The report endorses the CMA’s proposed operational split between audit and non-audit but argues that going further with a structural break-up would prove more effective in tackling conflicts of interest and providing the professional scepticism needed to deliver high-quality audits.
Competition and market resilience – segmented market cap and piloting of joint audits
The report also tackles the lack of competition in the audit market and its impact on market resilience, with concerns that it could go down to a Big Three or worse. In 2016-17, EY, PwC, KPMG and Deloitte (the 'Big Four' audit firms) accounted for 97 per cent of FTSE 350 audits and 99 per cent of FTSE 100 audits. To improve resilience and choice, the report recommends a segmented market cap and the use of joint audits, on a pilot basis, for the most complex audits to enable the challenger firms to step up. The report also recommends increasing the frequency of audit rotations to seven-year non-renewable terms and (should the CMA go ahead with an operational split) a cooling off period of three years, in which non-audit services cannot be offered to a former audit client.
Audit quality and detecting fraud – a “delivery gap”
The report rejects attempts by auditors—particularly the Big Four and Grant Thornton—to paint the crisis in audit as a perception problem arising from an ‘expectation gap’. The report notes that 27% of audits reviewed for 2017/18 did not meet FRC quality standards and finds that there is instead a “delivery gap” and a “serious failure of audit to deliver on its own current terms”. The report says that the detection of material fraud must continue to be a priority and recommends that, in light of the failings at Patisserie Valerie, audits must state how they have investigated potential fraud, including by directors.
Rachel Reeves MP, Chair of the Business, Energy and Industrial Strategy Committee said:
"Change in the audit market is long overdue. The reviews from the CMA and Kingman highlight the failings; now we need action. The ‘Big Four’s’ dominance has fostered a precarious market which shuts out challengers and delivers audits which investors and the public cannot rely on. Our report proposes a range of measures to boost competition, improve the audit product, and ensure that the UK continues to be a world leader
in corporate governance. A segmented market-cap and the piloting of joint audits would help to break the stranglehold of the Big 4 and deliver a healthier and more resilient audit market.
"For the big firms, audits seem too often to be the route to milking the cash-cow of consultancy business. The client relationship, and the conflicts of interest which abound, undermine the professional scepticism needed to deliver reliable, high-quality audits. Splitting audit from non-audit business would be a big step to boosting the culture of challenge needed to deliver high-quality audits.
"Change is needed to deliver for investors, workers and the public. The Big Four may not like it, they may seek to undermine the case for reform, but vested interests should not be allowed to get in the way of positive change. We must not wait for the next corporate collapse. Government and regulators need to get on and legislate to deliver these reforms and ensure that audits deliver what businesses, investors, pension-holders and the public expect."
A better audit product – graduated findings and assessments on corporate governance
The BEIS Committee’s report calls for a range of improvements to the audit product, encouraging Sir Donald Brydon to look into how to make audits more “forward-looking”. The report recommends audits move to include graduated findings, providing more nuanced information to investors and others. In the future, the report suggests that audits could provide a better picture of a company’s overall corporate governance, including assessments on areas such as pay policy, the gender pay gap, payment practices to suppliers, and on environmental sustainability.
Tightening of the dividend regime and booking of unrealised profits
The report highlights the reporting and audit failures that brought down Carillion —the imprudent payment of dividends out of optimistically booked, and, in hindsight, unrealised, profits – and calls for a tightening of the UK dividend regime and action from the regulator (the Financial Reporting Council) to produce a clearer and more prudent definition of realised profits.
Better regulation of audit
The report welcomes Sir John Kingman’s recommendations on the reform of the Financial Reporting Council (FRC) and the Government’s intention to implement them. It welcomes the introduction of the statutory-based Audit, Reporting and Governance Authority (ARGA) to replace the ineffective FRC, with increased powers and a more proactive approach.
The report welcomes the Government’s commitment to consider and consult on the possible introduction of a strengthened framework around internal controls on a similar basis to Sarbanes-Oxley. The report suggests that if adapted to the UK regulatory system, a UK equivalent could make a significant contribution to improving the reliability of financial reporting.