Authors

Andrew Howell

Partner

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Julian Randall

Partner

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Stuart Broom

Senior counsel

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Authors

Andrew Howell

Partner

Read More

Julian Randall

Partner

Read More

Stuart Broom

Senior counsel

Read More

10 January 2019

Initial reflections on the Kingman review of the FRC

On 18 December 2018, Sir John Kingman published his independent review of the Financial Reporting Council ("FRC"). It seems to us generally a well-reasoned paper: it seeks to grapple with many of the key issues facing audit and its regulation, with some 83 recommendations for change; and it was produced on time.

Many of the recommendations, as the Review recognises, would need statutory implementation but it seems from initial comment – once Brexit distractions fade – there is an appetite to embrace the suggested changes.

It was intended to be a "root and branch" review, focusing on the regulator's role in reshaping financial reporting. Sir John does not shy from criticism of the FRC, describing it as a "ramshackle house" which "leaks and creaks, sometimes badly". It is, he says, "time to build a new house".

Sir John's key recommendation is to replace the FRC with a new body, with a new name (the Audit Reporting and Governance Authority) and a new board. He recommends that the jurisdiction of the regulator be increased to cover a greater number of entities by expanding the definition of a PIE, and that it should have the ability to review the work of overseas component auditors.

The regulator should also be given greater powers to ensure that a consistent approach is taken against auditors, accountants and non-member directors with schemes equivalent to the AEP to be put in place.

The overall approach to enforcement is to encourage a robust approach from the regulator (albeit not necessarily reflected in an increase in sanctions), greater transparency and accountability and a broadening out of the current AEP regime, together with its lower hurdle for sanction, to cover more businesses, more work streams and overseas audits.

As to the auditor's duty and oversight, Sir John recommends broadening the auditor's duty so as to impose a "duty to alert" in respect of "viability or other serious concerns". He also puts forward a case for enhancements to the Auditor's Report to include "graduated" audit findings, which would entail presenting the auditor's judgemental views to shareholders on key audit issues in further detail. A further recommendation is that the regulator should be permitted to instruct skilled persons, paid for by the company, to investigate where the regulator has concerns as to key audit judgements. The more "graduated" reports could be helpful in allowing the auditor to set out what are often nuanced judgements with greater detail, but the recommendations are likely to place a greater burden on the auditor against the backdrop of increased scrutiny.

A difficulty with the Review however – as Sir John appears to recognise - seems to us the well-worn issue with corporate reporting and audit generally, namely the much discussed "expectation gap". A number of the recommendations made in the Review appear ultimately driven towards a structure which will allow corporate reporting better to safeguard against business failure, and to be more forward looking. But that, of course, is a limitation in audit itself which – going concern assessment aside – is generally a backward looking exercise. In many respects therefore, the Kingman review is criticising audit, and its regulation, for failing to perform a function it is not designed to perform in the first place.

To be fair to Sir John, he recommends a further review in relation to the expectation gap, but this seems to us the critical (and familiar) challenge. Corporate reports can never be a crystal ball. What then is fairly achievable through corporate reporting and the audit process, and how is the framework best set fairly to balance the responsibilities and risk of institutions, investors and those advising them? That conundrum remains unanswered.

Against that background, we set out below our comments on a few of Sir John's key recommendations.

Structure and governance of the regulator

  • The FRC should be replaced with a new independent regulator: the Audit Reporting and Governance Authority. This body will be accountable to Parliament, funded by a statutory levy by the firms and have an overarching duty to promote the interests of consumers of financial information.
  • The current incarnation of the regulator comes under heavy criticism in the report. Sir John concludes that traces of its mind-set as a self-regulatory professional body remain, that it has taken an "excessively consensual approach to its work" (a picture many regulated firms may not recognise) and that it has been "widely viewed as reluctant to act" and "slow to achieve results" on the enforcement side. Sir John is disdainful of the idea that "some of the biggest and most important economic actors in the UK" should be regulated "by their trade association". This view seems to us rather to colour the report.
  • There is an underlying message that ARGA should be prepared to take a "tougher" stance in the future, and Sir John is particularly enamoured with the "apparent respect of the major firms for the tougher approach of the PCAOB in the US, and the benefits it has brought". This is likely to result in a robust approach to enforcement going forward. That is not, however, to say that the level of fines should be increased: in fact, the Review concludes that there is no shortfall in the severity of the sanctions available to the FRC or Tribunal, and that the level of fines in the US has been more modest than those in the UK.

Powers and jurisdiction of the regulator

  • The definition of a Public Interest Entity is to be reviewed. The suggestion is that it might be broadened to include entities such as pension funds and investment companies. Such an approach would of course bring a greater number of entities and audits within the scope of the regulator's jurisdiction.
  • There is also a move to bring the regulator's overseas jurisdiction for component work on multi-national group audits in line with those of the PCAOB, with the power to send inspection staff to the relevant country to inspect locally held audit files and interview staff.
  • The Review also seeks to increase the powers of the regulator insofar as accountants in business and directors of PIEs are concerned. It recommends that a new statutory scheme should be put in place for accountants working in PIEs that aligns with the AEP (replacing the Accountancy Scheme), and that the regulator should have the power to hold directors (CEO, CFO, chair and audit committee chair) to account for any failings in the preparation of true and fair accounts, or in failing to deal openly and honestly with the auditors. This is a welcome development in our view. It should ensure that, where there have been failings with financial reporting, the regulator can properly investigate and sanction those primarily responsible for the financial statements within the PIE, alongside any investigation into the audit firm, and under a common scheme.

The AQR process

  • The current AQR process is criticised for having staff with a perceived lack of seniority and experience when compared to the PCAOB's staff, and who are therefore unable properly to challenge and engage firms on complex matters of judgement.
  • The Review recommends strengthen its resourcing, and to develop a pool of so-called "grey panthers" (being former or retired senior executives and experts) to boost capacity and deploy expertise at short notice. Increasing expertise in this manner seems to us a helpful development. Having that experience available at the FRC would also be helpful in assessing audit work in the enforcement context.
  • Of potential concern, however, is Sir John's desire to increase transparency to the extent that individual audit quality inspection reports, including gradings, are published in full. It seems to us that taking such a step risks creating a less constructive environment during the AQR process, particularly where increased media scrutiny may lead to greater risk of a follow-on enforcement action. This may cut across the purpose of the AQR process: being to operate an open and transparent review process which aims to improve the quality of financial reporting.

Corporate failure and viability statements

  • Sir John believes that the regulator (and auditors) should be "forward looking", in an attempt to avoid corporate failures where possible. This entails revisiting the viability statement, and a recommendation that the auditor should be under a "duty of alert" in respect of "viability or other serious concerns". This is similar to a system operated in France that requires auditors to report viability concerns to the company's board, and thereafter to escalate them to shareholders and ultimately to a regulatory body if those concerns and not adequately addressed.
  • It is unclear to us how this would operate in practice, or how far this extends beyond the going concern analysis already undertaken. As drafted, however, this has the potential greatly to broaden the scope of the auditor's duty and the potential liabilities auditors might face. It is easy to see circumstances in which shareholders may later complain that an auditor carried out insufficient steps to warn of potential corporate failure. It is notable that the uncapped liability of auditors and the practical failure of the capping mechanism in the Companies Act 2006 are not addressed at all.
  • Linked to the focus on attempting to avoid corporate failure is a recommendation that the regulator should be able to commission and publish a skilled person review, paid by the company, in circumstances where it has concerns as to key areas of audit judgement. This could, of course, result in challenges to the judgements reached by the audit team.

Appointment and remuneration of auditors

  • On the same day as he published his report, Sir John also provided his views on whether the regulator should have a role in the appointment and remuneration of auditors. This was not the subject of a full consultation, and his views were provided in a separate letter. The short point is that Sir John does not agree that in most cases a regulator should appoint auditors; that should be left to a properly functioning audit committee. There are exceptions to this – for example, where there are quality issues with the audits – but in principle, he does not advocate change.
  • He could see a role for the regulator in approving audit fees to ensure they are not "cheese-pared" in a way that affects audit quality. Whilst welcome, it is difficult to see how such a suggestion would operate in practice.
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