is concerned, then, especially if they are no longer anonymous, one can envisage intense arguments over the conclusions of the reviews with the aim of protecting reputations and guarding against the threat of consequent sanctions. The fact of publication may be a hook to enable judicial review proceedings to be launched; and
- One can also foresee clashes resulting from the Review’s recommendation that there be increased CRR and the CMA’s proposal that there be peer reviews and shadow audits. The expectation is that the ARGA will take action to ensure these steps are effective and to act on any findings. If that is to take place, one would expect arguments over whether information demanded of companies or auditors can be required or is necessary to facilitate reviews, the accuracy of any conclusions reached, and the legitimacy and appropriateness of any actions required or taken as a result of those conclusions. Auditors will wish to defend their work and reputation, while the officers of companies are unlikely to be passive where, for example, there is a risk of the ARGA recommending the removal of their key officers to shareholders. There is plenty of scope for relationships between regulator, primary auditor, shadow or second auditor and the audit client to become confrontational.
Perhaps the most striking part of the new proposals is the recommendation in the Review that the ARGA should regulate non-accountants who are CEOs, CFOs, chairs or audit committee chairs. In our view, this is a logical extension of the regulation of financial reporting. It is hard to see a basis for treating non-accountant officers differently to accountants in business when they each could have a fundamental role in financial reporting by a company, and the diligent and honest performance of their role is central to the interests of investors and by extension the wider economy. The proposal should also end the perverse incentive for such officers to give up professional membership, a practice that cannot be in the public interest and creates unfairness.
Expanding the jurisdiction of the regulator to involve more company officers is likely to be welcomed by the audit profession and should also add a new dimension to the traditional investigation of or disciplinary proceedings against the auditor and the finance director (and possibly the CEO if they happened to be an accountant). We expect to see cases where the ARGA pursues enforcement action against auditors and all the relevant directors in parallel. In the past auditors have often felt that directors’ responsibilities for deficiencies in financial reporting have been underplayed or overlooked. However, if both the auditor(s) and all the key individuals on the board at the audit client are subject to investigation simultaneously, then there ought to be more focus on the conduct of the directors who, after all, have the primary responsibility for the truth and fairness of the company’s financial statements.
© Ben Hubble KC and Miles Harris of 4 New Square Chambers, January 2019. The authors assume no responsibility to any party in respect of this article. Specific legal advice tailored to specific problems should always be obtained.
About the authors
Ben Hubble KC is recognised as a leading KC in professional disciplinary and regulatory law. He has particular experience of professional discipline in the audit sector, having been involved in many of the FRC enforcement cases of the past decade. He is ranked as a leading KC for professional disciplinary and regulatory and was nominated for the 2017 Chambers UK Bar Professional Discipline Silk of the year.
Miles Harris is a leading professional liability junior barrister with a fast growing practice in professional regulation and discipline.