The independent review of the UK audit regulator, the Financial Reporting Council (the Kingman Review) was released at the end of 2018. Among other things, the review recommends that the regulator be replaced with a new body with stronger powers and a new approach.
In addition, the UK Competition and Markets Authority (CMA) has delivered an update on its market study seeking feedback on proposed changes and a further review of the audit sector has been announced by the government (the Brydon Review).
A high level overview of these developments is below.
Completion of the Kingman Review
The 'root and branch' independent review of the UK audit regulator, the Financial Reporting Council (FRC) led by Sir John Kingman (the Kingman Review) was completed in December 2018 (see: Governance News 20/04/2018).
Reform is required
The Review identifies a number of constraints on the FRC in performing its role and a number of concerns around the regulator's current approach including that its work does not 'command the same credibility' as the equivalent US body, the Public Companies Accounting Oversight Board (PCAOB).
Having said this, the Review also identifies a number of strengths in the regulator's current approach including, among other things, that it has been an 'effective custodian of the UK Corporate Governance Code' though it considers that 'The Stewardship Code, whilst a major and well-intentioned intervention, is not effective in practice'.
Overall the Review concludes that though 'some of the FRC’s critics overstate their case' there is a case for reform on the basis that 'the FRC has tended, overall, to take an excessively consensual approach to its work. The FRC’s approach to its own governance has also not been consistent with either its public importance, or its role in championing governance in the corporate world'.
Some Key Recommendations
- The FRC should be replaced 'as soon as possible' with a new independent regulator with clear statutory powers and objectives. The new entity should be named the Audit, Reporting and Governance Authority.
- The regulator should have an 'overarching duty to promote the interests of consumers of financial information, not producers' the Review states. It should also have a duty to promote competition; a duty to promote innovation; and a duty to apply proportionality to all its work.
- Recommendations 4 and 5 set out the suggested strategic objective and duties that should be placed on the new regulator. It's suggested that the new regulator's strategic objective should be: 'To protect the interests of users of financial information and the wider public interest by setting high standards of statutory audit, corporate reporting and corporate governance, and by holding to account the companies and professional advisers responsible for meeting those standards'. Recommendation 6 outlines the 'core functions on audit and corporate reporting' that the new regulator should perform.
- The regulator’s corporate reporting work should be extended from its current limited scope to cover the entire annual report including corporate governance reporting. It should be given stronger powers to require documents and other relevant information in order to conduct that review work. The regulator should be given the power to require restatements promptly (rather than requiring a Court Order).
- The new body should be accountable to parliament, with the Chair and CEO subject to a pre-approval hearing with the BEIS Select Committee, and appearing annually in front of the Select Committee.
- The regulator should not be funded on a voluntary basis. BEIS should put in place a statutory levy
- The current self-regulatory model for the largest audit firms should end. The Review recommends that the new Audit Firm Monitory Approach (APFMA) which involves enhanced monitoring of the six largest audit firms, should not be carried out on a voluntary basis but instead that the regulator should be given statutory power to carry out this work.
- The government should review the UK’s definition of a Public Interest Entity (PIE) which the report states is 'too narrowly drawn' and 'may exclude entities whose audit arrangements are a matter of public interest'. The definition of a PIE is set by EU audit legislation and requires those entities and their auditors to adhere to requirements for auditor rotation, capping the provision of non-audit work, and the prohibition of some forms of non-audit work (which do not apply to non-PIE entities).
- The new regulator should work towards a position where individual audit quality inspection reports, including gradings, are published in full upon completion of Audit Quality Reviews (AQRs).
- The new regulator should be more 'sparing and disciplined than the FRC in promulgating guidance and discussion documents'. Only where the utility of such documents 'clearly exceeds the considerable costs they impose through users having to read and check them' should the regulator issue them, the report states.
Governance changes at the regulator
- A new board should be appointed. This should have some, but limited, continuity with the existing board. This is necessary, the report states to 'rebuild the respect of those it regulates and other stakeholders'. The report also specifies that the new board should be 'significantly smaller' than the FRC’s current 14 member board and should not aim to be 'representative' of stakeholder interests but instead should comprise a 'mix of the skills, experience and knowledge needed to ensure strategic direction and effective constructive challenge to the executive'.
- All board appointments should be public appointments approved by the Secretary of State for BEIS and all appointments to both the board and committees of the new regulator should be advertised, and head hunters used in the process. In addition, the report recommends that the posts of Chair and CEO should be subject to confirmation hearings with the BEIS Select Committee 'if the committee wishes'. The report also recommends that the simplification of the FRC's sub-board structure.
- Independence from the sector and management of conflicts of interest: 'The FRC has previously applied an inconsistent and incomplete approach to managing conflicts of interest' the report states. For the 'foreseeable future', the new regulator should not allow staff, or board or committee members ever to work on any regulatory functions relating to a past employer, removing themselves and/or delegating to others as necessary (in order, the Review explains, to rebuild the regulator's credibility.
Consideration should be given to abolishing the Stewardship Code (if the planned review of the Code does not go far enough)
The Review found that the 'Stewardship Code, whilst a major and well-intentioned intervention, is not effective in practice' and that a 'fundamental shift in approach' is needed to ensure that the revised Stewardship Code more clearly 'differentiates excellence in stewardship' with a focus on 'outcomes and effectiveness, not on policy statements'. The Review states that 'If this cannot be achieved, and the Code remains simply a driver of boilerplate reporting, serious consideration should be given to its abolition'.
[Note: The FT reports that the Financial Reporting Council is expected to open consultation on a revised Stewardship Code from 30 January. See: [registration required] The FT 05/01/2019]
The case for changing the way in which auditors are appointed: There is a case 'for at least considering radical change' writes Sir John Kingman
In addition to releasing the Review, a letter from Sir John Kingman to the Secretary of State for Business, Energy and Industrial Strategy (BEIS) setting out Sir John's view on whether there is a case for fundamental change in who appoints company auditors was also released.
Sir John writes that in his view, there is a 'principled case for at least considering radical change' and adds that Sir John is unconvinced that 'all the arguments for the status quo are fully persuasive'. He suggests that consideration should be given to granting the new regulator the right to appoint an auditor, in the case of PIEs, in certain circumstances. In addition, he suggests that consideration should be given to granting the new regulator the right, again in the case of PIEs, to approve audit fees, 'where it sees a case for doing so in the interests of quality'.
Competition and Market Authority (CMA) Market Study: update released seeking feedback on proposed changes
Separately, the CMA also released an update paper on 18 December, as part of its market study of the statutory audit market (see: Governance News 15/10/2018) which seeks feedback on a number of proposed changes to the sector aimed at fostering competition.
- enhancing regulatory scrutiny of audit committees
- introducing mandatory joint audits
- introducing a market share cap on the Big Four firms so that a given proportion of the market is reserved for challenger firms
- creating a 'market oversight and resilience regime' to protect against the 'negative effects' of further concentration in the audit market
- requiring full structural or operational split between audit and non-audit services
The review does not, however, appear to suggest that the big four audit forms be broken up.
The deadline for submissions on the proposed changes is 21 January 2019.
Further review (Brydon Review) of the sector announced
Following the release of the two reports, the UK government has announced that Donald Brydon (outgoing Chair of the London Stock Exchange Group), will lead a review (Brydon Review) of the quality and effectiveness of the UK audit market.
The terms of reference are yet to be released, however the government's statement says that it will make recommendations about 'what more can be done to ensure audits meet public, shareholder and investor expectations'.
More particularly, the review is expected to 'build on the findings' of the Kingman Review and the CMA market study and consider: a) how far audit can and should evolve to meet the needs of investors and other stakeholders; b) how auditors verify information they are signing off; c) how to manage any residual gap between what audit can and should deliver; and d) identify the public’s expectations from audit.
The Review will also test the current model and ask whether it can be made more effective as well as looking at how audit should be developed to better serve the public interest in the future, taking account of changing business models and new technology.
Commenting on the Review, Business Secretary Greg Clark said: 'I’m delighted that Donald Brydon will be leading this review, following the important work of Sir John Kingman and the CMA, and his work should help us improve and restore confidence in the quality and rigour of audit companies. Audit companies need to learn the recent lessons from high profile audit failures and reform to regain public confidence, or they will be forced to do it.'