The boundaries of UK audit and governance reform

So it is with recent efforts by Whitehall to get a grip on audit, the audit market and its regulation.

In a 230-page white paper, Restoring Trust in Audit and Corporate Governance, published in March, the UK government lays out a raft of proposals designed to confront a loss of public faith in audit following a series of corporate failures.

But the world is not watching gripped by the idea that only the British can fix complex financial issues. According to David Herbinet, Mazars’ Head of Audit and Assurance, the issue, with the notable exception of the US, is that a slew of countries are currently facing the same questions.

“Fundamentally, the issues in the UK are universal issues, not specific to Britain. There are few major economies where these are not live questions now,” says Herbinet. To take a few examples: Germany is still working through the Wirecard scandal and European commissioner Mairead McGuinness has ordered a review of the EU’s Audit Directive and regulation; South African audit has been rocked by events around the Gupta family and former president Jacob Zuma; Australia is considering recommendations to reform audit made by a parliamentary commission that reported in November last year.

The UK, Herbinet says, has always been viewed as a leader in corporate governance so the current white paper will be closely read for ideas. More importantly, regulators will be noting market reaction to see if the proposals win acceptance, even before implementation.

So where does the white paper make its mark? Herbinet says its influence may be felt across a number of themes.

Scope and structure

The white paper tackles the scope of audit, following a review by Sir Donald Brydon published in 2019, recommending the Financial Reporting Council work on a new framework that could see auditors add topics such as ESG measures, corporate culture and cybersecurity, as well as other non-financial issues, to their work.

“Many countries are going through some sort of thought process on this topic,” says Herbinet. The EU, for example, set out proposals for a new Corporate Sustainability Reporting Directive in April this year.

There are also big proposals for restructuring the audit market, following a review by the UK’s Competition and Markets Authority in April 2019. There has been a “consensus” for some time that markets with just four major firms risk “increasing limitations” caused by conflict of interest. Markets struggle with a lack of choice, a risk of regulatory capture and growing concern about the number of “commercial conflicts” (eg. big consultancy-only firms are shy of being audited by the Big Four because they are also competitors).

“The issue of market structure is key absolutely everywhere,” says Herbinet. “The question of other jurisdictions addressing market structure is no longer ‘whether’ they will but ‘how’ they will do it.”

As a remedy, the white paper recommends operational separation of audit from other service lines, and the introduction of shared audit (public interest entities would be audited by a Big Four auditor plus a so-called “challenger” firm). This last measure builds on the “four eyes” principle well-established in financial services regulation.

“Governments are seeing the need for new players and putting them in a position where they start to build capacity and capability to serve the needs of the top listed companies,” says Herbinet.

Governance and regulation

Governance also plays a major part in the white paper. It contains new “resilience” and internal controls reporting requirements as well as an acknowledgement of stakeholders’ importance alongside shareholders. This, of course, is underpinned by section 172 of the 2006 Companies Act which gives directors a duty to “have regard to” employees, suppliers and customers, communities and the environment.

“The white paper makes it clear that there is a wide range of stakeholders far beyond shareholders and that needs to be a universal message,’ says Herbinet.

But a universal message needs sound regulation. The white paper, on the advice of a review by Sir John Kingman, takes up the need to replace the Financial Reporting Council—the UK’s watchdog for financial disclosures, audit and the governance code—with a new body, ARGA ( the Audit, Reporting and Governance Authority).

Powers for ARGA to set new audit committee standards, even penalise committee members for failures, are also recommended along with the ability to place observers on audit committees or communicate directly with shareholders about them.

Such powers would add to other levels of supervision, notably by the Financial Conduct Authority for listed companies and regulated financial services firms. Herbinet says that increasing the layers of regulation will be watched closely for how they interact. Introducing the supervision of audit committees for the first time adds a whole new layer.

But there will also be scrutiny of the new regulator’s mindset.

“One question,” says Herbinet, “is whether the regulator should take an ‘improvement’ approach or focus on compliance.

“A regulator that attempts to impact outcomes will always be more powerful than simply ensuring the rules are followed.”

Development of the watchdog’s structure is likely to generate interest too. The FRC already brings together responsibilities that elsewhere are separated among different bodies. According to Herbinet: “The regulator has the widest range of topics under its responsibility and that is being closely watched as policymakers ask what the scope of a regulator should be.”

Without doubt the audit white paper has set in train reforms that will be scrutinised internationally by rule makers hunting for solutions to the same challenges. There will also be those who wish to influence UK deliberations for the very reason that they could be adopted elsewhere. That gives decisions made in London extra bite.

“There is a dynamic in the world that makes UK actions relevant elsewhere,” says Herbinet. “Other countries may not mimic measures in the white paper but they may use them as inspiration for solving their own problems. That makes it highly influential.”