Company audits: issues and proposed reforms

Audit basics

The Companies Act 2006 sets out the main responsibilities of directors and auditors. Directors have an obligation to give a “true and fair view” in the annual accounts. The auditor must verify whether, in their opinion, the accounts give a “true and fair view” of the company’s situation. Large companies can only pay dividends from “properly prepared” audited accounts. According to the Financial Reporting Council (FRC), the UK audit regulator, audit serves the public interest by underpinning transparency and integrity in business.

Issues

High-profile failures such as that of BHS (2016), Carillion (2018), Patisserie Valerie and Thomas Cook (both 2019) have drawn attention to alleged poor auditing practices. FRC fines for audit failures reached a record high in 2022 of £33.3m.

Lack of competition

The audit industry is dominated by the “Big Four” accountancy firms: PWC, Deloitte, EY and KPMG. The FRC confirm that between them, the Big Four audit almost the entire FTSE 350. Although four companies allows some competition in the market, the reality is that the Big Four would rarely all compete for the same audit contract.

Most often, a variety of conflicts of interest, including a prohibition on auditors also providing certain accounting services to clients, preclude one or more of the Big Four from tendering. For example, it is not possible for an auditor currently providing internal audit or tax advice to bid for the external audit contract of the same company. The consequence is that for companies seeking audit, there often aren’t four to choose from, but often two or even just one.

Conflicts of interest

Sometimes, management of the company and the auditor have contradicting interests, such as when there is a gap between market expectations and company performance. In such circumstances, there is a risk that management’s incentive is to overstate the performance of the company, whereas the auditor’s role is to objectively verify that the accounts are materially true and fair.

Management have the ability to make the audit more difficult by being less cooperative, the ability to not reappoint the auditor and the threat of not awarding contracts to other arms of the accountancy firm. Some have argued that the creation of audit-only firms is the solution, whereas others argue that accountancy firms should be banned from providing non-audit services to audit clients. Neither has been taken forward in the proposed Government reforms.

Quality and supervision

Many audits are found to be substandard by the regulator.

In 2023, KPMG was fined a record £26.5m (reduced to £18.6m for co-operation) and a further £3.5m (reduced to £2.5m) for deficiencies in its auditing of Carillion.

In recent years, PwC was fined £10m (reduced to £6.5m for early settlement) in relation to its audit of BHS, and the partner in charge of the audit received a 15-year ban from auditing. The FRC’s list of imposed enforcement sanctions  shows that fines have also recently been imposed against other big players too, including Deloitte (October 2022), EY (June 2021), Grant Thornton (November 2021) and BDO (June 2020).

Despite record FRC fines in 2022 of £33.3m, these are still relatively low in the context of comparable industries. In the same year, the UK’s financial services regulator, the Financial Conduct Authority (FCA), imposed total fines of £215.8m.

Proposed reforms

The Government has been exploring options to reform the audit industry for a number of years. It published a consultation and white paper in March 2021 outlining proposals for reform. The consultation received over 600 responses which the Government said, “helped fine-tune the package of measures”. The Government published its response including its final reform proposals on 31 May 2022.

Some of the key proposals from the Government’s response to the consultation include:

Audit Reporting and Governance Authority (ARGA)

• the creation of a new statutory regulator (the Audit, Reporting and Governance Authority – ARGA) with new responsibilities and powers, including “overseeing the accounting and actuarial professions, a stronger role in auditor registration, and new powers to tackle breaches of company directors’ duties relating to corporate reporting and audit.”
• a package of measures intended to increase choice, improve resilience, and enhance professional scepticism: notably giving challenger audit firms a meaningful proportion of subsidiary audits conducted for FTSE 350 companies; giving ARGA the ability to operate a ‘market share cap’; and powers for ARGA to require ‘operational separation’ of the largest firms and to monitor the health of audit firms.
• enabling ARGA to direct changes to company reports and accounts, rather than having to seek a court order, along with powers to publish summary findings following a review.
• giving ARGA powers to investigate and sanction directors for breaches of corporate reporting and audit-related duties.
• giving ARGA responsibility for registration of auditors within scope, and ask professional bodies to improve auditor qualifications, skills, and training.

Other reforms

• expanding “the scope of regulation to large private companies” – those with both 750+ employees and an annual turnover of £750m+.
• inviting the current regulator (the Financial Reporting Council) to strengthen the UK Corporate Governance Code to provide for an explicit directors’ statement about the effectiveness of a company’s internal controls and the basis for that assessment).
• changing reporting requirements to “introduce a new statutory Resilience Statement and a new statutory Audit and Assurance Policy” for companies within scope.
• a new statutory regime for the oversight of accountancy professional bodies and powers to investigate and sanction accountants.

The proposed reforms were met with a mixed response. Some stakeholders referred to the “watering down” of initial plans to overhaul audit rules, whereas others welcomed the “most radical shake-up” in years.

Implementation

A number of stakeholders have urged the Government to implement its proposals for reform more quickly. Despite being announced in the May 2022 Queen’s Speech, the Government did not publish a Draft Audit Reform Bill. Audit reform was not included in the November 2023 King’s Speech.

In October 2023, responding to a parliamentary question the Minister for Enterprise, Markets and Small Business, Kevin Hollinrake stated that:

the Government has carried out significant work towards audit and corporate governance reform legislation but has not set a date for publication of a draft Audit Reform Bill. The Government is committed to legislating when Parliamentary time allows.