Audit firm governance needs to reflect the public interest

Is audit quality good enough? In large part that must depend on how well firms that carry out audits are run, and the Financial Reporting Council has opened a consultation on its governance code for such firms.

The Audit Firm Governance Code dates to 2010, when the FRC introduced it to address audit problems from the banking crisis. It also hoped to keep clients’ choice of auditor as wide as possible by reducing the risk that a firm might leave the market because it lost public trust.

Getting the consultation right matters, for UK plc and the broader public interest. But is the FRC best placed to review the effectiveness of its own Code, and will it be bold enough in making change?

A bold stroke would be to narrow the ambitions of the review to the most important issues, but make sure it gets them right. There is no shortage of big challenges. Two of the biggest, however, are adapting the definition of public interest and the role of independent non-executive directors of audit firms, and the FRC would be wise to concentrate on them.

The Audit Firm Governance Code resulted from a recommendation in 2007 that every firm that audited “public interest entities” – large companies listed on the main market of London Stock Exchange – should comply with a code. In practice, that meant the code applied to the top eight auditors that had 20 or more clients listed on the main market of the London Stock Exchange.

That view now seems unduly narrow, but the challenge is in getting the public interest definition right. Clearly – as has been seen with some high profile banking and corporate failures – there are many stakeholders in audit quality. It cannot be a process that simply addresses clients and their shareholders.

But even if public interest can be defined, it will not be easy to build it into the responsibilities of independent non-executive directors (INEs) of audit firms. The INEs, being independent of the firm and its owners, can verify that its conduct does not conflict with the public interest. INEs have a key role in ensuring the success of the code, but lack defined legal status or job description. It is not even clear who they are accountable to. INE’s current duty of care is to the audit firm. In this review, the FRC needs to remove ambiguity.

The focus on audit itself also looks too narrow. Public interest must surely be tied more closely to oversight of each firm’s non-audit business. Non-audit now makes up 70%-80% of the revenues of the largest firms, and likely an even higher proportion of profitability. Most of this work is not subject to statutory regulation. That leaves far too much work for the Code to do, trying to leverage organisational governance from such a small part of the total. Audit itself is a mature market which may mean it gets less attention within overall business strategies.

The FRC hopes that the code can help promulgate British views and standards internationally. It is questionable whether a handful of INEs can do this; the major firms and international accounting networks cannot disproportionately recognise British interests, and it seems a job too many for the non-executives. It would be better to strip away lofty aspirations, and keep the code focused on governance and public interest.

Over 90% of FTSE 350 audits are conducted by the “Big Four” audit firms; Deloitte, EY, KPMG and PwC. They would claim that limited choice is not the same as lack of competition, but equally it is doubtful that the 2010 Code aspirations have been met. Firms outside the Big Four have not managed to increase their market share within the FTSE 350.

Although choice appears maintained, with eight audit firms still within the code’s scope, there is little sign that the code has levelled the playing field. Few major listed companies are willing to make a move from a top four auditor down to the next tier. A better test might be whether growing firms outside the top eight are adopting the code – it was supposed to be something that conferred commercial advantage. A quality standard needs active promotion, and should attract new business. There is a risk, if firms do not voluntarily join the code – that it could become a barrier, a moat protecting the largest firms.

Incorporating public interest cannot just be a matter of changing responsibilities of INEs, but should bring far more firms within the code’s scope. Many smaller firms, although they have fewer FTSE 350 clients, have considerable work for the public sector and non-listed companies. The current scope is rooted in an archaic definition, and tinkering with language may not be enough.

The FRC sets a number of codes and professional standards, and has a key responsibility to promote the quality of corporate reporting and auditing. But is it independent enough to review the effectiveness of a code that governs issues so close to its own responsibilities? Certainly, it has a diversified and distinguished board. But it is pinning a lot now on its request for responses that assess its work, and on its own candour after that, to report any criticism. Bringing more independence directly into reviewing the effectiveness of the Code to date could avoid any accusation of marking their own homework. There is still time to get this right. Consultations continue until August 28.

Since 2008 auditors have been required to publish an annual transparency report, including details of governance and independence procedures. The FRC accepts that the reports are not doing a good job of highlighting governance arrangements to users and the public. Indeed, many stakeholders have concluded the reports include a lot of boilerplate, and look more like dull compliance. Many of the reports are hard to find, buried under layers of menus in the deeper recesses of websites. By comparison, the Stewardship Code, also supervised by the FRC, appears to attract much more attention and scrutiny. The proactive stance of the FRC in raising the Stewardship profile could be applied to a new Audit Firm Code.

It is a lot to expect a code to improve overall governance, when audit is such a small part. And, the Code may not be the best tool for promoting British interests and competition. Instead the Code should focus on this update, in defining clearly the public interest, and creating a role profile for INEs that lets them balance this interest against other stakeholders. A high profile public consultation could pave the way for a more radical review and a much better code.

A version of this article was published as an Op-Ed in Financial News on June 8th 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; Creative Commons, some rights reserved.

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