Mike McKeon and Michelle Mullen discuss the latest proposals for audit reform and what impact they will have on the profession.
Last December, far-reaching proposals for reform in the audit market and in the governance of audit and accounting were published by the Competition and Markets Authority (CMA) and the working group under Sir John Kingman, respectively.
The CMA was looking at how to achieve greater competition and a higher level of quality in the audit of large listed companies and other Public Interest Entities (PIEs), while the Kingman report deals with the reform – in fact, the replacement – of the Financial Reporting Council (FRC), which oversees corporate financial reporting, auditing and the actuarial profession.
ICAS has welcomed reform in both instances, but not without reservations on the detail of some of the proposals, and it has also called for a far-reaching review of the audit process and what policymakers and stakeholders are looking for audit to achieve. Such a review has now been launched under the leadership of Sir Donald Brydon.
Meanwhile, The CA magazine met with Mike McKeon, ICAS Deputy President and Chair of the Audit Committee at National Express Group, and Michelle Mullen, ICAS Executive Director, Standards, to discuss the proposed reforms. Both worked alongside ICAS staff and a group of members to formulate ICAS’ responses to the reviews.
Why do you think we’re having this debate now, less than three years after some quite major audit market reforms have already come into effect?
Michelle: Audit, if you look at it in a global context, has been receiving a lot of attention. But the UK policy dynamic is very different and has led to a strong desire for change. On the back of a few relatively recent high-profile corporate cases, the public are more conscious of the word “audit” and are asking, quite rightly, questions about it. That has drawn attention to the audit expectation gap.
Mike: I think it goes a bit further back than that. In 2009, when the financial markets crashed, we ended up with a situation where people had an increasing lack of trust in business. People are asking the questions, “So what do we trust? Can we trust audit?” And those are legitimate questions. We should actually try to answer those questions.
Is audit, as some may suggest, broken?
Mike: I would say no. Audit is not “broken”, but the question is, “Is audit fit for purpose going forward?”
And that’s the legitimate question we have to answer.
How can we make audit fit for the future? What are the priorities?
Mike: The review under Sir Donald Brydon will be a key element in how we address this question. It’s something that we at ICAS have been asking for for some considerable time and we believe it’s an important debate to be had right now. It could be enormously valuable for both the UK corporate world, for wider business in general and for the investor world.
Michelle: This is a great opportunity to bring about positive and constructive change for the future. As we said in our submissions [to the CMA and Kingman Reviews] we need to undertake a holistic review of audit, corporate governance and corporate reporting. It’s like a three-legged stool. A holistic approach is very important.
So competition and regulation are important but we should also be looking at the content and the purpose of audit?
Michelle: The policy makers’ expectation seems to be that if you increase choice you will automatically improve audit quality, but there are much bigger questions being asked about what the audit is and what is covered within the audit.
Mike: Audit is a pretty well-defined, and statutorily defined, requirement for corporate Britain and indeed in corporates around the world, but that definition doesn’t meet the public expectation of what an audit should be today. That gap is there, it’s real. We need to figure out how, collectively, we can bridge that gap.
Has the debate moved on from explaining the expectation gap to finding a way to close that gap?
Mike: I think it’s both. I think there’s a way of closing it, which would involve government because government needs to articulate what an audit should be defined as and secondly we have to explain what that actually will become and manage the expectations of people going forward. That is not straightforward!
Michelle: And to add to that, audit is a creature of its time, and it has always been evolving, but the time has come for us to take stock, and decide what it needs to be for the future, to provide the levels of assurance that the public now demand. It’s not acceptable to ignore the legitimate questions that are being posed. They are a definite call to improve what an audit is today, as we know it. That is very apparent. The whole landscape is changing.
Perhaps one of the biggest changes proposed by the CMA is joint audits. We’ve seen that in France, but it’s not really been adopted in many other jurisdictions. What’s the thinking on what a joint audit would mean for large listed companies?
Mike: The supposition is that essentially you will bring other firms up to a capability that they’re in a position to audit larger PIEs. Whether that will actually work that way, whether firms will actually come forward and invest the time, effort and money required to meet those expectations is still to be proven. It’s still up for debate, because actually if you look at the example of France, the Big Four are still dominating the French market.
Michelle: It’s not a solution that will deliver increased choice in the market overnight; France has had it for over 50 years. And it would require legislative change. In our submission to the CMA, we will highlight that the current auditor liability regime is a key concern and would need to be reviewed and addressed, for example.
Mike: There will be a significant increase in cost related to doing this and, as Michelle said, it won’t be overnight.
An alternative to joint audits proposed by the CMA report was the idea of a market share cap. Any thoughts on how that would work?
Michelle: A market cap is an artificial measure, which you could argue actually limits choice.
Mike: There are some major issues with this proposal. If your choice of auditor is artificially limited, which is somewhat ironic coming from a competition and markets authority, then it may be that certain boards and audit committees can’t meet their fiduciary obligations. What do you do then? That is something that, as an audit committee chairman, concerns me greatly.
One of the key issues is audit quality. So what are the ways forward that you see that could be adopted to ensure and improve quality?
Mike: I think there are two points to make. First, people define audit quality differently. If you take the FRC’s definition of audit quality, in our submission to the Kingman report, we felt it was a somewhat slanted version of what audit quality should be. We argued quite strongly that audit quality should be tested, not only against the evidence that the auditors produce, but also against the quality of the judgements that they make.
Even within the FRC analysis, there’s only been one year where audit quality has actually declined and that was last year. Previously there have been five years, I think, of increased audit quality. One year doesn’t make a trend.
Michelle: It’s only fair to say that the large firms have invested significantly in their audit processes and methodologies and the use of technology over the last five years.
Mike: When we look at the future of audit, that is then probably the right place to ask the question, “How do we define audit quality properly?” Everybody agrees that audit quality is the primary concern… what will perhaps be better going forward will be the definition of what audit quality should be.
One of the things that Kingman suggested was increased transparency for joint inspection reports. Would it help if we could lift the bonnet and see what’s going on with audit?
Michelle: I think the proposed regulator, ARGA [Audit, Reporting and Governance Authority], would have a fundamental role to play, because it is the body that sets the bar. It’s the body that’s able to articulate what a good quality audit looks like. It’s not just about setting codes and principles and standards. It is also about telling the community: “This is what we would expect an audit to be.”
So the benchmark has to be very clear if it’s going to be enforced?
Michelle: As a regulator, it’s about fairness and transparency. It is about encouraging audit quality in a constructive and positive way, as opposed to using enforcement as your first port of call.
Mike: We should not be afraid of transparency in terms of audit quality… I don’t think we should be fearful of strong regulation. In fact, I think strong regulation and the right regulation will improve the quality of what we do as a whole, and I think the profession should welcome that.
One of the issues for the CMA is audit versus non-audit services and the question of actual or perceived conflict of interest. What is the best way to tackle this?
Mike: Empirically, the level of non-audit services provided to audit clients has dramatically reduced. It is now something like 15%, 16% of non-audit services provided to audit services in audit clients.
Now the challenge for firms, and for companies, is that when they’re looking to tender their audit they have to make sure that they somehow clear out those conflicts of interest. For a period of two years before you’re going to put the tender out, you need to make sure that any potential candidates for the audit are clean. I don’t believe it’s a major problem any more.
How about the ring-fencing idea? The CMA has proposed that firms create a separate operating entity in charge of audit.
Mike: The challenge here has been identified by the CMA that there are potentially perverse incentives for auditors and partners in the audit firms who are part of a larger firm to carry out a high-quality audit. There is, therefore, an argument that suggests audit firms should have their economic base ring-fenced, so that you could see that they are profitable, making good returns and that audit partners and their staff are properly incentivised and remunerated for the audit work that they do and they are not reliant on other, non-audit related, income.
I can see the logic of this, and I concede it would work reasonably well if it was done in a properly defined way. I don’t think that, in itself, it represents a groundbreaking solution to any perceived problem of perverse incentives. What it does is to bring a greater degree of clarity around what auditors do and what auditors are expected to do.
Would there be any practical difficulties for firms? One of the advantages of using the big multi-skilled firms is the fact that you’ve got a whole variety of people with different skills.
Michelle: The firms are best placed to identify the unintended consequences. And how easy it is to implement. There are other factors at play, too.
Mike: I worked for a considerable period of time at regulated utilities. We had regulated businesses, and non-regulated businesses, and they traded at arm’s length between each other. It worked perfectly well. If you do it properly, understand the rules and apply those rules carefully, it can be done without any real degree of difficulty.
Is this the end of self-regulation in audit?
Michelle: It’s not the end of self-regulation, for the profession, but I think very justifiable questions have been asked about how you regulate audit firms undertaking Public Interest Entity audit work. And, perhaps uniquely, we actually said in the ICAS response that we thought the time had come for the regulator to take on the issue of registration [for PIE audit only].
Following on from the EU audit reforms that came into force in 2016, the regulator carries out inspection visits, and takes the lead in enforcement for anything that relates to a Public Interest Entity. It did not feel right to us, against that landscape, that the licensing of a firm in relation to its PIE audit work was not sitting with the same regulator that was undertaking the regulator work for those audits.
That is one of the recommendations that Sir John Kingman has made to government. The RSBs are well placed to undertake the audit registration of firms, and should continue to do so for non audit work, but I think it’s very important that we can recognise the importance and the risk associated with Public Interest Entity audit and that we are prepared to create a framework that is appropriate.
Where would you both like to see this process go next?
Mike: What we have at the moment is a review of the regulation [with the Kingman report] and the Competition and Markets Authority is also recommending what should happen in terms of choice, for audit. And then you have the study that’s about to commence, led by Sir Donald Brydon, on the future of audit. Together those three should provide the three legs of the “three-legged stool” and provide a comprehensive input into the BEIS [Business, Energy and Industrial Strategy] department to suggest a way forward.
After that, BEIS will have to assimilate all this, and ultimately to consider how they bring forward all these elements in terms of regulation and legislation, and that is not straightforward. We’re probably talking about, if not a new Companies Act, certainly a large derivation of the Companies Act. This is going to take a little while.
It is important that they take the time to make sure we get it right. What’s been produced so far is good, in that it’s causing us to think about where we are going, but we’re not finished yet. The end of this year we’ll see the Brydon Review and then BEIS has to consider what steps it takes. There may be some interim steps, but I think the larger elements will come through later, probably in 2020.
Michelle: I think that we should look at the outputs of Sir Donald Brydon’s proposals to BEIS and then there needs to be a concerted effort to bring the three propositions together to sense-check them, and to double-check that the proposals on regulation are complementary to the proposals on competition, and vice versa, because there are some areas where they appear to be in conflict just now.
There will be some quick wins, but what you don’t want to do is deliver those quick wins and then realise that they’re going against the long-term journey.
This article was originally published in the March 2019 issue of CA Magazine.