“Is it time to build a new house?” Financial reporting – a new era beckons for professionals, directors and their insurers.

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“Is it time to build a new house?” Financial reporting – a new era beckons for professionals, directors and their insurers.

Published 20 March 2019

Two significant publications at the end of 2018 seem likely to transform financial reporting and its regulation. Looking at both increasing competition in the audit sector and reforming regulation, the objective is admirable; produce financial reports that investors can understand and rely on, making UK PLC a market of choice for investors in the increasingly global economy. 

Why we need to improve, and what the improvements should look like in the audit sector, were considered by the Kingman Review of the Financial Reporting Council (FRC) and Competition & Markets Authority Update Paper. The broad welcoming of these reports suggest that many of the recommendations will be implemented when Parliament has time. In the meantime, those affected, the professionals, the directors and their insurers, have time to prepare.

The Kingman Review

Corporate collapse and the role of auditors and their regulator, the FRC, has been a common theme of press reports on the financial sector since the financial crash in 2008. The Kingman Review was tasked with conducting a root and branchreview of the FRC, which is currently the regulator responsible for auditors, accountants and actuaries. Overall, the conclusions recognise some of the public criticism was misplaced but recommend that the FRC should be replaced as soon as possible with a new independent regulator with clear statutory powers and objectives. The Review notes that the FRC had not evolved as the other two main financial regulators had been forced to do post the crash, nor did not it have the credibility of other similar overseas regulators. It was time it was brought up to date and became both respected and when necessary, feared.

The Review acknowledged that some of the FRCs issues arise from its history and the result is that it is not always perceived as a modern regulator.  It points to it being named Councilrather than Authority and the fact it was not an institution established by statute.  It comments that its statutory basis lacks the clarity of other regulators and its roles are performed under a patchwork of statutory functions and delegated authorities.  It also does not hold back when highlighting fundamental issues of concern.  The Review found the FRC lacks appropriate powers; it isnt properly influencing the debate or championing improvements; there is a real conflict of interest given that it is largely funded (via a voluntary levy) by the very companies it is mandated to scrutinise; it delegates heavily to industry bodies; it is unable to effectively recruit top talent; and some of its work is limited in scale and scope.

So what does the Review propose? In short, it should be replaced with the establishment of a new, tougher independent regulator deriving its authority from statute, with wider powers, and greater and clearly defined roles and objectives. It should be known as the Audit, Reporting and Governance Authority (ARGA) and be held accountable by Parliament whilst being better funded through a mandatory levy. In a significant extension of the scope of its authority, company directors, who have responsibilities to produce fair and true financial reports, would fall within its reach. There will be a host of new powers enabling earlier intervention, skilled person reports and the power to recommend the removal of senior directors. The definition of PIEs will be widened. 

ARGA would be focused on outcomes and effectiveness with a clear shift towards addressing the needs of those who rely on the financial information. In this respect the Review recommends the production of better, more succinct and comprehensible reports particularly as the complexity of modern business increases and potentially pulls in the opposite direction. 

Finally, on enforcement, it makes various recommendations to ensure ARGA would be a respected and tough regulator, that ensures consistent enforcement action with publicly reported findings. The FRC would be replaced by a Board with direct responsibilities for enforcement decisions and the ability to initiate enforcement action.  Those accountants, auditors and directors that find themselves respondents to such regulatory action will want the benefit of good insurance cover to assist them navigate potentially financial and career critical proceedings.

Notably, however, the Review recommended that ARGA should not take on the responsibilities of regulating actuaries. This should instead pass to the PRA, who the Review concluded was better placed to perform this function.

Competition & Markets Authority Update Paper

With the regulation side of the equation being addressed, the CMA looked at how the audit market was working. Ongoing high profile corporate collapses and concerns about the lack of competition in the market suggest that the market itself needs rebalancing to provide the requisite confidence needed to ensure UK PLC is open for business.

The Paper suggests that at present the Big Fourauditors (PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte) have too much of the market for auditing the largest publicly listed companies including those listed on the FTSE 350.  Recent FRC data emphasises that the barriers to entry into this market have reduced the number of audit firms willing to be appointed for such engagements. The report seeks to address what it concludes is a lack of competition, plus other concerns such as conflicts of interest

The Update Paper makes four key recommendations. First, there should be a clear operational / structural split in firms along auditing and non-auditing lines (although it remains to be seen whether this is to apply to ‘challenger firms’ - see below - that have some clients in the FTSE 350). There should be compulsory joint audits with Big Four firms working with challenger firmon FTSE 350 auditing. Third, especially for companies considered particularly high-risk, there should be shadow audits and second phase reviews of overall financials. Finally, company audit committees must be required to report directly to the newly formed ARGA throughout each tendering process as well as during the life of the auditing.

The future

The level and extent of the reforms proposed by both papers are transformative and will fundamentally alter current financial and reporting procedures.  There is a real prospect that the actual future will largely mirror the future envisaged in these papers. There seems to be a genuine political appetite for reform and to convert what is described by Kingman as a ramshackle house with leaks and creaks into a hoped for symbol for the best in governance, transparency and independence.  The largest hurdle may prove finding time in the parliamentary timetable during a period of unprecedented political uncertainty.

This new world would create significant opportunities for those firms outside the Big Four. Challenger audit firms will have unprecedented market access. Theres likely to be a learning curve, with casualties along the way as both existing and challenger firms adapt to the new regime.  Directors will also need to embrace their new regulatory obligations and we can see the trend of investigating directors for poor corporate governance continuing its upward curve.  Ensuring the right insurance cover is in place to smooth any bumps in that road may prove crucial for some.

Authors

Rebecca Smith

Rebecca Smith

Bristol

+44 (0)117 918 2597

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