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Partner Paul Brehony and Senior Associate Kate Gee examine the government’s consultation paper on audit and governance reform and why trust has been lost, looking into issues arising out of a number of sudden corporate failures.

Paul and Kate’s article was published in Accountancy Daily, 24 May 2021, and can be found here.

The audit world has been subject to considerable independent forensic scrutiny in recent years. The Department of Business, Energy and Industrial Strategy (BEIS) has now published its long-awaited government consultation paper on audit and governance reform. It speaks to the need to increase competition and restore trust in the audit regime, but how does the government plan to do this and why are reforms needed at all at a time when businesses are struggling because of the coronavirus pandemic?

The consultation paper combines more than 150 recommendations drawn from three separate reports: the Kingman Review on the operation of the Financial Reporting Council (FRC) (December 2018); the Competition and Markets Authority update to its statutory audit paper on competition in the audit sector (April 2019) and the Brydon Review on the quality and effectiveness of the audit process and product (December 2019).

According to the BEIS Secretary, Kwasi Kwarteng, the vast majority of the recommendations made in these reports will be adopted by the government, as part of the effort to restore trust and confidence in the sector. He said: ‘It is vital that investors, financial markets and all those who depend on the largest companies in the UK can continue to rely on the information they publish. I am determined to reinforce the UK’s position in the wake of large corporate failures that have led to job losses and uncertainty among small businesses and local communities.’

The proposed reforms are comprised under six headings:

1. Directors’ accountability. The Audit, Reporting and Governance Authority (ARGA), the successor regulator to the FRC, will have the power to sanction directors of all large companies for breach of their duties under the Companies Act 2006 in respect of reports and accounts. This includes the duty to approve accounts only if they give a true and fair view, and the duty to provide information to auditors.
2. The audit process. There will be new reporting obligations on both auditors and directors relating to internal controls as well as the detection and prevention of fraud. Consultation is taking place on different options, including a regime similar in scope to the US Sarbanes-Oxley Act on auditor assurance on internal controls.
3. Annual accounts. The current mandatory going concern statements and viability statements will be replaced with a single ‘resilience statement’, which requires directors to focus their minds on short term survival, medium term reliance and long term threats to resilience.
4. The audit market. In order to increase the number of firms which participate, FTSE 350 companies will be required to use a smaller “challenger” firm to conduct a meaningful portion of their annual audit, creating a form of joint audit regime where a “challenger” firm audits a subsidiary business. A cap on the Big Four’s market share of FTSE 350 audits could be enforced if “the sector does not improve”.
5. Executive pay. Under the UK Corporate Governance Code, listed companies will be expected to be able to recover bonuses or share awards from executive directors if they have failed to protect customers’ and employees’ interests.
6. Dividends. Directors will be required to make a formal statement about the legality and affordability of any proposed dividend.

Turning now to the reasons behind the need for change: why has public confidence been lost to a degree requiring such extensive reform? It will come as no surprise that in recent years the UK has seen a catalogue of high profile, sudden corporate failures – for example BHS, Carillion and Patisserie Valerie. Stemming directly from these failures, a series of actions alleging or threatening to allege negligence on the part of the auditor has emerged:

• According to a 2018 report by the FRC into the role of BHS’s former auditor, PwC, the company’s audited accounts were misleading and featured unrealistic forecasts before Sir Philip Green sold the business for £1 in 2015. The PwC partner who signed off on the accounts was banned from the profession for 15 years.
• KPMG currently faces a £250m claim for alleged negligence relating to its audits of Carillion before its collapse in 2018. The claim is brought by liquidators working for the Government: the first time that such a claim has been made in the UK. The official receiver has claimed that Carillion’s board of directors believed that the business was “profitable and sustainable” as a result of KPMG’s audit report.
• Grant Thornton also faces a £200m claim brought by the administrators of Patisserie Valerie. Damages are being sought in relation to the firm’s audit reports for the period September 2014 to September 2017. The company collapsed in 2019 after the discovery of a £40m accounting fraud involving false invoices. A subsequent investigation by KPMG has found evidence of ‘devastating’ fraud and ‘very significant manipulation of the balance sheet and profit and loss accounts’.

If all (or most) of the proposals in the Consultation are implemented, they may go some way towards restoring public confidence in the audit regime. Nevertheless, as we start to emerge from the Covid-19 pandemic, fiscal and other support measures are withdrawn and we start to see the inevitable uptick in post-pandemic corporate failures and restructurings, we are likely to see further claims being brought against auditors, for negligence and potential wrongdoing. Audit firms will remain deep-pocketed targets and large claims seem inevitable in the second half of this year and throughout 2022.

The urgent need for reform was highlighted by a recent study by the Institute for Public Policy Research identified “glaring deficiencies” in auditing practices which expose the sector vulnerable to more high-profile collapses. While potential claims are likely to be highly fact-specific, the recent Court of Appeal decision in AssetCo v Grant Thornton highlights a common theme: where an auditor is held liable for a company’s losses, significant damages can follow.