‘Corporate financial audit in the UK is “built on weak foundations” (Kingman, 2018). In light of this statement, regulation to improve the independence of auditors is desperately needed.’ Discuss.
The crux of the auditor independence issue is that auditor appointments and remuneration are solely dictated by the corporations to whom they owe their professional services to.1P Davies and S Worthington, Gower’s Principles of Modern Company Law, (10th edn, Sweet & Maxwell 2016) 743 This lack of independence understandably causes concerns for those market participants relying on the objectiveness of the audits. Accordingly, it will be this Article’s intention to discuss why Kingman believes corporate financial audit in the UK is built on weak foundations and whether regulation to improve the independence of auditors is desperately need.
The Financial Reporting Council (“FRC”) is the UK’s current competent authority for regulating auditors and the standards of audits produced.2ibid 744 However, the FRC was not established as a regulator but as a council.3John Kingman ‘Independent Review of the Financial Reporting Council’ (2018) < https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/76 7387/frc-independent-review-final-report.pdf> accessed 27 October 2019, 6 It was founded in an era of flexible self- regulation or soft regulation as is evidenced by the UK Corporate Governance Code which incorporates several interesting forms of governance including “comply or explain”. However, as expectations of its role have shifted substantially overtime, it has attempted to remain relevant through “patching and mending” to assume the role of a regulator. Yet, to this day, it has no meaningful statutory base.4John Kingman ‘Independent Review of the Financial Reporting Council’ (2018) < https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/76 7387/frc-independent-review-final-report.pdf> accessed 27 October 2019, 6
The FRC nonetheless plays a key role in establishing and maintaining some of the UK’s most important governance standard for protecting shareholders and investors who rely on published audits for generating returns. For instance, statutory provisions and directives have attempted to directly regulate auditor independence through making it an offence for an officer or employee of the company to serve as an auditor5Companies Act 2006, s 1214(6), mandating disclosure requirements to account the non-audit remuneration received by auditors6Companies Act 2006, s 494, and introducing a variable cooling-off period between being a statutory auditor and taking on a management position in a corporation. The FRC largely discharges these obligations via its ethical standards. Yet despite the FRC’s efforts, it has been suggested that as much 40% of corporate financial audits contain serious issues pertaining to their quality. Of the problems identified, 41% of the problems are related to auditor independence and ethics.7Madison Marriage, ‘Accounting Watchdogs Find Serious Problems at 40% of Audits’ Financial Times (London, 11 March 2018) 2 These statistics present a clear picture of the issues surrounding auditor independence.
Perhaps one of the FRC’s biggest failing is its powers or rather, lack of powers. The FRC is expected to safeguard those relying on the quality of audit work by ensuring those who produce it does so honestly in presenting a true and fair view. Surprisingly however, the FRC has no direct recourse for managing major audit firms as the government requires the FRC to delegate so far as possible all regulatory responsibilities to industry bodies.8John Kingman ‘Independent Review of the Financial Reporting Council’ (2018) < https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/76 7387/frc-independent-review-final-report.pdf> accessed 27 October 2019 This makes the FRC much more analogous to a trade body than a regulator.9House of Commons, ‘The Future of Audit – Business, Energy and Industrial Strategy Committee’ (Publications.Parliament.UK, 2 April 2019 <https://publications.parliament.uk/pa/cm201719/cmselect/cmbeis/1718/171811.htm> accessed 27 October 2019>)
Another key failing of the FRC is its financing structure. The FRC is partly funded by the audit profession amongst other groups who profit from FRC regulation.10Financial Reporting Council, ‘Funding’ (About the FRC, 2019) <https://www.frc.org.uk/about-the- frc/funding> accessed 27 October 2019 This clearly creates runs the risk of diminishing the FRC’s ability to oversee and effectively regulate members of the audit profession. This is because any enforcement action by the FRC on contributing members of the audit profession may risk resulting in diminished contributions in subsequent years. Whilst conjecture, this may be contributing factor for why the FRC took “an excessively consensual approach to its work” when it had a range of sanctions available to it.11House of Commons, ‘The Future of Audit – Business, Energy and Industrial Strategy Committee’ (Publications.Parliament.UK, 2 April 2019) <https://publications.parliament.uk/pa/cm201719/cmselect/cmbeis/1718/171811.htm> accessed 27 October 2019
Accordingly, this Article agrees with Kingman’s statement that corporate financial audits in the UK are built on weak foundations. Furthermore, regulation is urgently needed for improving auditor independence in order to ensure that the UK will continue to remain as a leading international financial centre supported by a robust international regulatory regime.