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Partner Paul Brehony examines the prospects for success of proposed major reforms to the audit regime, in Bloomberg Tax.

Paul’s article was published in Bloomberg Tax, 7 March 2022, and can be found here.

The “Big Four” audit firms—Deloitte LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers LLP, or PwC— have been in the news again; the apparently endless stream of regulatory investigations into audits shows no sign of abating. The most recent to be announced is the U.K. Financial Reporting Council’s (FRC) investigation of PwC over its audits of Galliford Try and Kier, two of the U.K.’s biggest construction contractors. PwC audited Galliford Try for 20 years until 2019 when it was replaced by BDO under rotation rules, and has audited Kier, the government’s largest construction contractor, since 2014.

These are only the latest in a now bulging list of probes into the Big Four’s historic audit work; there are presently seven ongoing regulatory inquiries into PwC audits. These include its audits of British Telecom and haulier Eddie Stobart Logistics. Further, the FRC announced in January that it was also investigating PwC’s audits of the defense company Babcock International Group, stretching back over a four-year period.

Since 2020, the FRC has opened further probes into PwC’s audits of a collapsed mini-bond company, London Capital and Finance, and Wyelands Bank, which was owned by the steel billionaire, Sanjeev Gupta. In addition, PwC was fined 10 million pounds ($13.3 million) in 2018 for its audit of the retailer BHS, which subsequently collapsed.

PwC is in good company. As is well known, KPMG is currently being sued in relation to its audits of the troubled outsourcer Carillion: The U.K.’s official receiver is bringing an unprecedented action as part of its efforts to maximize returns for creditors of the collapsed firm.

In August 2021, the FRC fined KPMG 13 million pounds and ordered it to pay over 2.75 million pounds in costs as a result of its role in Silentnight’s 2011 insolvency.

Meanwhile, in Germany’s biggest post-war accounting scandal, Ernst & Young continues to deal with the fallout from the collapsed payments processing firm Wirecard, which it audited for a decade before its subsequent insolvency.

After Lookers’ announcement that it had discovered potentially fraudulent transactions at one of its units, Deloitte is also being probed by the FRC over its audits of the car dealership. Having overseen Lookers’ accounts for 14 years, Deloitte resigned as auditor in 2020.

In addition to being investigated over its auditing of Essar Oil U.K., Deloitte was also fined a record 15 million pounds over serious misconduct in its “reckless” audits between 2009 and 2011 of the Cambridge-based software giant Autonomy, for which it was severely reprimanded.

Tax Implications

Unless the audit failure leads to insolvency, where U.K. tax authority HM Revenue & Customs (HMRC) is invariably out of the money, when it comes to tax, the usual pathology where auditing or accounting black holes are unearthed is that profit (net income) is overstated (the effect of which is to inflate retained earnings and owner’s equity), and thereby a higher tax liability is (presumably) incurred, so there is no fraud on the Revenue.

In generic terms, construction contracts often present difficulties of booking revenues and costs over the lifespan of multi-year contracts. The Galliford Try and Kier investigations may yet serve as good examples to illustrate the point. As a result, errors in accounts (whether fraudulent or negligent), where tax is understated or the tax liability is misrepresented, will usually pique the interest of HMRC and interest and penalties will likely flow. In the case of tax fraud, HMRC investigators can trawl back over the accounts for up to 20 years.

Audit Reform—Current State of Play

Given last year’s FRC audit quality inspection results and the sheer quantity of regulatory interventions currently, the evidence that the existing U.K. audit regime is in urgent need of overhaul is overwhelming. It should be noted that the so-called “challenger” firms are faring little better than the Big Four, with Grant Thornton and Mazars in the regulator’s sights at present.

One would think the envisaged reforms could not come rapidly enough. However, it is now nearly three years since the recommendations for reform were first put forward and 12 months since the government formally announced its long-awaited overhaul of the U.K. audit regime. This included proposals to break up the dominance of the Big Four, to increase competition from the smaller challenger firms, and to introduce new reporting obligations for directors.

There have been recent reports in the media that the proposals are now with government departments for final (yes, final) sign-off. However, there remains no guarantee that they will be included in the government’s next legislative program, although it is anticipated they will feature in the Queen’s Speech in May 2022. They may well not become law until 2024.

Key Features of Reforms

Turning to some key features of the reforms, the Department for Business, Energy and Industrial Strategy (BEIS) is on record as stating: “It is not healthy for audit quality that the U.K. audit market is so concentrated, with 97% of FTSE 350 audits undertaken by just four audit firms. This concentration is not helped by the fact that those firms also compete to provide a wide range of other business services to the largest companies.”

When announcing the report, Business Secretary Kwasi Kwarteng suggested that major new reforms to the audit regime would “restore business confidence” following the major corporate collapses and accounting scandals such as Thomas Cook, Carillion and BHS. Part of the long-awaited plan involves replacing the U.K.’s audit watchdog, the FRC, with a new regulator, the Audit, Reporting and Governance Authority (ARGA).

The introduction of “managed shared audits” is anticipated, which will require FTSE 350 companies that are currently audited by one of the Big Four to be handed over in part to the smaller “challenger” firms in order to improve competition. It also expected that the definition of “public interest entities” will be extended, imposing extra governance requirements on more companies.

In further commenting on the reforms, there has been much optimistic talk from the Big Four themselves about the opportunity the reforms present to build a stronger business by improving standards for corporate governance, reporting and the audit ecosystem to ensure the U.K.’s competitiveness in the future.

Other commentators have argued that they can build long-term value, improve trust and resilience, and ultimately reduce the cost of capital; they further suggest that the value created would far outweigh the cost of additional regulation.

Going Forward

Much of this appears self-evident, since it is indeed vital that the government maintains momentum in implementing reform of the audit industry. But one has to question whether the strength of purpose behind the rhetoric and the capacity to implement widespread reform will be sufficient to see the necessary level of change being entirely realized.

While the government appears intent on tightening regulatory oversight of the audit profession, in the financial services space at least, the direction of travel seems very different. Under new plans outlined last November by Chancellor Rishi Sunak, the U.K.’s post-Brexit financial services regulation will be rather more laissez-faire. According to the Treasury, there will be a “once-in-a-generation” opportunity to reform how financial services are supervised and policed. The government said in January 2022 that it wants to repeal a significant volume of EU law relating to financial services as one of its key “benefits of Brexit.” It seems this may well include measures aimed at preventing future financial crises.

Having endured one recent global financial crisis, many commentators are nervous about any regulatory loosening in this context, and wonder: Will the existing regulatory lacuna in audit oversight simply be shifted to financial services oversight post-Brexit in a “regulatory robbing” of Peter to pay Paul?