The future of audit is here

So how do you improve the quality and effectiveness of audit? That was the big question Sir Donald Brydon wanted to address in his ground-breaking report, released just before Christmas.

At the heart of his report was the need to make audit more informative to its users, and thereby improve the cost and allocation of capital – adding value to the whole economy. The final report makes 64 recommendations, including the establishment of a new corporate auditing profession with a unifying purpose and set of principles.

Worryingly, Sir Donald feels that audit lacks a clearly understood and fully encompassing purpose. He is proposing a fresh definition, which would need to be enshrined in company law. The recommended definition is: “The purpose of an audit is to help establish and maintain deserved confidence in a company, in its directors and in the information for which they have responsibility to report, including financial statements.”

The purpose of this change is to reflect the fact that audit is undertaken in the public interest, and is more than just compliance with laws and rules. The report explains: “Audit exists fundamentally to help its users know how confident they can be in the audited information and, by extension, in those who have produced that information.”

A new profession

Perhaps the biggest surprise in the report was Sir Donald’s call for a new standalone audit profession. He felt that auditing is too important to be left to an adjunct of another profession. “It should be an independent profession in its own right, with its own governing principles, qualifications, and standards.”

At present it is just the extension of the accounting profession, whose ethics and arguably mindset it largely adopts.

The report recommends that the Audit, Reporting and Governance Authority (ARGA) – which is to replace the FRC – should ‘facilitate’ the establishment of a corporate auditing profession based on a core set of principles. ARGA would then be the statutory regulator of the ’new’ profession. On top of this, the ARGA would need to develop a coherent framework for corporate audit that includes, but is not limited to, the statutory audit of financial statements.

The new profession needs to encompass all corporate auditors, including the statutory auditors of the financial statements, and auditors of other corporate information; for example information covering cyber security or environmental figures. While some of these corporate auditors would come from traditional audit firms others may come from new specialist audit entities. What Sir Donald wants is for them all to serve the same audit purpose.

The report wants to see more prominence given to auditor behaviour, and has added additional principles around openness, independence, challenge and the public interest. Sir Donald believes, if implemented and applied effectively, these principles would provide an incentive to deliver more informative audits. He is hoping the courts will consider adherence to them as part of any defence against future legal action, which may claim that an auditor’s opinion has harmed the audited company.

The report also introduces, in addition to the concept of professional scepticism, the need for professional suspicion.

There is a growing challenge in using ‘true and fair’ as a descriptor of financial reporting, with financial reporting increasingly using estimates and judgements. Together with the fact that the audit is intended to provide assurance that the company accounts are free of material misstatements, Sir Donald says it is difficult to see “how either directors or the auditor can communicate effectively that the modern company accounts are ‘true’ in accordance with any reasonable person’s understanding of the world.” He is therefore recommending that ‘true and fair’ be replaced in UK company law with the term ‘present fairly, in all material respects’.

Directors’ reporting

The report goes on to say that directors should have a legal obligation to state that the financial accounts they present each year have been fairly presented in all material respects, and the auditor should have a corresponding duty to assess whether this is the case.

To enhance the informative nature of the audit report, Sir Donald has said auditors need to:

• Create continuity between successive audit reports.

• Provide greater transparency over differing estimations, perhaps disclosing graduated findings.

• Call out inconsistencies in information made public.

• Reference external negative signals and how they have informed the audit.

He wants directors to present to shareholders a three-year rolling Audit and Assurance policy.

This would indicate their approach to the appointment of auditors, the scope and materiality of all auditing (including that of the financial statements), the assurance budget, and the relationship of any audit to identified risks. Shareholders would be invited to express their views on this policy in an advisory vote.

Another recommendation is that directors publish their statement of principle risks and uncertainties before determining the scope of each year’s audit and actively seek shareholder and other views on the appropriate emphasis.

To improve the understanding of the resilience of their company Sir Donald is demanding directors publish a ‘resilience statement’, which incorporates a going concern opinion for the short term, a statement of resilience in the medium term and a consideration of the risks of resilience in the long term. This resilience statement would replace the existing going concern and viability statements.

When it comes to recognising the legitimate interest of all users the report recommends that directors present an annual Public Interest Statement, which explains the company’s view of its obligations to the public interest, and how the company has acted to meet this ‘interest’ over the pervious year.

On top of this, the report wants to see the introduction of a new reporting duty on directors to set out the actions they have taken each year to prevent and detect material fraud.

Sir Donald feels that there should be enhanced transparency when it comes to audit fees too. Audit committees would agree an annual assurance budget, within which they have primary responsibility for negotiating and agreeing the audit fees, and which sets a framework for company spending on any other assurance work.

Role of shareholders

Interestingly, the report also tries to make a number of recommendations that would enable and even encourage shareholders to influence the scope of the audit, and hold the audit committee and auditor to account. These are intended to ‘complement’ the directors’ new disclosure requirements.

This could mean there would be a standing item on audit at the company’s AGM, to permit questioning of the audit committee chair and auditor.

Auditors will, however, have to think beyond the shareholders. The report says the Principles of Corporate Auditing should include a statement that auditors act in the public interest and have regard to the interests of the users of their reports beyond the shareholders.

The audit report should, said Sir Donald, include a new section in which the auditor states whether the director’s section 172 statement is based on observed reality ‘on the basis of the auditor’s knowledge of the company and its processes’.

When it comes to whistleblowing the report believes the Statutory Auditor be added to the list of ‘prescribed persons’ under the Public Interest Disclosure Act. This would allow employees legitimately to raise concerns and relate information directly to the auditor – provided that they meet the public interest criteria set out in the Act. Sir Donald has asked the government to look at widening the Act in this respect to enable customers and suppliers to raise concerns with the statutory auditor.

The report notes the relative lack of information in respect of the performance regarding payments to suppliers within annual reports. The recommendation here is for existing voluntary and statutory company disclosures on supplier payment performance be brought into the annual report, and be subject to a level of audit.

Auditor transparency

When it comes to auditor transparency, Sir Donald wants auditors to disclose within the audit report the hours spent on each audit by each grade within the audit team.

The firm must also ensure a clear separation between the team, which negotiates the audit fees, and the team that carries out the audit(s).

Audit firms would also be required to publish the profitability of their work from audit, and the remuneration of their senior statutory auditors, and the attendant performance measures around that remuneration.

Finally, clear reasons have to be given for any resignation, dismissal or decision not to participate in a retender, with auditors and companies being prepared to answer relevant questions in a general meeting.

A moment in history

Sir Donald explains that this is an important moment in the history of audit, and it needs a ‘genuine desire by auditors’ to grasp the opportunity his report presents – both to the users of audit and of their own profession.

Some of the changes will need to be taken forward through legislation or regulations. Others can be left to the ARGA. It is now up to the Secretary of State for BEIS to determine how this report’s comprehensive recommendations can be implemented (so watch this space).

Sir Donald honestly believes he is proposing to create an new environment, where the status of an auditor will be enhanced and will help create an audit profession that will be attractive to new entrants.

• ‘The quality and effectiveness of audit: independent review’ is the third of three audit reviews commissioned by the UK government. It follows: – Sir John Kingsman’s ‘Independent review of the Financial Reporting Council’, which considered the role of the audit regulator. – The Competition & Market Authority’s study of the statutory audit market.