Financial reporting – a new era beckons for professionals, directors and their insurers

Financial reporting – a new era beckons for professionals, directors and their insurers

The future of audit hangs in the balance. Rebecca Smith, partner at DAC Beachcroft, takes a forensic look at some of the proposals on the table

Criticism of auditors and their regulator, Financial Reporting Council (FRC), has been a common theme since the 2008 financial crash and high profile corporate failures.  Three government reviews later – the Kingman Review, the Competition & Markets Authority Update Paper and the Brydon Review (report awaited) – significant reforms to transform financial reporting are now expected to follow. Their objective: to place the UK at the forefront of corporate governance internationally, making us a market of choice for all investors

The Kingman Review

Kingman recognised that while some of the public criticism was misplaced, there was still a myriad of genuine concerns about the effectiveness of the FRC and its perceived lack of credibility compared to similar overseas regulators.

The Review recommends replacing the FRC with a new, thoroughly independent regulator established under statue, called the Audit, Reporting and Governance Authority (ARGA). Future levies would be mandatory to avoid conflicts of interest concerns.  It will have wide powers, more clearly defined roles and objectives and will be accountable to Parliament. For example, its likely to have new powers enabling earlier intervention and requiring external skilled person reports.

ARGA is to be instrumental in developing an effective enforcement regime in relation to Public Interest Entities (PIEs) seeking greater transparency over corporate conduct and management. This includes having oversight of relevant company directors (who have responsibilities to produce fair and true financial reports) with the power to recommend their removal or refer them to the Insolvency Service and ultimately face disqualification.

Overall  ARGA will aspire to be more interventionist, influencing the debate, championing improvements and focused on outcomes and effectiveness.  It will be active on enforcement, demanding high standards of audit and seeking to promote the production of transparent, succinct and comprehensible reports – something the Brydon Review is likely to build upon.

Competition & Markets Authority Update Paper

With the regulation side of the equation being addressed, the CMA looked at how the audit market was working.

It found that at present the Big Four auditors have too much of the market for auditing the largest publicly listed companies including those listed on the FTSE 350.  Recent FRC data illustrates that the number of audit firms willing to be appointed for such engagements has actually reduced.

The Paper seeks to address this lack of competition and concerns over conflict of interest with four key recommendations. First, there should be a clear operational / structural split in firms along auditing and non-auditing lines (the actual hiving off of audit from consultancy was not endorsed). Second, there should be compulsory joint audits with the Big Four firms working with challenger firms on FTSE 350 auditing. Third, for companies considered particularly high-risk, there should be shadow audits and second phase reviews of overall financials. Finally, company audit committees must be required to report directly to the newly formed ARGA throughout the tendering process and during the life of the audit.

To date, this review has prompted the most controversy in the Press and amongst those affected. It remains to be seen whether this push back results in any watering down of the recommendations.

The Brydon Review

This third review by Sir Brydon examines the quality and effectiveness of audit.  The consultation phase recently closed and the report is expected by the end of 2019.

The review will address a perceived widening of the “expectations gap” – the difference between what users expect an audit to achieve and the reality of what an audit is. It will examine the needs and expectations of existing and future stakeholders, how assurance can be more effectively provided for investors, how audit findings can been more effectively communicated, the impact of evolving technology and the benefits of international engagement and cohesion on auditing standards.

The future

The level and extent of the reforms already proposed and likely to be supported in the Brydon Review are transformative and will, if implemented,  fundamentally overhaul current financial and reporting procedures. There seems to be a genuine political appetite for reform and it is hard to fault the objectives of aiming for the best in governance, transparency and independence.  The largest hurdle may prove finding time in the parliamentary timetable during a period of unprecedented political uncertainty.

This new audit world will create significant opportunities and new risks. There’s likely to be a learning curve, with casualties along the way as both existing and challenger firms adapt to the new regime.  Directors will also need to embrace their new regulatory obligations and we can see the trend of investigating directors and their auditors for poor corporate governance continuing its upward curve.  Ensuring the right professional indemnity and D&O insurance cover is in place to protect against the cost of regulatory investigations and possible adverse findings is likely to be crucial.

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