Upcoming proposals to reform audit and corporate governance in the UK need to be watchful of turning into a box ticking exercise, according to Franki Hackett, head of audit and ethics at audit tech vendor Engine B.
On February 4, The Financial Times reported that the long-awaited reforms to the audit sector are due to be published imminently in the form of a white paper. According to the broadsheet, there are set to be over 200 recommendations, including making directors “personally responsible for the accuracy of their company’s financial statements”.
Hackett acknowledges that holding directors more responsible is an important step forward in improving UK corporate governance, but says the wording and interpretation of the reforms will be key to avoiding a “fudge”.
“This could work really well, or it could cause some of the same counterproductive stuff we saw with Sarbanes-Oxley,” Hackett says.
“It could lead to more of a checkbox approach. It could lead to directors trying to cover themselves rather than really engaging. But if they have to declare that they have looked at the risks and they’ve looked at their control structures, and they’ve done that in a substantive way, that could lead to directors getting much more engaged.”
This would allow auditors to take more of a “controls-based approach” to audit, making the process more efficient.
Alternatively, the new rules could see directors showing they’ve done the checklist of exercises around corporate governance to “cover their behinds”, bringing in “cumbersome and bureaucratic” processes that don’t fully engage directors into having proper oversight of their businesses, Hackett says.
Pressure on for ARGA
Key to ensuring directors are substantively engaged in financial reporting will be the power and resources of the new regulator, the Audit, Reporting and Governance Authority (ARGA) which is set to replace the Financial Reporting Council (FRC) as part of the overhaul.
“If the regulator doesn’t have the resources to enforce, then we’re going to see trouble. A lot of the other reforms we’re seeing are going to put quite a lot of pressure on ARGA when it comes into being.
“That for me is a real concern, but I think this goes a good way to realigning what ordinary people think happens when a company delivers a set of accounts,” Hackett says.
Engine B’s head of audit and ethics believes the litmus test will be seen in those first few cases that ARGA takes on. The new regulatory body will need to have not only the resources, as their remit widens from the FRC, but the power to clamp down on poor engagement with risk assessments.
“Will they accept the director who says: ‘Oh, yes there was a massive fraud under my watch which I wasn’t personally responsible for. But I held risk assessment exercises and I reviewed our system of internal controls so it’s not my fault’?
“If ARGA will accept that, where actually a director should have been asking more questions, should have been more substantively engaged should have done that leadership… Those things are softer, they’re much harder to manage, how far should we expect directors to dig in and to explore all the risks?”
Concern over operational separation
In July 2020 the FRC set out the principles for the operational separation of audit practices of the Big Four firms, EY, KPMG, Deloitte and PwC. The objective of the split was to ensure that audit practices were focused “above all” on delivering high quality audit and were not dependent on subsidy from the consulting arms of the Big Four firms, the FRC said.
The operational separation of audit would in theory remove any allegations of conflict of interest between the audit side of the business and the other, more profitable arms such as consulting.
Hackett is concerned that this will leave a group of unprofitable audit firms in an increasingly “challenging market”.
“It doesn’t really enable smaller firms to access big audits because they don’t have the ability to engage with the data. Those FTSE 100 companies are too big to be audited by small firms as small firms can’t take in the volume of information that’s involved.
“My real concern is if we end up with regulation that prevents investment in technology or makes it really hard for small players to invest,” she says. “What we really want is something that equalises access to technology and makes it easier to level that playing field so we don’t entrench the inequalities of access that we’ve already got in the market that makes it uncompetitive.”