Rachel Reeves, BEIS Chair, keynote speech on Future of Audit report

• BEIS Committee Future of Audit Report
• Business, Energy and Industrial Strategy Committee

On the morning of Tuesday 2nd April, Rachel delivered a speech at Chartered Accountants' Hall on the BEIS Committee's report ‘Future of Audit' report, the need for audit reform, upholding standards in corporate governance, and restoring trust in business.

Audit: a new product in a new market - speech by Rachel Reeves MP

It is a pleasure to be back here today and to see so many of you.

And not only because the future of audit is light relief from talking about Brexit.

Today I hope I can give you a positive message about how Parliament views audit. And an outline of a way forward to restore trust in the sector and address the challenges we all know exist.

When I announced our inquiry into the future of audit back in November, I spoke about a lack of trust and the need for reform. 

There can be no doubt that the problems on audit really are profound. We have heard evidence on a whole series of failures of audit: failures to act as a check against incompetence, obfuscation and sometimes fraud.

This should be seen against a backdrop of low public faith in business and an economy that is not working for far too many people.

We have traced this lack of trust through different strands of the select committee's work. We have reported on the lack of rights too many have in what can be a precarious workplace.  We have flagged up the weak attempts of companies to tackle their totally unacceptable gender pay gaps. Gaps which we heard only yesterday are getting worse, not better. 

And just last week we published our conclusions on executive pay. We found that greed has been “baked into the system”, allowing eye-watering bonuses and pensions for CEOs.  But nothing equivalent for the employees who also contribute to corporate success. 

While politicians grapple and argue – to the anger of most businesses and even more voters – it is worth remembering that an awful lot of people voted leave previously because they felt the economy didn't work for them. Whatever happens about Brexit, we need to return to how our economy works and who it works for.

Today I want to sketch out our Committee's findings and our vision for how audit and the audit market can regain trust. And how the audit product itself can be made much more valuable both to the company and to investors.  

I am delighted to have with me Antoinette Sandbach, the MP for Eddisbury, who played a key role in what was for us a broad but very intense select committee inquiry.

This morning we published the results of that inquiry; an 85 page report which was agreed unanimously by our 11 member, cross-party Committee.

Spotlight on audit

So, what were we looking to achieve when there are three separate inquiries on audit: the CMA market study; the Kingman review of the Financial Reporting Council; and the Brydon review of the audit product itself?  

We were very conscious that many previous reviews have identified similar failings to those that have surfaced recently but whose findings have been quietly shelved. So, we wanted to examine how these inquiries might best complement each other. And to provide political pressure on the Government and on regulators to actually implement the reforms that are recommended this time.

Reforms that would not only meet the interests of investors and the audited companies, but will help to regain the public trust in audit.  We are reporting now so that the CMA can take our views into account in its final decisions on the audit market, expected shortly.

So, let me tackle in turn the three key sets of reforms we are recommending. These are:

1. Competition in the market for audit services;
2. The regulation of audit; and
3. The audit product itself.

1. Competition

Let me start with competition.
There are three driving forces behind our proposed reforms to competition in the audit market.

One is the need for more players in the market capable of auditing the FTSE 100 companies. Too often, because of conflicts of interest and non-audit work, there is little genuine choice for some companies or indeed competition between the Big Four. And there is a risk that this could get worse.

We need more players in the market to improve resilience. We cannot afford to go down to a Big Three or even fewer.

Encouraging more auditors to enter the FTSE 100 audit market is perhaps the most intractable problem around competition.

At present, the barriers to entry are real and they are high. To break them down, we encourage the CMA to opt for segmented market caps on the Big Four, to ensure that challenger firms can get a slice of the action, but are not asked to bite off more than they can chew. The CMA should work on the detail to ensure the Big Four are not allowed to cherry pick the most lucrative audits when this happens.

We recognise the limitations of joint audits. But as a mechanism for increasing choice, rather than quality, they may have a role to play in enabling challenger firms to audit the largest companies in the longer term. We urge the CMA to test them with a pilot.

A second objective to improve quality and competition is to ensure that audit is priced correctly and that there is a genuine level playing field on competition for audits.

We extracted from the Big Four data that demonstrates that they are, in effect, consistently under-bidding for audit work. Across the Big Four, 37% of audits end up costing significantly more than originally budgeted. In 73% of these instances, a higher fee for the audit was subsequently negotiated.

Just as a builder might give you a good quote for an extension, but then double it when he discovers complications, so it is with audit. Some require additional and unforeseen work.  

No wonder it is very difficult for challenger firms to compete on price with the Big Four.  The Big Four are both cross-subsidising audit and under-pricing in their tender bids.  This is anti-competitive and it must stop.

Fair competition requires that a true market price is paid for audit. At the moment, audit is less profitable than non-audit services. But the true costs of audit are hidden. Multi-disciplinary firms subsidise audit with their broad range of specialist advisory skills – IT, tax, sector-based knowledge - and with the profits of non-audit services. These subsidies are not reflected in the price of an audit.

The third driver of our proposals for reform is linked directly to quality and relates to addressing the concerns around audit culture. The recognition that the culture of advisory services is about helping management; and the culture of audit is about challenging management. When combined in one large-multidisciplinary firm these two cultures mix like oil and water. And it is not surprising that it is the more lucrative component that floats to the top.

Studies have found that when non-audit services form the bulk of the business, as they do for all of the Big Four, audit quality suffers.

It is the lack of professional scepticism and challenge that was identified by the FRC as the biggest weakness in audits. In addition, the Audit Culture Thematic Review found that the values of objectivity and independence are “not sufficiently prominent” in multi-disciplinary firms.

It is perhaps not surprising that it is the advisory culture that prevails. Because that is what helps to secure more business.   How can an auditor be critical of a company and try to secure more business from it? The evidence suggests, with great difficulty.

We have recommended that the conflicts intrinsic to being an auditor while also seeking future business are mitigated in two ways.  First, by moving to a non-renewable contract for audit of 7 years, rather than the current renewable ten year period. And second, by a cooling off period of 3 years from the end of the audit contract for seeking non-audit work from that same client.

The case for separation

But these measures alone will not be enough. To ensure that there is a genuine level playing field and to change the culture of the firms, we believe that formal separation of audit from non-audit services is required. 

We considered three models:
a) governance separation,
b) operational separation (to separate economic interests), and
c) structural separation (to create two fully independent entities).

a) So first, on governance separation.  This includes a different management structure for audit but maintains shared profits. So it does not in any way separate the economic interests of the audit and non-audit arms of the firm. Nor does it address the cross-subsidy point.

For these reasons, we reject this option. Audit must be transparent. And stand on its own two feet financially.

b) Operational separation. This includes the separation of profit and pension pools for the audit and non-audit parts of the business. And involves full pricing for utilising specialist skills from other parts of the firm.  In this model both the audit and non-audit businesses could still share some central operations, such as branding, and both would remain part of the same multidisciplinary network.

We believe that this degree of separation has the potential to deliver the independence and transparency that are needed. But only if it is properly implemented and carefully monitored. We recommend that the CMA pursues this option.

However, we are yet to be convinced that this separation of economic interests will go far enough to improve audit culture and the audit market.

c) A full structural split of the Big Four would require UK audit firms to become stand-alone separate legal entities. They could remain part of a multidisciplinary international network but would need to contract-in specialist support as necessary, or develop it in-house.

Of course, the Big Four will strongly resist this option. But we believe that the arguments against – on recruitment difficulties and access to specialist skills – are very much overstated. They are in our view, special pleading.

Legal separation and independent ownership do not present a barrier to providing a seamless international audit. We found that good examples of legal separation and audit-only firms already exist.  

Of course, there would be short-term disruption and potentially an increase in audit costs. But these disadvantages are, in our opinion, outweighed by the advantages.

Full legal separation can provide the benefits of unquestionable independence, better quality, a proper audit culture, and transparent pricing. This is a prize well worth striving for.

We urge the CMA to weigh up carefully the costs and benefits.  If they opt for the operational split, we recommend that they conduct a review of these arrangements after three years to determine whether the split has worked. Whether it has ended cross-subsidies and improved culture, independence and transparency. If not, we recommend that they move to implement a full structural break-up of the Big Four into audit and non-audit businesses in the UK.

2. Regulation

The improved market which we envisage will still require regulation, so let me now turn to that topic.

In analysing the case for the full structural split, we urge the CMA to do so in conjunction with the new regulator that Sir John Kingman's review has recommended replace the FRC.

We conclude that the weak and ineffectual Financial Reporting Council has contributed to the failings of audit and lacks the credibility to fix it. A new broom, a new mindset and new people are required to start afresh. 

In line with the Kingman review, the Audit, Reporting and Governance Authority (ARGA) will replace the FRC and will be armed with the greater powers we have already recommended and, we hope, a more interventionist and proactive mindset.

Our Committee has asked that we are given the opportunity to hold a confirmation hearing with the preferred candidate to Chair the new body. We will look forward to that opportunity. 

Audit committees

Let me say a word about audit committees. There should be no need for the regulator to get involved if audit committees are doing their jobs.

But we concluded that too regularly they are not paying sufficient attention to securing quality audits and the regulator has just sat back. We cannot understand why “chemistry” or “cultural fit” should be more important criteria than “challenge” for the appointment of a firm to carry out an inspection function, not a service. You don't need to get on with your HMRC tax inspectors, you just need to co-operate with them.

That is why we support the CMA's proposal for a new role for the regulator in monitoring the tendering process in certain circumstances, for FTSE 350 companies, and being able to intervene where necessary.

ARGA should be driving audit standards up and have a proper market scanning function to help identify where things are going wrong. Before companies fail.

We are pleased that the Government has accepted the thrust of the 83 recommendations made by Sir John. But good intentions are not enough. We have called for the Government to introduce the legislation necessary to establish the new regulator in the next session of Parliament and will not be letting the Secretary of State rest until he has done that.

3. Audit product 

Finally, let me deal with the product itself.

I strongly believe that the reforms on competition and regulation should be implemented, even while the industry re-examines the nature of audit itself.

In many ways audit is a 19th century product adjusting to a 21st century global economy.

So it is perhaps not surprising that the nature and quality of audit is not what we want or what we need today. But I can tell you it was a struggle to get the leaders of the Big Four, when they came before us in January, to admit that their own audits were not up to scratch.

Instead, too many senior people in the industry prefer to talk about an expectation gap: people are expecting too much of audit. I reject that. We found not an expectation gap; but serious delivery gaps. According to the FRC, some 27 % of audits are below standard. What other industry would survive with this level of quality? A school would be put in to special measures straight away; a supermarket would see customers flocking somewhere else immediately. Yet audit continues as it is, because the client does not mind if the product is poor and investors do not ask enough questions (at least until the company goes bust). And because the market is failing.

If there is an expectation gap, it is fuelled by auditors themselves, who are very happy to tell us what audit doesn't do. We were surprised, for example, to hear from the CEO at Grant Thornton that they don't look for fraud. And yet their whole job is to sign off accounts as “free from material misstatements, whether due to fraud or error”. That does rather imply to me that they should at least keep an eye out for evidence of fiddling the books.

If an audit cannot spot a £90m fraud in a £110m-a-year cake shop, you have to ask questions about what use it is at all.

Some of the failings in audit arise from what we found to be a great deal of confusion over what counts as distributable profits. We found that there is an unresolved tension, an inconsistency, between international accounting standards and the demands of UK law, under the Companies Act.  International standards have moved away from a “prudent” approach, but the law has not. Accountants and auditors appear to adhere more to accounting standards than to UK law. It should be the other way around, and we recommend that the Government and the regulator clarify the position this way as soon as possible.
 
Similarly, the treatment of goodwill is open to abuse, without proper challenge from auditors, or the audit committee.
 
These are not academic or technical accounting points. They have a real world impact.  As the customers, suppliers, pensioners and workers at Carillion can vouch for.

The other myth about audits is that they are not forward looking. But they are, at least up to a point. The “going concern” assumption demands that auditors make an objective assessment of the short-run future of the company.

We recommend that the Brydon review explores how to make the audit a more forward-looking product. One that will be more useful to investors, employees, pension holders and suppliers.  To that end, we recommend an end to the black and white nature of the assessments: qualified accounts or “true and fair”.  The more nuanced approach allowed for by graduated findings is a key step in the development of a more informative, subtle audit. We believe that investors should welcome this, even if company management do not.  

But we believe that an audit should be broader still.  In several of our inquiries we have identified weak corporate governance as responsible for corporate failure.

An audit could evolve into a full health check of a company's corporate governance. This could include:

• compliance with the Corporate Governance Code,
• an assessment of its pay policies – such as gender pay gaps and pay ratios between executive and employees
• its payment practices for suppliers
• and whether it is supporting environmental sustainability. 

This would make an audit a genuinely useful product for investors. Yes, it may well be more subjective in places, and it will require a broader range of skills from auditors. But it will make the job of auditing more varied, more skilled, more useful, more attractive to potential new entrants to the sector.

But ultimately, and certainly most importantly, it will be more meaningful in its service to the public interest. We look forward to Sir Donald Brydon's report on the purpose of audit by the end of this year.

Conclusion

So, in conclusion, Britain's model of capitalism is undergoing a crisis – of weak growth and productivity, and record levels of in-work poverty. But it is also struggling with a loss of faith in business for many people. Business seems to have become untethered from any sense of value or purpose beyond immediate returns for shareholders.

Reforming audit is a key part of resetting the British economic model on firmer foundations. And the audit world will be watching what the UK does in this area.

The reform of audit in the UK should form one key part of the corporate governance reforms that we have been pressing for. On pay, fairness, diversity, transparency and stewardship.  It is ever more important that the UK can market itself as the best place to locate a business; of having the highest standards, of fair competition and the best regulators.

The changes required to fix the audit product and the audit market are major. But they are also achievable. We have marked out a clear pathway. It is now for you, the regulators and your industry to choose to follow it.

We in Parliament will be right behind you.  And will be prepared to push if we have to. 

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