Government consults on plans for overhaul of audit market

Plans for a radical overhaul of the audit market are progressing as the government launches an eight-week consultation to gauge views on CMA market reforms, including possible introduction of joint audits, operational split at Big Four to hive off audit, and more powers for the new audit  regulator

This follows calls from business minister Greg Clark for a root and branch review of the audit market following the collapse of outsourcer Carillion and retailer BHS, where auditor KPMG is under investigation for its handling of the audits. This follows increasing concerns about audit independence, the lack of competition across the listed audit market and the current regulator’s failures to take swift action to avert audit failures.

The government has signalled its intention to go ahead with plans to set up a new regulatory body with stronger powers, set out in statute, as soon as possible with confirmation that the Auditing, Reporting and Governance Authority (ARGA) will replace the Financial Reporting Council (FRC). A new chairman, Simon Dingemans, ex CFO of GlaxoSmithKline, is currently being vetted by parliament to replace Sir Win Bischoff, while Jon Thompson, current head of HMRC, is going to replace under-fire FRC chief executive Stephen Haddrill who leaves the audit regulator this October.

The eight-week consultation, described as an ‘initial consultation’, is seeking views on the four core Competition & Markets Authority (CMA) proposals, including strengthening the audit regulator, extending the powers of audit committees, the viability of mandatory joint audit and peer review, measures to mitigate the potential collapse of a Big Four firm, and a possible structural break-up of the Big Four firms – PwC, Deloitte, EY and KPMG.

The plans for the new regulator and mandatory joint audits would require legislation and would be unlikely to reach the statute book before 2020 at the earliest, due to Brexit overload. The consultation, led by the Department for Business, Energy and Industrial Strategy (BEIS), has been issued over the summer period, and this is usually followed by a three-month review period before any concrete proposals are set out by the government.

The consultation forms part of a multi-pronged attempt to overhaul the UK audit market, kicked off by the Kingman review recommendation to create a new audit regulator, Brydon review into fundamental problems with auditing standards, and the CMA report into audit market competition and independence.

‘We will take forward a set of proposals which draws on all three of these important pieces of work, to build a coherent and rigorous new regulatory framework for the statutory audit market in the UK, maintaining our global pre-eminence in this important sphere in line with the aims of our industrial strategy,’ the BEIS consultation stated.

Audit committee scrutiny

The government supports the CMA proposals on extending the powers of audit committees, increasing transparency over tenders, and is likely to ask the regulator likely to write new standards and guidance specifically covering the audit tender process.

‘We agree that the audit committee plays an extremely important role and that there should be clear expectations and standards for audit committees to ensure they deliver the best results for shareholders, and that there should be a role in this for the regulator,’ BEIS said.

Strengthen the regulator

The consultation seeks feedback on the proposals for extension of regulator powers and oversight for the regulator, with a view to understanding how such a regulatory environment would work and the type of scrutiny framework for audit committees, including monitoring compliance and the powers to take remedial action.

It also considers whether powers should be extended to give the regulator the power to intervene when an auditor has received a poor audit quality review, early departure of an auditor or a significant restatement of the company’s accounts, indicating fundamental issues with the audit process.

Mandatory joint audit and peer review

The CMA recommendation to introduce mandatory joint audit has been met with mixed reaction, with the government describing the proposal as ‘innovative’. There are also suggestions in the academic literature cited in the CMA’s report that the joint audit proposal would lead to an increased cost of 25-50% on current audit costs.

There are also concerns about issues of liability and whether smaller challenger firms would end up taking the junior role in any relationship where a Big Four auditor naturally falls into the role of lead auditor. The CMA does not recommend making changes to the UK’s current liability regime, meaning that both firms within a joint audit would be jointly and severally liable for the overall audit.

Previous audit reforms have failed to extend competition beyond the Big Four, the government accepted, and it is now preparing to consider a more radical approach.

‘We recognise the importance of providing meaningful and effective competition and choice for audit clients in the statutory audit market, both as a stimulus to quality and efficiency, and as a bulwark to market capacity and resilience.

‘We are aware of the finely balanced arguments between a joint audit and a shared audit and note the CMA’s view that a shared audit may cement preconceptions that challenger firms are less capable and may limit opportunities for them to gain experience on more complex audits,’ BEIS stated.

On joint audit, the consultation is looking for feedback on whether challenger firms, such as BDO, Grant Thornton and Mazars, currently have capacity to provide joint audit services to the FTSE 350, and whether a staged approach is needed to transition to a shared audit engagement, with possible suggestions for credible timescales for this.

Measures to mitigate effect of collapse of Big Four firm

Concerns about the long-term financial stability of the audit market are raised, with the endemic risk of one of the Big Four collapsing, which would cause significant market disruption and potential instability.

The government is cautious on CMA recommendations to require audit firms to give financial health checks on their businesses and advance notification of tenders to the regulator. In the consultation document, it stated ‘that there is more that the regulator could do to monitor and act on the health of audit firms, particularly while the statutory audit market remains so concentrated.

‘Implementing solutions in this area will need careful consideration in order to avoid the moral hazard risks highlighted by the CMA in their report. The government is keen to implement a monitoring function that can support the market in an effective and competitive way.’

Areas for review include the reasons for a regulator intervention in the event of a’ distressed statutory audit practice’ and any extensions of its powers.

Operational split at the Big Four

Breaking up the Big Four was always a major threat for the profession due to conflicts of interest, but the government is mindful of the multi-disciplinary nature of the major profession services firms and instead of wholesale break-up is considering whether it would be feasible to enforce an operational split at Big Four firms, separating audit business from all other services, including highly lucrative consulting work. There are also concerns that this would not increase competition.

 ‘Going forward, the government is determined to identify and implement a powerful and proportionate package of measures to increase choice and capacity in the audit market,’ BEIS said.

‘We recognise that the multi-disciplinary nature of the Big Four audit firms means that they can be prevented from tendering for a company’s audit because of past consultancy work they have undertaken. This further reduces choice for clients and we are therefore committed to increasing meaningful and effective competition, while addressing the conflicts that the CMA identifies between audit and non-audit practices.’

The CMA’s fourth recommendation would require the Big Four firms to put in place a strategic and operational split between their audit and non-audit services. The aim of this recommendation is to ensure that auditors focus on conducting high quality audits, without their incentives being affected by the much greater revenue and profits which may accrue from the non-audit side of the firm. The consultation aims to understand how this would work in practice, including the manner and design of the operational split recommended by the CMA, and the overall market impact of such measures.

The initial consultation closes for comment on 13 September 2019.

BEIS Initial consultation on recommendations by the Competition and Markets Authority, issued 18 July 2019

Report by Sara White | 19-07-19

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