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BEIS Committee report on the future of audit

BEIS Committee report on the future of audit

  • United Kingdom
  • Corporate

09-04-2019

The BEIS Committee has published a Report following its enquiry into the future of audit, which sets out its recommendations for audit reform. Whilst the underlying focus of the report is the FTSE 350, if adopted, the recommendations in the Report will have far reaching implications for both companies and the audit industry as a whole.

The Report aims to bring together the independent reviews of Sir John Kingman into the FRC (see our briefing here) and of Sir Donald Brydon into UK audit standards, and also the Competition and Markets Authority (“CMA”) market study of the statutory audit market in the UK.

What does the Report recommend?

The Committee recommendations fall into a number of key areas.

The audit product

  • the detection of fraud must be a priority within an audit, and audits must demonstrate how potential fraud, including by the directors, has been investigated. The Committee expressed surprise that a number of audit partners did not consider fraud detection to be part of their remit
  • auditors must look ahead. The Brydon review should explore how audits can be made more forward looking to make it a more useful product, and how auditors can express more forward looking opinions 
  • the Brydon review should also look at how the scope of audit can be widened to cover the whole of the annual report, but with different levels of assurance and reporting
  • auditors should be required to present at the AGM in order to generate shareholder engagement

Capital maintenance

The Committee considers that there has been insufficient regard given to the capital maintenance regime in the Companies Act 2006 in the context of dividends, and accounting standards have been allowed to take precedence over the law. The Committee recommends:

  • tightening the UK dividend regime. The Government and the FRC should produce as a matter of urgency a clear, simple and prudent definition of what counts as realised profits. BEIS supports defining realised profits as realised in cash or near cash.
  • companies and auditors should take a more critical look at the valuation of goodwill for the purposes of distributions. This appears to have been an issue in relation to the collapse of Carillion
  • companies should be required to disclose the amount of distributable reserves in the annual accounts, and break down profits between realised and unrealized
  • the Government should adopt a complementary solvency based test whereby directors must state that dividend payments will not make the company insolvent or create cash flow problems

Separation of audit from non-audit

This is one of the key recommendations of the Report. The CMA should aim for a full legal split of audit and non-audit services, or at the very least, an operational split. A split based on separate governance alone will not achieve the desired objectives. If the CMA pursues the operational split route, the arrangements should be reviewed after three years to assess whether it has produced improvements in culture, independence and transparency. If it has failed to do so, the CMA should then proceed with a full structural breakup of the ‘Big Four’ accountancy firms into audit and non-audit businesses in the UK.

One of the key drivers behind the proposals for separation is that values of objectivity and independence are not deemed to be prominent in multi-disciplinary firms which carry out non-audit services which are more lucrative. Culturally, the purpose of audit should be to challenge management, whereas other services are to help management, and the culture of audit firms needs to change to be more challenging.

Fees

There should be greater transparency on reporting audit fees, possibly including the disclosure of audit hours, staff mix and hourly rates. The new regulator (see below) should be given powers to investigate whether fee structures are fit for purpose.

These recommendations are driven by concerns that the ‘Big Four’ are underbidding on audit assignments to secure other, more lucrative mandates, when smaller firms cannot afford to do so. There are also concerns about audit services being subsidised by more lucrative non-audit work.

Ensuring independence, challenge and professional scepticism

There should be more onus on audit committees to factor in professional scepticism and challenge into their criteria for selecting auditors, rather than focusing on the cultural fit. The Report concludes that if audit quality, choice, resilience and the professional scepticism and independence of auditors remains an issue, the independent appointment of auditors by the regulator should be considered. 

Other proposals include:

  • reducing audit rotations to seven year non-renewable terms that can only be terminated in exceptional circumstances
  • “cooling off” periods of up to three years during which other services could not be provided after the end of an audit engagement could be introduced to remove a conflict of interest for auditors

It is hoped that these measures would help with independence and assist firms outside the ‘Big Four’ to break into the market.

Competition, choice and resilience

This section of the Report considers the CMA market study into the audit market. The Committee considers that the CMA should prioritise remedies to enable other firms to enter the audit market for the FTSE 350.  The Committee considers that a segmented market cap (whereby audit firms outside the Big Four be offered the chance to take up a proportion of audits across the FTSE 350) and the use of joint audits could be introduced, on a pilot basis, for the most complex audits in the FTSE 100 to enable greater competition in this market. These are issues for the CMA to consider.

Regulation

The Committee is supportive of the new proposed audit regulator, the Audit, Reporting and Governance Authority (ARGA), whilst being critical of the FRC. The Committee calls for legislation to replace the FRC with ARGA be introduced in the next session of Parliament.

 Next steps

This is potentially a time for significant change in the audit sector, given the recent and current reviews and investigations. The BEIS Committee’s recommendations call for significant change, and would bring about some fundamental changes to the audit regime if taken forward by the Government. Directors and Chairs of audit committees need to be aware of these proposals, some of which are likely to increase the onus on them, and highlight the importance of good governance.

Useful links

BEIS Committee Report: The Future of Audit

For more information contact

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