UK Audit Reform—Investors Attempt to Assess the Net Effect and Timing of the Proposed Reforms: Has the “Expectations Gap” Been Narrowed?

Recently CFA Institute submitted a response to the 232-page UK Department for Business, Energy, and Industrial Strategy (BEIS) Consultation, Restoring Trust in Audit and Corporate Governance: Consultation on the Government’s Proposals (the “Consultation”). Although the Consultation included 98 questions, we chose not to answer all that were raised. Instead, our goal in reviewing the Consultation was to respond to matters of key concern to investors and to assess how these proposals may collectively improve audit quality. The latter assessment was the most significant challenge. What investors can fully expect in reforms (and when) is not precisely laid out in the Consultation. As such, it was a challenge to assess whether the “expectations gap,” so widely emphasized as part of the Brydon Review, will be narrowed.

Key Instrument of Reform: An Empowered Regulator

Our key takeaway from the Consultation is that the UK government’s most significant instrument of reform is an empowered audit regulator, replacing the Financial Reporting Council (FRC) with the new Audit Reporting and Governance Authority (ARGA).

We are supportive of the proposal for an independent, self-funded, regulator with broad authority and a charge to improve audit quality. We also support, in general, the UK government’s proposal to grant ARGA the necessary statutory authority to gather information, to conduct and report on meaningful audit firm inspections, to adopt appropriate rules and standards, and to rigorously enforce those rules and standards. We comment on the proposed reforms extensively in our letter. That said, we highlight two concerns as it relates to the regulator:

1. Protecting and Promoting the Interest of Many Stakeholders. The Consultation notes the proposed general objective of ARGA will be “[t]o protect and promote the interests of investors, other users of corporate reporting and the wider public interest.” This, in our view, may be difficult to implement as it is vague and quite broad. Financial reports and audit reports serve as the primary communication between companies seeking capital and investors providing capital. The accounting standards upon which those financial reports have been built are developed with the view that capital providers are the audience for the financial statements (i.e., the anchor to most corporate annual reports). As such, providing ARGA with a remit that is broader than the audience for the financial statements may present an oversight and regulatory challenge for the new ARGA, particularly given that not all stakeholder interests are aligned and the information being provided is not fit for all stakeholder purposes. Accordingly, we worry that the Consultation sets at the feet of ARGA a responsibility to all corporate report users it may not be able to fulfill.
   
2. Enforcement. ARGA also must have the authority to conduct investigations, including obtaining information from third parties, as well as the ability to enforce its rules, standards, and regulations with meaningful measures. For investors to have confidence in the regulator as an instrument of reform, we believe that ARGA will have to develop a reputation of strong enforcement. Companies, directors, audit committees, and auditors must perceive such enforcement as swift, strong, visible, and frequent for it to be an effective deterrent. This will take time.

A stronger regulator with more significant enforcement powers can be an effective deterrent, but reliance on a regulator generally is not the most immediate or preventative mechanism for improving audit quality. Detection may be delayed or reactive rather than proactive.

ARGA Has A Long To-Do List but No Timetable for Completion

The Consultation sets forth lofty expectations for ARGA, but in many cases, provides few details. ARGA must undertake many activities to bring the proposals in this Consultation to life. For example, the Brydon Review emphasized the importance of investor engagement; however, the Consultation simply defers to ARGA the duty to publicize channels for engagement. As another example, the Consultation notes ARGA is charged with developing the regulatory oversight for audit committees, but it does not provide substantive details on when or how they will be accomplished.

Still further, the Consultation highlights: (1) the need for forthcoming revisions of the Corporate Governance Code and Stewardship Code; (2) the new paradigm of corporate reporting recently proposed by the FRC; and (3) the relationship of the reforms to corporate law (Companies Act), Listing Rules, and professional standards. How exactly changes to these meaningful and core principles will manifest is not specified, which presents a significant challenge in envisioning the full scope of the proposed reforms.

The Consultation outlines many actions necessary by ARGA, but it does not provide an itemized to-do list that includes timing of when and how ARGA will effectuate all these proposals. We believe BEIS and ARGA should publish a list of action steps and a timeline for their completion to ensure that progress can be measured by constituents.

Assessing the Impact on Audit Quality: 
Investors Need an Analysis and Synthesis of Impact of Reforms by Intermediary

Our comment letter not only asks BEIS to set forth a timetable for the proposed reforms but also to provide an itemized inventory and analysis (matrix) of the proposed reforms that does two things:

1. Analyzes Proposed Consultation Reforms Relative to Previous Consultations. Such an analysis should highlight the reforms proposed as a result of the Kingman, Brydon, and CMA Review along with an explanation of how the UK government’s proposals in the Consultation have disposed of (addressed or passed on) the issues.
   
2. Analyzes Proposed Consultation by Intermediary. More important than the analysis above, investors need an analysis of reforms by intermediary.  Investors must rely on agents and intermediaries, such as management, the board, the audit committee, the auditor, and regulators, to protect their interests and ensure the performance of high-quality audits. Reliance on intermediaries necessitates that investors assess the Consultation reforms through the lens of how the responsibilities of all the intermediaries they rely on are really changing and whether they are gaining more (or less) assurance from these changes. Only then can investors assess whether in the aggregate the reforms will result in a higher quality audit.

Nothing in the Consultation provides an analysis and synthesis for investors to be able to assess the cumulative effect of the reforms by intermediary. Without a clear picture of the nature, timing, and extent of changes in roles and responsibilities of management, directors, auditors, and regulators, it will be difficult for investors and other stakeholders to assess the net result of the audit reform process and take confidence in the breadth and scope of the reforms.

The Bottom Line

Overall, stepping back from the Consultation and all its contents, it is a challenge to collectively assess whether the proposed reforms in the aggregate actually address the much-discussed “expectations gap” as well as what, and when, the audit market will be considered reformed. Although some of the proposals in the Consultation present bold new approaches, the Consultation, in our view, falls a bit short of the original promise of this nearly three-year-long endeavor. In our next blog, we discuss one very significant way (i.e., internal controls over financial reporting) in which it falls short.

Photo Credit @ Getty Images / Peter Dazeley