Audit reform: if not now, when?

Tuesday 7 November 2023 should be a landmark occasion. It is the day when King Charles will give his first King's Speech, setting out the government's legislative programme for the next session of Parliament. The speech is the formal annual mechanism whereby the government sets out its priorities and its intended forthcoming legislative programme. Widely expected to be the government’s last opportunity to set the agenda before the next general election, the King’s Speech will attract special attention for what it contains.

But for some, the greater concern will be what is left out. Of particular note for the business community is a further delay to the already much-delayed overhaul of the UK’s audit and corporate governance regimes. Regrettably, the government is expected to omit these from its roster of legislative reforms for the coming year. Although primary legislation has frequently been promised, it has been pushed back repeatedly by ministers, who have instead focused on other issues more likely to appeal to voters.

As confirmed by repeated announcements from the Department for Business, Energy & Industrial Strategy, the overhaul is designed to restore public trust in the way that the UK’s largest companies are managed and scrutinised. In the wake of several high-profile corporate collapses and serious concerns over their audit quality - BHS in 2016, Carillion in 2017 and Patisserie Valerie in 2019 - the government has made it clear that it wants to legislate in order to ensure that the UK’s most significant corporate entities are governed responsibly.

Another stated ambition is to empower investors, creditors, workers, and other stakeholders by giving them access to reliable and meaningful information on a company’s performance. The government’s final objective is to keep the UK’s legal and regulatory framework for major businesses at the forefront of international best practice.

(Parliamentary) time waits for no man

The envisaged overhaul already has a long history. The single most important feature of the proposed reforms, a new regulator, was originally suggested in March 2019. This was reiterated in a policy paper, Restoring trust in audit and corporate governance, published in March 2021. Introduced by the then business secretary, Kwasi Kwarteng, the white paper set out proposals to strengthen the UK’s framework for major companies and how they are audited.

In May 2022, the government finally issued a response to its consultation paper, Audit regime overhaul to help restore trust in big business, which outlined its revised plans. It detailed a revamp of the UK’s corporate reporting and audit regime through a new regulator, greater accountability for big business and addressing the dominance of the main audit firms, which had been at fault in both the Carillion and BHS collapses.

The government confirmed that The Financial Reporting Council (FRC), the accounting watchdog, would be replaced in April 2024 by a new, more powerful regulator, the Audit, Reporting and Governance Authority (ARGA). The creation of this more robust regulator had initially been proposed by Sir John Kingman in a government-commissioned review in which he described the FRC as a “hangover from a different era”.

According to the Minister for Corporate Responsibility, Lord Callanan, ARGA will have tougher enforcement powers and be funded by a levy on industry. Meanwhile, Kwarteng pledged to create the ARGA when “parliamentary time allows”.

Building on the recommendations of three independent government-backed reviews - by Sir John Kingman in December 2018, by the Competition and Markets Authority (CMA) in April 2019, and by Sir Donald Brydon in December 2019 - the government’s white paper on audit and corporate governance reform had already been subject to a public consultation.

Concluding its report, CMA chairman Andrew Tyrie said: “People’s livelihoods, savings and pensions all depend on the auditors’ job being done to a high standard. But too many fall short – more than a quarter of big company audits are considered sub-standard by the regulator. This cannot be allowed to continue. The Government now has three reports to hand. In large part, they come to similar conclusions. Conflicts of interest cannot be allowed to persist; nor can the UK afford to rely on only 4 firms to audit Britain’s biggest companies any longer. Early action will require legislation – hence the CMA’s proposals.”

Market re-alignment in the audit market

The government’s proposed revamp of the UK’s corporate reporting and audit regime through a new regulator is designed to deliver greater accountability for big business and to ‘address the dominance of the Big Four audit firms’, according to the Department for Business.

To limit what it terms the ‘unhealthy dominance’ of the Big Four, companies will be required to conduct part of their audit with a challenger accounting firm. To reduce the dominance of KPMG, EY, PwC and Deloitte, FTSE 100 and FTSE 250 companies audited by one of the Big Four firms will be forced to appoint a smaller firm to work alongside them. The idea is that more choice and competition for the audits of big businesses can, and should, drive up their quality.

ARGA will also be empowered to make the big audit firms keep their audit and non-audit functions operationally separate and to enforce a market cap if the state of the market does not improve.

Another new proposal is an expansion of public interest entities (PIEs). For the first time, the largest private companies, AIM-listed companies, and third sector companies – those with more than 750 employees and an annual turnover above £750 million – will come under the scope of the new regulator, reflecting the impact they have on the wider economy. By expanding the definition of PIEs to include these companies, around 600 new companies will be subject to the new classification, under what has become known as the 750:750 test. Once established, ARGA will have greater enforcement powers over the directors of PIE companies.

It is also designed to help prevent further sudden large-scale collapses like Carillion and BHS, which had such a damaging impact: 7,000 suppliers and contractors were affected by the collapse of the outsourcer Carillion, for example, while more than 11,000 jobs were put at risk by the collapse of BHS, the department stores chain.

In its March 2023 report, the FRC noted with characteristic English understatement: “We were disappointed by further delay (in legislation to create the ARGA in 2023) and the need to push back our planning by one year, to 2024.” That disappointment would have been made much worse by the Financial Times article published on 31 August 2023.

Under the headline, ‘UK government set to omit audit reform from legislative plans’, the FT broke the news that the overhaul of accounting regulation and corporate governance is facing a fresh delay. The story explained: “The expected absence of legislation to underpin the overhaul in November’s King’s Speech, which will set out the government’s reform priorities for 2023-24, would mean that the changes are unlikely to be implemented before the next general election.”

Officials at the Department for Business, which is responsible for overseeing these reforms, have said in private that they are not a political priority, although it was possible this could change, according to the FT’s report.

In response to this piece, Anne Kiem, chief executive of the Chartered Institute of Internal Auditors, wrote that “It would be deeply concerning if the much-needed overhaul of audit and corporate governance regulation were further delayed, following the report that it is to be omitted from the King’s Speech.”

She added: “It has now been over five years since the collapse of the construction company Carillion, over four years since Sir John Kingman delivered the final report of the Independent Review into the Financial Reporting Council, over three years since Sir Donald Brydon delivered the final report of the Independent Review into the Quality and Effectiveness of Audit and over two years since the government published the Restoring Trust in Audit and Corporate Governance white paper. So, if not now, when exactly?”

Her position is entirely valid and the question certainly apposite. It leads to the broader question of whether His Majesty’s Government is genuinely serious about restoring public trust and confidence in the UK audit industry. Government spokespeople have been at pains to emphasise to various media outlets that it will introduce legislation when parliamentary time allows and a legislative programme will be announced in due course. But if it were realised, the much-anticipated absence of a draft audit reform programme from the King’s Speech would be extremely disappointing.

In February, Michael Izza, CEO of the Institute of Chartered Accountants in England and Wales (ICAEW), noted that since the reforms are more or less ready to go, we are waiting “for politicians to effectively push whatever button it is they push, and slot it into the timetable. It’s just a question of priorities.” His prescient words now seem prophetic.

Overriding everything that the government does during the next 12 months is the forthcoming general election, which must be held by no later than 28 January, 2025. In reality, the date will be fixed at some point in 2024. Whatever the outcome, it will probably result in further delay to planned reform.

As the UK heads towards its fourth general election in nine years, the ruling Conservatives remain 20+ points behind Labour in the opinion polls. Their focus will therefore be to try and capitalise on vote-winning policies, rather than corporate governance and audit reforms.

Like every government facing a ticking electoral clock, the government has reiterated the well-established challenge facing them: primary legislation can only be enacted when parliamentary time allows.

Notably, the Labour Party, which is widely anticipated to be the winner of the next election, has not stated that they plan to do anything in audit reform relating to the Big Four. Commentators have suggested that such reform is not high on Labour’s legislative agenda and that the ARGA may now not be up and running until 2027.

The nearest to a public pronouncement has been Jonathan Reynolds, Labour’s shadow Business Secretary. On 31st August, he wrote on X, formerly Twitter:

“The Conservatives have dragged their heels on audit reform for far too long. Delaying important legislation because of their own incompetence simply isn’t good enough. Labour supports the principles of audit reform and has been calling on the Govt to publish this important legislation for months. While the Conservatives backtrack on manifesto promises Labour has a plan to give businesses the sure footing they deserve and grow our economy.”

Meanwhile, most of the government’s flagship reform measures - the creation of the ARGA, the widening of the PIE regime, and providing competition and choice in the audit market – are time-intensive. Indeed, in the government’s May 2022 response to its consultation paper, it did not seek to set out a precise timetable, but rather to outline the actions that needed to be taken, including what the government intends to ask of the regulator and other stakeholders.

One area already suffering from the delay is local government: one of ARGA’s tasks will be to oversee local government auditing. Since 2015, when the government scrapped the Audit Commission, local government accounts in England have been audited by the private sector. According to a report published by the House of Commons public accounts committee in June, fewer than 100 “key partners” are registered to carry out this work across England.

The report also noted a backlog of more than 630 unaudited local government accounts with only 12 per cent of audits being completed on time. Dame Meg Hillier, the committee chair, said that the problems at several councils in trouble, “should serve as flashing red signals for the government” to get a grip. “Delays to the publication of audited accounts for local government bodies increases the risk of governance or financial issues being identified too late and hinders accountability for £100bn of local government spending,” the committee said.

Repeated delays to implementation of the reforms will inevitably see momentum die down. Should reforming legislation fail to materialise, there can only be one conclusion: in the face of electoral priorities, political expediency will almost always trump less eye-catching, if overdue, primary legislation.