There is a very good chance that life is about to get much tougher for audit committee members. While in the past those serving on the board committees that supervise auditors may have undertaken their work in relative obscurity, that is set to change with new regulatory oversight and potentially public punishment.
But how are things about to change? And are audit committees on the cusp of becoming much less attractive places to be? Undoubtedly something has to happen. MPs on the House of Commons business committee, Sir John Kingman in his widely publicised review of the accountancy regulator and now the Competition and Markets Authority have all called for substantial reforms to ensure audit committees play a much more significant role in choosing auditors and monitoring audit quality.
The aim is that by clarifying audit committee responsibilities and bringing it under a regulatory microscope, audits themselves can be improved and with that the reliability of financial reporting.
The transformation of audit committees comes as part of a raft of measures addressing the perceived problems with audit following a series of corporate failures, including the construction giant Carillion. In December last year the Kingman review recommended closing down the existing accounting and audit regulator to create a new body with revised powers. Among those responsibilities should be an “enforcement regime” holding directors to account for their duties, including audit committee chairs.
Sir John also wants the new watchdog to commission a “skilled person” review paid for by companies, where there are suspicions that the audit committee is falling down on the job. Sir John also suggests the regulator be able to order an evaluation of an entire audit committee.
The CMA too has made recommendations that would place audit committees in the spotlight. There is a recommendation that the proposed new regulator “mandate minimum standards” for audit committees to adhere to for appointing and monitoring auditors. The new regulator would then inspect compliance with the new standards.
The CMA also suggests powers to place an observer on an audit committee, issue statements about an audit committee’s performance directly to shareholders and deliver public reprimands when things go wrong.
—Statement from the House of Commons business committee
In a special report, MPs on the House of Commons business committee have generally backed the CMA’s proposals and added their own concerns to the many.
MPs summarised the issues in this statement. “Because of our concerns about the independence of audit committees, their lack of attention to audit and the lack of emphasis they are placing on challenge, we fully support the CMA’s proposed remedy on greater scrutiny.”
When the CMA spoke to investors it found them fretting about the independence of audit committees when judging the work of auditors; that they do not sufficiently challenge management on their accounting judgements “or auditors on the depth of work and analysis they have undertaken”. They were concerned audit committees relied on executive feedback about auditors, rather than developing their own views. There was also disquiet that audit committees lack a “best practice” statement or model when it comes to monitoring auditors.
Time spent by audit committees on monitoring the work of external auditors also sparked anxiety. After looking at 18 companies, the CMA concluded that the time spent on external audit matters “varied significantly”, with figures showing variation from 400 hours down to less than 20 hours in total.
Needless to say, audit committee members bridle at the idea that there are widespread failings. But there are those that concede that audit committee performance may vary.
Regardless, audit committees undoubtedly face increased scrutiny, which will be painful for some. According to Elizabeth Richards, head of corporate governance at chartered accountancy institute the ICAEW, current audit committee members will conclude their work now involves increased stresses. Combined with the need to oversee joint audits, also recommended by the CMA, the workload is only rising.
“Were the proposals for mandatory joint audit to be taken in conjunction with the threat of greater sanctions, this would represent a material increase in the risk profile of being an audit committee member or chair,” says Richards. “It is very possible that some might find this a deterrence from taking up such a position.”
Tim Copnell, the head of an advisory service for audit committee members at KPMG, the professional services firm, accepts the “risk–reward” profile of the job may be changed, which could prompt a need to make it more attractive, potentially with pay. And yes, the reforms are certain to make many audit committee members “uncomfortable”. However, will that cause an exodus of audit committee chairs? “I don’t think that’s likely,” says Copnell.
—Elizabeth Richards, ICAEW
In some respects that may depend on the final shape of the legislation. There is still a long way to go before anyone’s recommendations are turned into law. If the new rules stress what Copnell calls the “passive” elements—such as increased reporting responsibilities—that’s low stress and relatively easy to accommodate. If the final legislation is balanced towards active interventions—observations, reviews and public reprimands—that may make things significantly different.
The trouble is there is much uncertainty about what form the final regulatory regime will take. And Copnell has a warning about the drafting: a system that rests on up front and personal regulatory observation of committee meetings could cause “unintended consequences”, such as prompting committee members to “exhibit certain behaviours” to please the regulators rather than make good decisions for their companies.
This view comes with some support. According to Richard Fairchild, a lecturer in finance and accounting at the University of Bath, the government needs to take care when drafting legislation that it understands how “sanctions and punishments” will affect the psychology and economics of audit and audit committees. He goes so far to suggest ministers could first pass the issue to the government’s own Behavioural Insights Team, AKA the Nudge Unit, before making final decisions.
“I would say this is a very deep area and that a lot of analysis and thinking is required for effective implementation of these plans,” says Dr Fairchild.
A resourcing problem
The question of observers across all listed companies raises further issues. According to Jock Lennox, chair of the Audit Committee Chairs’ Independent Forum (ACCIF), the trouble with observers is not so much about the reaction they will cause, but simply whether there are enough around with the right kind of expertise.
Lennox points out an oversight regime reliant on observers would need to cover 1,000–or more–companies with a multitude of business models. That makes it what he calls a “resourcing and capability” problem.
“That is a huge challenge and I really question how that could be achieved in any practical way,” says Lennox.
Lennox is also concerned with broader issues. The reforms, if mishandled, could present a challenge to the UK’s unitary board system. That’s because assuming audit committees alone are responsible for audits and financial reporting ignores the point that under the UK Companies Act boards as a whole are accountable.
That means if any real solution for audit quality is to be had through an oversight regime focused on audit committees, board responsibilities will need to be more closely defined.
“If you start with the board and work out what the board is responsible for and, within that, the role of the audit committee, you could make it work,” says Lennox. “If you just jump straight to the audit committee and don’t do anything about the board, that’s an issue.”
—Sabine Dembhowski, Better Boards
The same goes for the purpose of audit, over which there has been much disagreement. A report, the so-called Brydon Review, is due to be published by the end of the year, but defining audit committee responsibilities or the best practice standards for audit committees to monitor audits will be hard until those results are in.
While Lennox may have concerns about how the recommendations can be delivered effectively, others question whether greater regulation can make audit committees better at what they do. According to Sabine Dembhowski, managing partner at consultancy Better Boards, the reforms will certainly mean a more complex working environment in which performance will need to be judged using new criteria. But she adds that the secret to high performance lies elsewhere, rather than regulation.
“I am sceptical if regulation will make audit committees any better. I believe, and have seen, that other routes might be far more promising, like a focus on the right culture, alignment around values and ethics, a committee where members feel psychologically safe, i.e. they have a shared belief that the committee is safe for interpersonal risk-taking,” she says.
The trick now for government will be to bring all recommendations from the Kingman Review, the CMA recommendations and, eventually, the Brydon Review together into a coherent legislative whole. Whether they will be done any time soon given the ongoing debacle over Brexit is anyone’s guess.