A lawyer’s perspective on audit reform

In May, the UK government published its long-awaited roadmap for reform of the audit market. The roadmap sets out the framework for the new accounting and financial reporting regulator, the Audit, Reporting and Governance Authority (ARGA), which is to replace the Financial Reporting Council (FRC).

Key reforms are to include:

• An expansion in the definition of Public Interest Entity (PIE) subject to enforcement by ARGA, to include large unlisted companies.
• ARGA to have powers to investigate and sanction directors of large companies for breaches of duties relating to corporate reporting and audit.
• FTSE 350 companies will be required either to appoint an auditor outside the Big Four or to allocate a certain portion of their audit to a smaller firm.

These reforms have been criticised as “watered down”, so it’s worth asking what was missing?  Well, the more radical notions have not found favour.

• The proposals do not go so far as the – more stringent – US Sarbanes-Oxley regime. The FRC’s own CEO, Sir John Thompson, criticised this a “missed opportunity”.
• No break-up of the Big Four.
• To be a PIE, a large unlisted company will have to be very large indeed – annual turnover of £750m+ and 750+ employees.

So, is the criticism justified?  In our view… not really.

The more stringent a financial reporting regime, the greater the compliance burden for corporates.  Will capital flow to the UK post-Brexit because of a manageable compliance burden, or because of gold-plated corporate reporting? Does a stringent system of internal controls prevent corporate misfeasance, or just give a false sense of security? There are no solutions here, only trade-offs. And whether a trade-off is a beneficial one is only knowable – if at all – with time. Just look at the amount of ink spilt by US accounting professors over the merits or otherwise of Sarbanes-Oxley.

In that context, the gradualist approach has merit. Meanwhile, these proposed reforms tie into themes with which audit firm management – and PI partners in particular – are becoming increasingly familiar. As lawyers working in the field of audit liability (both civil and regulatory), we have drawn together a number of these below:

• The expanding PIE – We suspect the expanded definition of PIE will have little effect on the regulator’s approach to enforcement, but not because the “750” floor is high. Rather, the FRC’s enforcement powers already extend beyond PIE audits, and a simple glance at the open cases on the regulator’s website shows that this is not a theoretical power – many of the audits under investigation are not PIEs under either the existing or the new definition. The FRC’s enforcement priorities are likely to be governed by a mixture of perceived public interest, and what is possible given ARGA’s resourcing.  However, a few more entities may fall within supervisory scope, and hence be caught for enforcement purposes.
• The shifting PIE – Companies may shift in and out of the PIE definition, based on changing turnover and employee numbers. Perversely, a company suffering a precipitous fall in revenue could fall outside the PIE definition just when ARGA would be most interested, not that, in our view, this would stop the FRC taking an interest in the audits of such failing entities.
• The expectations gap is as wide as ever – The going concern assumption is one based on historical data.  It is not a guarantee, and an auditor is not there to underwrite a company’s business. Nor, for that matter, is corporate insolvency a bad thing necessarily – this is part of how economic assets are reallocated to growing businesses. But that is not the tenor of the Government’s announcement. The word “collapse” appears eight times in the press release.  In the real world, in any given year there will be a certain number of corporates insolvencies,and for a variety of reasons, many of which may not be foreseeable based on the historic picture of the company given to auditors.
• ARGA finally given power to investigate and sanction directors – Audit “failings” originate with the management of the audited entity. The FRC currently has no powers to investigate those who do the actual financial reporting – the board of directors. However, we have sympathy with directors who face being judged by a regulator that views their actions through the prism of financial reporting standards rather than the messy day-to-day reality of running a business.
• ARGA must beware the chilling effect on business entrepreneurialism – But it is a question of balance, because the reasons for corporate failures have often been hidden behind a veil, with audit investigations limited by the fact that half of the picture effectively lies behind a veil.
• The current inability of a regulator to sanction directors may have contributed to corporate governance failings – The current regime under the Company Directors Disqualification Act is effective in punishing minnows, but directors at the helm of large corporate failures have rarely been brought to account.
• Complexity and costs of investigation will increase – This is a simple corollary of having more parties, divergent interests, a larger document universe, and potentially the involvement of multiple regulators with overlapping jurisdictions. Management and auditors may have divergent interests if both are pulled into the same investigation.  Each may have an incentive to blame the other for the same or related failings.
• The interplay between regulatory enforcement and civil litigation becomes even more fraught – Parties in a regulatory investigation typically have an incentive to seek settlement early (to access a discount on any fines). However, if both management and auditors are involved in civil litigation and regulatory investigation in parallel, they will be approaching the investigation with an eye to the (potentially much larger) sums of money at stake in civil litigation. No party will want to accept a point that prejudices its case – verified by a statement of truth – in civil proceedings.

Richard Highley and Julian Bubb-Humfryes of DAC Beachcroft LLP are both are members of the London Solicitors Litigation Association