CMA and Kingman confirm sea-change for the audit sector

21 December 2018

In November of this year we blogged on the Financial Reporting Council’s (‘FRC’) recently published report Developments in Audit’  and highlighted that the FRC’s review was running in parallel with the Competition and Markets Authority (‘CMA’) review of the sector. As we reported, such extensive review has been triggered following the high-profile collapses of companies such as Carillion and BHS.

 

On 18 December CMA published an update paper on its statutory audit market study. On the same day a report was published concerning the independent review of the Financial Reporting Council (‘FRC’) led by Sir John Kingman.

The reports confirm significant change is on the horizon for the accountancy profession. We detail below the headline points arising from these important publications for the sector.

CMA Proposed Remedies

CMA states the following in its recent report, ‘Competition and regulation should work together so that audit firms and individuals all have the strongest possible incentives to deliver quality.’ To that end it has detailed in its report four key remedies to create incentives for better audit quality. The intention is that such remedies will operate ‘in tandem’ with improved regulation as recommended in the separate Kingman review.

1. Regulatory Scrutiny of auditor appointment and management

According to CMA, auditor appointments need to be made with a focus on ensuring that companies’ numbers are tested as effectively as possible. CMA’s position is that this could be fully achieved if appointments were taken away from audit companies, particularly in the absence of widespread investor focus on audit. However, it has recognised that ‘at least not now’ this would not be possible for all large companies as the European legal framework appears to preclude it. As an alternative, CMA recommends close scrutiny of audit appointment and management by the regulator to secure audit committees’ accountability and independence from companies.

2. Breaking down barriers to challenger firms – mandatory joint audit

CMA comments that the market structure needs to change, ‘to ensure that there are enough realistic alternative audit providers so that every incumbent auditor feels another firm breathing down its neck, ready to serve shareholders’ and the public’s interests better.’ It proposes that FTSE350 audits should be carried out jointly by two firms, at least one of which should be from outside the Big Four so as to tackle the ‘entrenched Big Four’. Whilst challenger firms will gain access to the largest clients, there would also be a cross-check on quality, as each auditor reviews the other’s work. An alternative recommendation is a market share cap which would ensure a subset of major audit contracts are only available to non-Big Four Firms. CMA recognises there should be a ‘resilience remedy’ to prevent the Big Four becoming the Big Three.

3. A split between audit and advisory businesses

CMA’s view is that to ensure best quality ‘auditors’ exclusive focus should be on providing audits…their wider business interests should not in any way compromise this.’ CMA reports that changes at firm level are required to ensure a single-minded focus on audit quality and that this could entail firms’ audit and non-audit businesses being split into clearly defined separate operating entities, with separate management, accounts and remuneration, but which remain under the same organisational umbrella; ‘[t]hat way auditors would only be rewarded for providing good audits, but would still be able to draw on expertise from their sister firms.’

4. Peer review

Introducing peer review of audits, commissioned by and reported to the regulator, could offer an additional way of enforcing standards, both keeping auditors ‘on their toes’ and making quality levels ‘more visible’ according to CMA.  

CMA has invited views from interested parties on the proposed remedies by 21 January before making a final decision on any recommendation to the Government.

The Kingman Proposals

In his report, Sir John Kingman has recommended that the FRC be replaced with a new independent statutory regulator, accountable to Parliament, with a new mandate, new clarity of mission, new leadership, and new powers. It would be called ‘the Audit, Reporting and Governance Authority’. The report states, ‘[a]ll in all, the Review considers that some of the FRC’s critics overstate their case. Nevertheless, the Review does have sympathy with the view that the FRC has tended, overall, to take too consensual an approach to its work.’ The report goes on to state, ‘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.’

Comment

The publication of these two reports marks a pivotal moment for the audit sector. The Government has announced subsequently that it will now launch an independent review into the “quality and effectiveness” of the UK audit market which will build on the findings of CMA and Kingman. The review process, therefore, intensifies.

The future for audit is set to be one of deepened scrutiny where protection of audit quality and, in turn, investors and the wider public is paramount. Auditors and Audit Firms will need to closely monitor developments as the review continues and plan ahead to ensure processes and systems are in place to accommodate the fundamental change set to come.

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