Yesterday, I was delighted to welcome to Chartered Accountants’ Hall two members of the House of Commons Business, Energy and Industrial Strategy (BEIS) Select Committee; Rachel Reeves MP, the Chair, and her colleague Antoinette Sandbach MP.
Rachel was officially launching the Committee’s report on its inquiry into the future of audit - which I gave oral evidence to in February.
Back in November when she came here to announce the inquiry, Rachel was very frank about the need for reform - and yesterday she certainly did not let courtesy get in the way of candour. She described the problems with audit as ‘profound’, but challenged the notion that an ‘expectation gap’ was the cause – instead criticising the profession for a ‘delivery gap’. In outlining her Committee’s analysis of the situation, she highlighted the lack of choice and resilience in the market, failures in regulation, poor performance by auditors and questioned whether the audit product itself has maintained its relevance and utility. You can read the full text of Rachel's speech here.
It makes for uncomfortable reading in parts, but I broadly welcome the Committee’s report: It sets the right tone in focusing on the twin objectives of improving the quality of audit and increasing its value to business and wider society. It contains a total of 32 recommendations, many of which are very sensible – including that audit should take a more holistic view of a business and generally be more forward-looking.
I agree with its call for greater clarity on the responsibilities of auditors and directors under the Companies Act – especially around distributable reserves and the difference between realised and unrealised profits. This would increase transparency for shareholders.
The report is also very clear that the various reviews and investigations of audit now under way – by Sir John Kingman, the CMA and Sir Donald Brydon - must all work together as a comprehensive and coherent programme of reform. This is good to hear.
I very much support the Committee’s objective of achieving greater choice in the market for FTSE 350 audits, and endorse its view that a segmented market share cap would encourage more mid-tier firms to rise to the challenge.
However, I am concerned that some of its ideas for reducing conflicts of interest - such as the break-up of the largest multi-disciplinary firms - might prove counter-productive. There is a real risk that this could both drive out incumbents and discourage new entrants, meaning that an attempt to guarantee the independence of audit firms actually ends up undermining the resilience of the market.
In addition, we must ensure that audit remains an accessible career for future generations and continues to attract and retain high quality talent. I am not convinced that audit-only firms would help with this, even if, as the Committee envisages, audit itself expands its scope to address wider business needs and the increasing expectations of society.
The BEIS Committee’s report builds on the conclusions of Sir John Kingman and the emerging findings of the CMA: as much as anything its purpose is to support their recommendations and ensure that the Government does not delay or dilute their implementation. It also aims to give Sir Donald Brydon points to consider in the course of his own review, due to conclude by the end of the year.
I took the opportunity to remind Rachel and Antoinette that the professional and business services sector – audit and wider accountancy included – represents an internationally-acknowledged centre of excellence for the UK, and that maintaining this must be a key part of our national industrial strategy. I also wanted the Committee to remember that their understandable focus on the ‘Big Four’ and the FTSE 350 should not drive changes which make life difficult for the very many medium and smaller-sized firms currently providing vital and excellent services in every corner of the economy.
In my view, this report is a constructive and influential contribution to the debate about how we modernise audit. I am sure that its ideas will be noted by the other reviews under way – indeed both Lord Tyrie and Sir Donald Brydon were in the audience at Chartered Accountants’ Hall – even if not all of them subsequently find their way into policy, regulation and legislation.
Rachel concluded her speech by challenging us to embrace reform: I am confident that this profession is already rising to that challenge.
Please follow me on Twitter @MichaelIzza for further updates on this and my other engagements.
'Holistic and forward looking'. This is the key. A large component of the reason for the recent 'failed audits' of large complex organisations is that the auditors didn't understand the business, its methods and practices. Some of which were questionable and ought to have been questioned. Business is far more complex than it was and in most cases sails much closer to the financial winds. The probity of the average director is not at the level it was a generation ago. Auditors must recognise all this and respond accordingly. There should be far more SCEPTICISM, one of our hallmarks. Venture capital structures result in acquisitions carrying debt at unsustainable levels to enable new investors to extract cash at an early stage. The funding models are often based on unachievable business plans. This load means that most such businesses will fail at some stage - and they do. Ad nauseam. There should be a statutory limit on debt/capital ratios in public interest companies. Auditors have not been alive to all this. They must question the financial structure of a business where it is not clear that it is viable. And qualify when this is required. For instance, the report could state the required profit and turnover growth assumed in order to service the debt taken on. Readers might then form their own view of the chance of that being achieved. Auditors should examine if it is safe to assume a business will still be solvent and functioning in two or three years time. And they should be made to express an opinion on that.
This isn't rocket science (nor is auditing!) but despite all the great and good working on it, the proposals for change still don't fully address these obvious issues.