Audit reform takes a step forward in the UK but the journey is incomplete

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Jane Fuller

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Whisper it softly but the UK is showing some leadership on the thorny issue of audit reform just as weaknesses have been exposed in the supervision of auditors in Germany in particular, and the EU in general.

As a long-time advocate of the need to split audit practices from consultancy, I am bound to cheer the UK Financial Reporting Council’s (FRC) announcement of principles for operational separation at the Big Four firms – PwC, KPMG, Deloitte and EY. The ring-fenced practices will have separate boards, profit/loss accounts and pay structures, and no cross-subsidies from a consultancy side that has grown to be four times bigger than audit. 

Yes, it falls short of full separation and a change in form cannot guarantee improved content, but now is not the time for the best to be the enemy of the good. 

David Rule, executive director of supervision at the FRC, told BBC Radio 4’s Today programme on July 6 the aim was to ensure that those involved were “focused above all on high-quality audit”, had a “culture of independent challenge” and were “protected from any influences in the rest of firm that might divert that focus”.

The timing is good. The Wirecard accounting scandal in Germany, where €1.9bn cash is missing, has raised questions about the quality of audit firm supervision in that country, as well as about the work of the auditor, EY. It also shows that the FRC is making progress with reforms even though its transformation into the Audit, Reporting and Governance Authority (ARGA) is taking far longer than Sir John Kingman would have hoped when completing his review of the FRC in 2018. 

The move to ring-fence audit practices implements one of the remedies proposed by the Competition and Markets Authority, also in 2018, and it lays the groundwork for realising key recommendations of last year’s Brydon review of the quality and effectiveness of audit. Sir Donald Brydon advocated a new corporate auditing profession, which would encourage members to have a “forensic mindset” and to be suspicious where necessary. They should also grasp the nettle of being on the lookout for fraud. 

Put this together with the FRC’s 2020-21 strategy document, which envisages a 50% increase in headcount in supervision and enforcement, plus the trend towards imposing much higher sanctions for audit failures, and you have evidence that the UK “authority” has grown teeth.

The German Audit Oversight Board was set up in 2016 when European Union (EU) legislation called for the naming of a competent authority for audit. It is part of the Federal Office for Economic Affairs and Export Control, rather than sitting with corporate reporting and governance, as in the UK, or under a markets regulator such as the US Securities and Exchange Commission (SEC). 

The SEC has investor protection at its heart whereas the reflex reaction in Germany was to protect Wirecard. The AOB’s supervisor, Bafin, last year banned short-selling of the company’s shares and pursued Financial Times journalists investigating its accounts. The European Securities and Markets Authority (ESMA) is set to investigate Bafin’s handling of the affair. 

Nicolas Véron, senior fellow at Bruegel in Brussels and the Peterson Institute in Washington, said in a recent blog: ‘The Wirecard debacle calls for a rethink of EU, not just German, financial reporting supervision’ 30 June, that “this disaster has revealed major gaps in audit regulation and accounting enforcement in Germany and by extension in the European Union”. He describes it as the latest example of economic nationalism that has “twisted the incentives of authorities and led them to neglect their primary mandate”.  

His solution is to see ESMA take another step towards being the EU’s version of the SEC, pooling the public mandates for supervising auditing and accounting, perhaps through an agency resembling the US Public Company Accounting Oversight Board (PCAOB). This would not only counter national protectionist tendencies but also focus the authorities’ attention on investors, who rely on the integrity of company accounts when deploying capital.

But it is not all good news for the FRC. It is looking for a new chairman after Simon Dingemans resigned just eight months into the job. The additional powers that Kingman recommended for the new ARGA await that body’s creation, and it has a litmus test looming in the result of its investigation into the accounts and audit of Carillion. 

It is not part of the UK’s markets regulator, the Financial Conduct Authority, which would aid investor focus. It is accountable to the UK government through the Department for Business, Energy and Industrial Strategy, where ensuring the fair and transparent operation of capital markets has a lower place on the agenda.

The new chair will need to be good at handling politicians while demonstrating the regulator’s independence from political pressure. This problem will sound familiar to those dealing with EU institutions and responding to consultations (as the CRUF does) driven as much by politics as by the needs of investors. 

The UK is doing better than Germany, but the FRC/ARGA’s journey towards being a regulator with the clout of the SEC and PCAOB has some way to run.

Jane Fuller is a CRUF UK Participant, fellow of CFA UK and a former chair of its financial reporting and analysis committee.  Jane is co-director of the Centre for the Study of Financial Innovation www.csfi.org where this blog first appeared. She served on the CMAC at the IASB, 2007-14. Previously, she was financial editor of the Financial Times.

Disclaimer: The views expressed in the blog are those of the author and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.

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