The scale and complexity of the government’s proposed audit reforms means that a number of unintended consequences are inevitable, industry participants have said.
The overhaul was announced in March by the department for Business, Energy and Industrial Strategy (BEIS), and is now undergoing a 16-week consultation period due to end on July 8.
“This is really wide-ranging, substantial and important legislation for companies and auditors in the UK. And any legislation is always going to have some risk of unintended consequences that might arise out of the best endeavours,” says Mike Suffield, director of professional insights at the Association of Chartered Certified Accountants (ACCA).
“Government absolutely has to be alive to that risk, and I don’t think anybody would argue with that.”
The proposed reforms, which include a new audit regulator and a potential cap on market share across the industry, are largely formed of recommendations made in two reports (the Brydon Review and the Kingman Review), in addition to a series of papers published by the Competition & Markets Authority (CMA).
Suffield goes on to cite managed shared audit, the centrepiece of the proposed reforms, as a key example. A lack of detail and support from major stakeholders could render this impossible to implement, he argues.
“The potential unintended consequence here is that what’s quite a radical move doesn’t work at all. Government needs to really bring along with them all the different stakeholders in this, but particularly the audit firms outside of the big four, to design something that’s going to work for them and to expand the audit market over time.”
If brought into practice, the proposal would see the involvement of a so-called ‘challenger firm’ (non-Big Four) in all FTSE 350 audits. This encapsulates one of the core themes of the reviews into the sector: increasing competition and redistributing market share.
Suffield’s view appears to form part of a consensus, with Kari McCormick, partner at law firm Eversheds Sutherland offering a similar perspective.
“There were concerns expressed in the CMA report and elsewhere around a lack of competition in the audit market and the impact that has on quality. But the general consensus seems to be that managed shared audit is not the way to address such concerns,” she says.
“There is a concern that all managed shared audit will do is increase the cost and potentially dissuade certain firms from participating. And therefore, there’ll be no improvement in audit quality.”
McCormick also criticises the plans to broaden the definition of a public interest entity (PIE). If brought into effect, it would place up to 2,000 organisations within the purview of the regulator, including large private companies and ‘large’ Alternative Investment Market-quoted (AIM) companies.
“One of the things that the government really needs to look at, given the extent of the reforms it’s proposing anyway, is whether now is the right time to be expanding the definition of PIE. And if so, how broadly to do it.”
BEIS has proposed two possible tests to extend the definition of a PIE. The first and broadest would mirror the test used to identify companies already required to use a corporate governance statement in their directors’ report, covering organisations with either more than 2,000 employees, or a turnover of more than £200m and a balance sheet of more than £2bn.
The second, narrower test, would incorporate the threshold for additional non-financial reporting requirements for existing public interest entities. This would cover companies with both more than 500 employees and a turnover of more than £500m, generating around 1,000 new PIEs.
McCormick’s stance is echoed by Iain Wright, managing director, reputation and influence at the Institute for Chartered Accountants in England and Wales (ICAEW). These proposals could overwhelm the market, he argues.
“Whatever happens, the capacity of the whole audit, corporate governance and assurance ecosystem will not stand a massive markup in the number of PIEs – the system will just topple over.
“You could get audit firms thinking ‘we quite fancy being in the PIE market, we’ll take on much more staff’ – and of course the quickest way to get more staff is probably from much smaller firms. So, you suck up talent from different parts of the ecosystem, and that has a knock-on effect,” he says.
Wright also challenges the prospective PIE definitions, arguing that the tests are “crude” and should be based on a wider range of factors than simply turnover and balance sheets.
“We need to make sure we’ve got clarity based on both qualitative and quantitative criteria, otherwise you don’t capture the right thing.”
However, he concludes on largely positive sentiment, arguing that if the focus is on reforms that will have “a real, meaningful impact”, this will render the government’s efforts net-positive.
“The overall intention is good. The whole essence of our response to the whitepaper is that reform is needed. We absolutely welcome it, and we want to make sure we can work with the government and the new regulator to put in place meaningful, impactful reforms.”
Schofield shares this optimism, claiming that whilst there are some legitimate concerns, the government “shouldn’t cave in to those arguments” too easily, and must be cognizant of not “over-diluting its proposals”.
“Overall, we’re positive about the reform agenda. Our sense is that government and the FRC have taken this consultation period very seriously – they’ve done a great deal of proactive engagement.”