FRC Revolution to Fix Audit and Accounting Problems

A major announcement that will impact investors was made yesterday by the Government. You may not have noticed it in the midst of political turmoil, but it’s worth studying.

The Kingman review of the Financial Reporting Council (FRC) was published last December. It was a quite damning criticism of many aspects of the current regulatory regime that had resulted in so many audit failures and poor-quality financial reporting. See my previous blog post on this subject here: https://roliscon.blog/2018/12/18/all-change-in-the-audit-world/

There are few experienced investors who have not suffered from audit failures in the last few years. Accounts need to be accurate, reliable and trustworthy but they have been far from that in the last few years. It is now proposed that the FRC, which regulates the audit world and sets accounting and corporate governance standards be scrapped and replaced by a new body to be called the Audit, Reporting and Governance Authority – ARGA as it will no doubt be abbreviated to. ARGA will have stronger powers, a new mandate and new leadership.

There is a public consultation on the proposed new body and supporting legislation which can be obtained from here: https://www.gov.uk/government/news/audit-regime-in-the-uk-to-be-transformed-with-new-regulator . Anyone with an interest in improving auditing, and preventing company failures such as those at Patisserie or Carillion and major banks in 2008 should respond. ShareSoc & UKSA will respond on behalf of our membership, so please let us know if you have any comments or suggestions. But there are so many changes proposed that the document may take time to digest. I pick out some of the more important ones below:

A new Chairman and Deputy Chairman are being recruited to head ARGA so there will be change at the top. Let us hope they manage to change the culture of the FRC even if many of the FRC’s staff move into the new body. It needs to be more than a change of name.

The ARGA will have clear statutory powers with a clear purpose and objectives, supported by a “remit letter” from the Government. One objective will be “to protect the interests of users of financial information and the wider public interest…” which is a positive statement and replaces the unclear historic accumulation of limited powers by the FRC.

The new board responsible for the ARGA will be smaller, more diverse and less representative of “stakeholder” interests. Let us hope that this means less dominated by major audit firms and the audit profession.

The Audit Firm Monitoring Approach will be put on a statutory basis and with enhanced skills and seniority in the team. There are also proposals to improve the Audit Quality Review system which sound promising although such reviews only affect large companies. There will also be expansion of Corporate Reporting Review activity focused on higher risk companies and the new regulator will have the power to change accounts without going to Court.

The “audit expectation gap” where, for example, investors expect auditors to detect false accounting or even fraud whereas auditors don’t perceive that as part of their job will be reviewed. There is indeed a problem with the failure of auditors to challenge the information they receive from management and the latter’s forecasts and interpretation. Let us hope that is a meaningful independent review that results in some changes.

A new “pre-clearance” system will be introduced to enable companies and their auditors to obtain approval for “novel and contentious matters in accounts in advance of their publication”. This may assist auditors to “pass the buck” to someone else if they have doubts about how to present the financial figures.

More transparency in the new body is encouraged on such matters as disclosure of undertakings from concluded cases and it will become subject to the Freedom of Information Act. There will also be more publication of information on complaints and improved handling of them. Such changes are to be encouraged to stop the current secrecy under which the FRC operates which frustrates investors.

The oversight of the accountancy profession is proposed to be improved although the details are unclear and it may require primary legislation. The wording suggests that audit firms may escape substantial change.

The prevention of corporate failure is to be tackled by developing a market intelligence system to identify emerging risks in companies. This will enable a change from a purely historic analysis of corporate failures which is rather like shutting the stable door after the horse has bolted to a more proactive, future-looking approach. Auditors may also be required to warn of concerns about viability.

The ARGA will be able to commission a “skilled person review” where concerns are raised about a company. Details of how this will operate are to be determined, but this appears to be a useful step forward. The cost would be charged to the companies where it is invoked.

The Government accepts that there is merit in improving internal company controls by something along the lines of the US Sarbanes-Oxley regime. They will explore options in this area and do a consultation on it in due course. This is a welcome move and I covered the benefit of such a change in a previous blog post: https://www.sharesoc.org/blog/company-news/brexit-prevarication-patisserie-holdings/

It is proposed to improve “viability” (i.e. “going concern”) statements and the FRC has been tasked with taking that on immediately. Such statements are certainly ineffective at present and could be improved in several ways, e.g. to avoid the “all or nothing” approach at present. Such questions are not simple black and white issues in most cases. ShareSoc and UKSA are currently reviewing proposed changes to UK audit standards relating to assessment of going concern status and will respond to the FRC in due course.

It is proposed to replace the existing, and most peculiar, voluntary funding arrangement of the FRC with a new statutory levy for the ARGA. This is surely welcomed as money is the key to improving many of the regulatory functions. It is clear that the FRC is under-resourced in terms of the numbers and skills of staff.

In summary, most of the recommendations in the Kingman review are being taken forward.

Comment: These long-overdue reforms are certainly welcomed and the Government does seem to be applying some urgency to them, although with a log-jam in Parliament at present it may take time to get some of the needed statutory law changes in place. But cultural changes in organisations are never easy. Old bad habits in the FRC may persist, while it remains to be seen whether adequate funding will be put in place for the ARGA. There is also a lot of detail yet to be worked out. Let us hope it is a case of welcome to ARGA and not AARGH when we learn the details.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )