Lord Sikka
To ask His Majesty’s Government what plans they have to address any external auditing deficiencies highlighted by the collapse of BHS, Carillion, Patisserie Valerie, and London Capital and Finance.
Lord Sikka (Lab)
My Lords, I am honoured to open this debate and flag some of the issues, which I hope the Government will address. Ever since the collapse of BHS in 2016 and Carillion in 2018, the previous Government promised a Bill, but none materialised. This year, the King’s Speech promised an audit reform and corporate governance Bill. Naturally, I look forward to it. I have a particular interest in that Bill, not only as an accountant with 56 years’ experience but as an adviser to the Work and Pensions Committee for its investigation into the collapse of BHS and Carillion.
I understand that much of the Government’s attention is focused on transformation of the Financial Reporting Council into a statutory audit, reporting and governance authority, or ARGA—a very awkward name. This was recommended in Sir John Kingman’s 2018 report. Those reforms are welcome but they will not be sufficient.
In addition to ARGA, the audit industry will have four other regulators: the accountancy trade associations. None has the required independence from its members and all are outside the remit of freedom of information laws. A fragmented system would inevitably result in waste, duplication and obfuscation. Will the Minister ensure that accountancy trade associations are not allowed to act as regulators, for the reasons I specified?
The Kingman report was concerned about independence, but ARGA will remain dominated by large corporations and big accounting firms, which fund accounting and auditing standard setting and provide key personnel to the bodies. Despite Brexit, the UK has abandoned its powers to set accounting and auditing standards relevant to the local environment. Instead, it adopts international accounting and auditing standards. These are primarily crafted by big corporations and accounting firms at both international and UK level. This makes for poor financial reports, audits and public accountability. Good luck to anyone trying to figure out the UK profits of Google, Microsoft, Starbucks, Apple or other global corporations. Water companies routinely inflate investment and distributable reserves by capitalising interest and repair and maintenance payments. It is all permitted by the accounting rules and no auditor has ever objected to it. Profit shifting is a major tool for avoiding tax, but group accounts provide zero information about intragroup transactions, so it is hard to see how the Chancellor will clamp down on tax abuse by companies. I look forward to hearing from the Minister how the Government will address regulatory capture and reform accounting practices.
I will raise questions about the conduct of audits, because major firms are unable or unwilling to deliver robust and honest audits. While penalties for negligent directors need to be strengthened, that should not deflect attention away from the failures of auditors. Annual audit quality reports from the FRC show that many firms do not even meet the feather duster auditing standards applied in the UK.
There are fundamental fault lines. In contemporary society, we come across numerous types of audits on a daily basis. For example, at airports, our passports are audited by immigration officers acting as auditors. In no case is the auditee allowed to hire, remunerate or fire the immigration officer or appoint him or her as an adviser, yet that is the starting point for company financial audits. Will the Minister explain why that situation persists?
Some may argue that audit committees consisting of non-executive directors should have a greater role in liaising with external auditors, but audit committees at BHS and Carillion were not effective. I saw that at first hand. Almost all major corporations mired in scandals had audit committees and non-executive directors. None rocked the boat.
It is hard to think of any financial scandal highlighted by auditors. At BHS, PricewaterhouseCoopers’s audit partner backdated the audit report to appease Philip Green and other directors. At Carillion, KPMG never objected to imprudent accounting policies relating to accounting for good will. The company also capitalised interest payments to inflate its balance sheet. At Patisserie Valerie, auditors did not even check the bank reconciliation; they just continued to dish out the usual clean audit bill of health. Naturally, they were not going to bite the hand that feeds them.
Research by Professor Adam Leaver at Sheffield University looked at 250 listed companies that collapsed between 2010 and 2022. Despite publicly available evidence, only about 25% carried a “going concern” audit qualification. The Nelsonian auditors were rewarded handsomely.
Does the Minister agree that the appointment and remuneration of auditors at large companies by an independent body will give them some backbone? Will he insist that the auditors must act exclusively as auditors, meaning that no other business must be done by audit firms?
There is an urgent need for transparency about the delivery of audits. This would enable stakeholders to make assessments of the quality of audit and ask focused, timely questions. Currently, we get a glimpse of audit problems only after scandals; if by hook or crook a company survives, poor auditing practices remain buried.
At BHS, a PwC audit partner was budgeted by the firm to spend just two hours on the audit, and 31 hours on consultancy. For all practical purposes, the audit team was led by a person with only one year’s post-qualification experience. Unsurprisingly, the audits were shambolic.
The auditor appointment usually begins with a kind of beauty parade. Firms submit a tender and then make presentations to companies. I have sat through some of those. The most common phrase in these tenders is something like, “We have a reputation for constructive accounting solutions, and will help you to present your financial statements in the best possible way”. I wonder how many banks that crashed were told that. Auditors remained silent at those companies.
Audit tenders are not made publicly available because the firms say they are secret, even though their senior personnel know all about the contents. The same people migrate to other firms and take the knowledge with them; so rivals know what the firm’s policies are, but the stakeholders are denied that information. Audit tenders must be made publicly available.
Section 493 of the Companies Act 2006, requires disclosure of the “terms of audit appointment”, but Governments have failed to enact that section. I hope that the Minister will tell us when this section will be enacted.
To prevent firms assigning inadequate time budgets and audit teams to audits, there must be disclosure of the composition of the audit team, grade of staff and time used. Such disclosures are already made by insolvency practitioners, so it is hard to see what objections auditors could have. The disclosures would have prevented PwC from assigning just two hours to a partner to conduct the audit of BHS.
There need to be disclosures of the key questions that auditors ask and the replies received from directors. Such information is included in what are called management representations. All this information should be publicly available and can be filed at Companies House when the annual accounts are filed.
For far too long, audits and audit firms have escaped transparency. That silences stakeholders and leads to poor audits and accountability. I hope that the Government will address these failures.
Lord Shipley (LD)
My Lords, I thank the noble Lord, Lord Sikka, for enabling us to have this debate, which is timely. I thank him also for the forensic examination he has presented of some of the failures in the audit system. I have noted his concerns about the powers and responsibilities of accounting bodies and audit firms and their public responsibilities. We will need to debate many of his points when we consider the draft audit reform and corporate governance Bill.
In the debate on the King’s Speech in November last year, I questioned the absence of an audit Bill in that Session. I am pleased that this year’s King’s Speech has rectified that. Anything the Minister can say on the content and timing of the draft audit reform and corporate governance Bill would be useful to hear.
I have several times expressed concerns in this House about the state of audit and risk management in the public sector. The absence of proper and timely audits following the abolition of the Audit Commission has proved an increasing problem. I have concluded that it will require firm leadership from the Government to deliver improved standards.
The problems with audit in the private sector are equally well established. We simply must strengthen private sector audit and corporate governance. As the noble Lord, Lord Sikka, said, it is of great concern that, according to the Audit Reform Lab, three out of four of the largest 250 publicly traded companies in the UK that failed between 2010 and 2022 did not have an audit warning of that possible failure.
This means that the commitment in the King’s Speech to replace the Financial Reporting Council with the proposed audit, reporting and governance authority must be fulfilled. This will enhance enforcement powers both in investigations and in applying proper sanctions for the serious failures in both financial reporting and audit work.
In 2011, I was privileged to be a member of the Economic Affairs Committee when it reported on auditors and the concentration of the audit market on a very small number of audit companies. The report is worth revisiting by the present Government. It made many proposals, but the following brief extract is relevant:
“The Committee’s concerns about the Big Four’s oligopoly of large firm audit were intensified by their failure to give warning of trouble in the run-up to the financial crash. Clearly bank auditors cannot express concerns openly about banks’ finances without undermining confidence and risking a run. But the Committee was highly critical of the fact that, as our evidence revealed, confidential dialogue between auditors and bank regulators had fallen away before the financial crisis so that there was no pooling of information or concerns which might have given warning or allowed some action to mitigate the worst effects. This failure to maintain dialogue seems to the Committee a dereliction of duty”.
That was 2011, but much in the audit world has stayed the same. As the noble Lord, Lord Sikka, said, we need to separate audit services from other services provided to companies to avoid conflicts of interest.
We should note that over three-quarters of the revenue for audit companies comes from non-audit services, and there are clear risks to the audit process of firms generating most of their income from these other non-audit services.
This QSD is about restoring public confidence in corporate governance to ensure that investors and consumers can have confidence in the financial robustness of UK companies. When companies collapse, people lose their jobs, and the public purse can be called on to cover the costs.
Auditors exist to assess the financial health of companies and to report on risks. At present, the regulator has insufficient power to rectify failures. There is huge support for reform from the Institute of Directors, the Chartered Institute of Internal Auditors and the Institute of Chartered Accountants in England and Wales, among others.
I hope that the new regulator will have the enforcement powers it needs. I hope that it will be required to report annually to Parliament. I hope that auditors will be trained to exercise due scepticism as well as due diligence. I hope that directors of companies will be required to declare annually on capital maintenance decisions and on the legality of distributions and the effectiveness of resilience planning, as part of an annual report, in addition to a report on the formal accounts.
These are all core functions of an audit process. In creating a regulator with teeth, international investors, as well as domestic investors, will be able to have confidence that the UK is a safe home for their investments.
Baroness Ford (CB)
My Lords, I too thank the noble Lord, Lord Sikka, for securing this important and timely debate—important because trust in public information is essential to the proper functioning of our capital and equity markets, and timely because we all expect the long-awaited audit reform and corporate governance Bill later in this Session. I draw noble Lords’ attention to my current and previous interests in the register, particularly to my position as chair of the Centre for Public Interest Audit, a recently created research body focused solely on improving quality in UK audits and supported by the entire range of firms involved in this activity in the UK.
I have worked in the equity and capital markets for almost 40 years and have chaired a number of public companies and large privately owned enterprises, so I absolutely understand the requirement for accurate, truthful and timely public information that has been fully audited and assured. More pertinently to this short debate, I have also worked in a number of corporate restructuring and refinancing situations, so I can genuinely say that I have seen some of the best of corporate behaviour but also examples of some of the very worst.
It would be fair to say that, in those situations, the reason for failure or near failure lay squarely with the directors of the company and the decisions that they took. Companies do not generally fail because of audit failings; they tend to fail because of poor decisions taken by directors. Although the sanctions regime is clear and appropriately punitive as it relates to failings by auditors, there is no equivalent regime for holding directors to account. This asymmetry simply cannot be right, and we should look to the forthcoming legislation to see how we might deal with that.
However, it would be naive to imagine that the auditors do not have a role to play. The public and all those invested in companies, not just financial investors—we think of employees and suppliers—are entitled to be completely baffled when a disorderly period occurs a short period of time after a clean audit opinion is signed. When that failure is as high profile as some of those signalled in this debate today, questioning the role of the auditor has even more resonance.
That question has been the subject of serious and intelligent analysis over the last six years. Things have certainly changed. Specifically, as set out in the CMA report, Sir John Kingman’s review of the FRC and Sir Donald Brydon’s comprehensive analysis, virtually no stone has been left unturned in analysing the environment in which auditing takes place in the UK. We are not short of recommendations on how to improve matters, but we have had no opportunity until now to enshrine some of those important recommendations in legislation. That is why I imagine we all welcome the forthcoming Bill and the Government’s decision to prioritise this important issue.
Because of the time it has taken to get to this point, we have taken some important steps in the right direction without legislation. The CMA’s recommendation on operational separation has been given effect by the four largest audit firms, which have done so entirely voluntarily under the FRC’s close supervision. I hope I can reassure the noble Lord, Lord Shipley, that it is no longer permitted to sell audit services to the same client for which you are the statutory auditor. That has been the case since the standard was changed and it just does not happen anymore. We should all welcome that.
The four largest firms now have to formally demonstrate, to the FRC’s satisfaction, that they are formally separated from the advisory practices and that no persistent subsidy exists between the advisory business and the audit practice. More pertinently, they need to be able to show that their primary focus is on delivering high-quality audit in the public interest. The separated businesses also have to show that partner promotion and renumeration is related above all to audit quality indicators, not to income that is brought into the businesses. All those processes are now overseen by an independent board comprised of non-executives who have a direct line back to the FRC. That is not a trivial development, and it goes quite a long way to satisfying the CMA’s objectives. All the accompanying revisions to the Audit Firm Governance Code in the last few years are also welcome and pretty clear.
On Kingman, the FRC has already taken steps to change the way it works. The focus on audit quality inspection has toughened up considerably, and the very public nature of the AQR framework and scores delivers an unprecedented level of transparency to users and the public. Maybe this is an area on which the noble Lord, Lord Sikka, and I would take issue: the enforcement function has shown serious teeth in the light of the failures that we have been discussing today—although of course it would be better if it did not have to enforce at all.
Just as importantly, the FRC’s revisions to the 2024 Corporate Governance Code, relating particularly to director responsibilities on reporting material controls, are a welcome development. They tread a very fine line between a full-blown SOX regime and ensuring essential accountability for directors, and they are massively overdue.
However, there are numerous other areas in the Kingman and Brydon reviews that absolutely require legislation. I look forward to working closely with noble Lords to make sure we get this right. Time is short today, so I will finish with the hope that, when we receive the Bill in your Lordships’ House later this Session, we do not lose sight of the wider reforms to corporate governance that were outlined in both those reviews.
We have waited a long time for this opportunity. The 1992 McFarlane report contained many of the questions and recommendations rehearsed again by Donald Brydon, and the irony was not lost on him. We have a generational opportunity to get this right, and this time we need to seize it.
Baroness Warwick of Undercliffe (Lab)
My Lords, I thank my noble friend Lord Sikka for securing this debate. He has great expertise in this area, and has reminded us today of the terrible fallout, not least in terms of human misery, from such high-profile corporate failures. The scandalous collapse of Carillion in 2018, and in fact all the cases that he mentioned, highlighted poor auditing practice and inadequate supervision and accountability in the operation of those companies. The various reviews that followed all said the same thing: as the Audit Reform Lab puts it, the auditing industry is plagued by conflicts of interest, poor standards and weak regulation.
I am grateful for the various briefings for today’s debate, which have set out the systemic nature and extent of the problem. In 2022, Deloitte, KPMG, PwC and EY—the big four—earned 96% of FTSE 350 audit fees. Alongside that, a huge percentage of revenue of the big four firms comes from non-audit services. If the vast majority of your revenue comes from offering consultancy services to the same companies that you audit, there is surely a real risk of conflicts of interest.
I also learned that fines by the Financial Reporting Council for audit failures reached a record high in 2022 of over £33 million, yet, as the Audit Reform Lab highlights:
“From 2015 to 2022, regulatory fines for poor audits were on average just 0.16% of revenue and 0.85% of profits for Big Four firms”—
as the briefing says—
“too small to materially affect partner pay or change behaviour”.
From 2020 to 2022 the average pay for partners at the big four firms rose by 31%, while average pay for Deloitte partners reached over £1 million. Directors at these firms are being rewarded for failure.
Almost seven years on from the collapse of Carillion, businesses, regulators and auditors all agree that we need a corporate regulatory framework that is fit for purpose. Audit serves the public interest by underpinning transparency and integrity in business, while trust in our major companies is essential if we are to have long-term investment in the UK economy. Financial transparency and accountability are essential parts of economic stability. Failures such as BHS, Patisserie Valerie and London Capital and Finance undermine that stability.
Like all other speakers in the debate, I warmly welcome the Government’s intention to publish a draft audit and corporate governance Bill, which will replace the Financial Reporting Council with a new regulator—the audit, reporting and governance authority. It is clear that the Government have inherited a completely inadequate audit system. The UK needs a regulator with the teeth to tackle bad financial reporting and to ensure robust and rigorous scrutiny of company accounts. The inclusion of the draft Bill in the King’s Speech was a welcome indication of this Government’s determination to bring about reform. Given the crowded legislative timetable—40 separate Bills were included in the King’s Speech—can the Minister give us any idea whether this one will be a priority in the current parliamentary Session? When can we expect the ARGA to be functioning?
It is important that our Government push forward on audit reform because, in very simple terms, by doing so they are acting in the interests of working people, who are always the victims of business failure on this scale. In the cases noted by my noble friend, failures in the audit process cost working people their jobs and pensions and hurt suppliers and investors. I am thinking of the 11,000 jobs lost and a pension deficit of £571 million when BHS collapsed. At Carillion, companies went into insolvency, leaving huge debts, thousands of unpaid subcontractors, and delays to school and hospital building projects. Yet those responsible for the financial chaos that follows corporate failure are not the ones who pay the price.
I understand that directors of a company making incorrect financial statements can be held accountable by the regulator only if they are members of an accountancy body. Can the Minister assure us that the Bill will seek to ensure that all directors in the UK’s most significant companies face consequences if they neglect their duties regarding financial reporting?
Lord Livingston of Parkhead (Non-Afl)
My Lords, I join others in thanking the noble Lord, Lord Sikka, for tabling this important debate.
I am not a renowned academic in this area. My contribution is as somebody who has been a practitioner: I have been the CFO of two FTSE 100 companies and on the audit committee—or chair of an audit committee —in five different companies, in both the UK and the US. The four corporate failures are very important, but there is a danger with all of this that we are looking in the rearview mirror, because they are quite old and a lot of things have changed since then. I will talk later in this debate about that.
I have to say that a number of the contributions describe an audit process I do not recognise. The role of independent directors and audit committees is now very important and strong. On the issue of auditors doing consultancy work for businesses, I am sorry but it does not happen now. In fact, if you wish to do consultancy work for a major corporation, do not be its auditor. Yes, auditors do consultancy work, but they do it for other people. There are some ancillary services, such as valuations, that have to be done—working capital reports, for example, are a non-audit service, but have to be done by the auditors. We are describing, perhaps, a situation that was definitely true 10 or 20 years ago.
This is a debate about auditors, but it should be remembered that the primary responsibility for a company’s accounts and its reporting is with management. It is the executives and non-executive directors who are responsible for the first, second and third lines of events, as it is termed. But there have been failures in the fourth line, among auditors.
The firms and partners involved in these failures have received significant sanctions, and rightly so. There has rightly been a response by the Government, regulators and the profession. We have waited too long for statutory changes, but there have been many other things. So despite the delay in legislation, we have seen many improvements. For example, there is now a much better viability report, which usually stretches to five years and which the auditors report on, that every company has to prepare. That viability report tests various downside scenarios that might happen.
Audit reports themselves, when I first started as an accountant, were two paragraphs and talked about a true and fair view. Today, they run to 10 or 11 pages and cover issues such as the approach to the audit, the going-concern review, key audit matters and how they are dealt with, exceptions, et cetera. The FRC’s role regarding audit quality has been strengthened considerably. This is taken extremely seriously, by not just audit firms but audit committees. I know that committees challenge when their particular firm has had a poor result. Although even among the big four the results are not perfect, a lot of the exceptions have been based on documentation rather than the accounts being wrong.
These changes will be taken forward, we assume, by ARGA, and I welcome that. We expect to see, more explicitly, that all directors should be held to account—and they should be; it should not be about whether you are a member of the accountancy profession. There will be a requirement to report on the adequacy of internal controls. That will cover a wider range of controls than is even covered by the famous Sarbanes-Oxley legislation in the US. For many companies, particularly those that are not US quoted, it will represent a great challenge regarding documentation and testing.
However, more regulation is not necessarily better regulation. The UK governance process has gone from being admired as a good balance of regulation and pragmatism, as encompassed by the “comply or explain” doctrine, to “comply, explain and document at length”. Annual reports can now run up to 300 pages in length, and they are not read by even the most diligent investors. I wonder how many noble Lords have read, cover to cover, an annual report at any time in the last year or two. I obviously defer to academic experts on that, but I suspect not many other people.
We have heard some other suggested proposals, including the mandatory use of second-tier firms, either for whole audits or shared audits. It is worth noting that the FRC’s reviews have seen the big four’s results improve regarding the quality of audit. Regretfully, a number of firms outside the big four not only have lower results but are going backwards. There is a real concern among many companies that shared audits will lead to higher costs and lower quality.
On the mandatory allocation of audits, I will give a practical example. I was involved in a company that wanted to bring in one of the non-big-four on the audit tender. Every single one that was approached said, “We are not able to do this. We do not have capabilities, we do not want the exposure, we do not have the insurance and we do not have international coverage”. The practicalities are more difficult. I agree that there is a problem with there being only four major audit firms, but that cannot be solved by this proposal.
You can never guarantee that a business will not fail, nor in a market economy should we seek that, but we have seen good improvements in reporting, and boards and shareholders do not want another massive rewrite. We understand what is on the table. Today, there is a major investment conference at which the Prime Minister has warned against the negative impact of overregulation. If the Minister and his party are truly committed to growth, my message is that we should continue on a path of evolution and continued improvement, rather than revolution and yet more legislation.
Lord Davies of Brixton (Lab)
My Lords, this debate is about the manifest deficiencies in external auditing. That has been clear from the catastrophic collapses of major companies, including those mentioned in the Question: BHS, Carillion, Patisserie Valerie, and London Capital and Finance. I have heard the remarks from the noble Baroness, Lady Ford, and the noble Lord, Lord Livingston of Parkhead, who tell us things have improved. The problem with these cases, which are not all that historic, is that they indicate an attitude within the auditing profession. It is the tell that is there. We have to respect that, and no doubt will debate it at length when we consider the Bill. It is still worth going through these specific cases because they have shaken public confidence and they call into question the robustness of the auditing profession.
Let us start with BHS. When it collapsed in 2016, it left 11,000 employees out of work and a £571 million pension deficit. Despite these glaring financial issues, BHS’s auditors, PricewaterhouseCoopers, had signed off its accounts without raising any red flags. The issue here lies in the auditor’s failure to adequately assess BHS’s ability to continue as a going concern, and a failure to highlight potential risks to investors and employees.
When Carillion, a construction and facilities management company, collapsed there was £7 billion in liabilities and just £29 million in cash. This collapse shook the whole UK construction industry and led to widespread job losses. KPMG had signed off on Carillion’s accounts for 19 years without challenging its aggressive accounting practices. Carillion overstated its revenue and delayed recognising losses, which created an illusion of financial stability. What we have here is that the audit failed properly to address the company’s rising debts and overreliance on short-term contracts. This failure highlighted a systemic issue: the auditors’ unwillingness or inability to challenge management effectively.
Patisserie Valerie’s collapse in 2019 was perhaps even more shocking, due to the outright fraud that had occurred and with Grant Thornton, as my noble friend mentioned, even failing to adequately check the company’s bank accounts. This indicates the auditors’ seeming lack of curiosity and investigative rigour, and that behaviour went unnoticed for years.
Finally, London Capital & Finance adds another dimension to these auditing failures although, in this case, the collapse stemmed from regulatory shortcomings as well. It sold risky and often misrepresented financial products to ordinary investors, many of whom lost their life savings when the firm went into administration.
These auditing companies are still there and still doing the work. We need more assurances from the auditing profession that things have improved. We want to see systemic changes that will avoid these problems arising in future. The auditors failed adequately to assess the financial viability of the companies they were auditing; the provision of more information and longer reports does not really address that issue.
Clearly, the role of external auditors is crucial to the functioning of our financial markets. They are needed to provide an independent assessment of a company’s financial statements and offer a degree of protection to investors, employees and the broader public. The solution to this, as my noble friend Lord Sikka identified, is much greater openness about the auditing process. That is really what the auditing profession is failing to provide to us. I hope that we are going to have a very interesting Bill and interesting discussions on it. These issues will need to be addressed and I urge my noble friend the Minister to give us some assurance that they will be taken on board.
In my final few seconds, since I have the Minister’s attention, I will just mention the actuarial profession, which is being swept into the Bill—I declare an interest as a fellow of the Institute and Faculty of Actuaries—in a way that seems to show a lack of understanding on the part of the department of the work that needs to be done in this area. If the actuarial profession is to be regulated, there needs to be much more work on exactly how that is to be done than appears to have been done so far.
The Earl of Effingham (Con)
My Lords, during this debate we have heard references to the big four, which, as many in the House will recall, used to be the big five until 2002, when Arthur Andersen itself was dissolved as a result of accounting and auditing irregularities at Enron. We have heard about Carillion, BHS, Patisserie Valerie, London Capital & Finance and more. It is indeed an alarming statistic that of the 250 largest companies listed on the London Stock Exchange which defaulted between 2010 and 2022, only 25% had a going concern warning included by their auditors in what transpired to be their final set of accounts. However, what we must be crystal clear on is that if this was easy, we would not be having this debate. No one audit company caused any one collapse. What happened is that they did not see the dangers and either did not understand or underestimated the risks embedded in the firms they were auditing.
The noble Lord, Lord Sikka, and many others in your Lordships’ House will be well aware that these matters are extremely complex. Indeed, in 2013 the regulator itself—the FRC—approved the quality of KPMG’s audit of the Co-operative Bank during an annual review, shortly before it was discovered that there was a £1.5 billion capital shortfall at the lender. The FRC also approved the quality of an audit of Patisserie Valerie’s accounts six months before the company revealed the £40 million fraud and maintained that its
“routine monitoring of audits is designed to ensure the audit was conducted in a satisfactory manner and not to identify aspects such as fraud”,
which further illustrates the potentially challenging nature of audits.
The FRC did flag textbook failures in KPMG’s audit of Carillion, citing that:
“Many of the breaches involve failing to adhere to the most basic and fundamental audit concepts such as to act with professional scepticism and to obtain sufficient appropriate audit evidence”.
Independent judgment appeared in some cases to have been woefully absent. Conflicts of interest are apparent: Carillion was a very important and long-standing client for KPMG, generating £29 million in audit fees. This created a risk to objectivity, and on several occasions
“the audit team failed to adopt a rigorous and robust approach”
and agreed to
“the presentation of financial information that suited Carillion’s management”.
In the ensuing aftermath and investigation of the collapse, newspaper reports told of a 2016 extensive internal survey of staff and partners which suggested a lack of accountability or consequences for poor behaviour and a hierarchical culture that did not encourage junior employees to challenge their seniors. It is critical that we address the issue of external audit deficiencies in this country. Their failures cause immense pain to employees, society and shareholders. But it is also essential that we do it the right way.
We want the UK to be one of the best places in the world to do business. For that to happen, we must have clarity of intention. We must cut red tape for our amazing companies and not create it. We therefore seek answers from the Minister for the purposes of transparency and further debate, as some of the potential reforms require deep scrutiny.
Will the Government dictate the content of financial reports? Will they oblige FTSE 350 firms to appoint two audit companies? What will the legal and enforcement powers of the new audit, reporting and governance authority be? Will the Government force large UK-listed and private companies to produce an annual resilience statement, distributable profits figure, material fraud statements and triennial audit and assurance policy statements?
On company culture, how will the Government ensure that a culture of professional scepticism is built into the audit industry and guarantee training on forensic accounting, fraud awareness and the use and abuse of accounting rules in real-world situations? As we have heard about this from other noble Lords, what will the Government do to ensure that all companies of a certain size, not just auditors, focus on strong controls, sound corporate governance and accurate and reliable financial reporting to avoid future catastrophes?
The right package of reforms will increase investment in the UK economy. It will fuel the growth needed to make us the envy of the G7 nations.
Lord Leong (Lab)
My Lords, I am pleased to respond to this Question for Short Debate. I thank my noble friend Lord Sikka for introducing it. I commend my noble friend for his commitment to and tireless campaign for more effective auditing. I thank all noble Lords for their valued contributions.
When companies fail suddenly, jobs and lives across the UK are affected. Many noble Lords mentioned that 11,000 jobs were lost when BHS collapsed. Carillion’s failure left approximately £4.9 billion of debt, affecting around 7,000 first-tier suppliers and contractors and displacing 19,000 UK jobs.
The Government therefore want to address the financial reporting issues that have been factors in some recent corporate failures. This is part of our mission for growth. Confidence in the audit regime is vital to ensure that our leading companies command the confidence of financial markets and the investment community. Through fair and reasonable regulations, we will boost investment and create sustainable long-term growth for the country.
We are looking at changes in three broad areas: a new powered-up regulator; new accountability for companies, directors and finance professionals; and new measures to help the audit market work better. First, we intend to transition the current audit regulator, the Financial Reporting Council, or FRC, into a new statutory body. The audit, reporting and governance authority, ARGA, will have new responsibilities and enhanced powers to tackle bad corporate reporting.
The second core area is to look at new and better systems to hold companies, directors and finance professionals to account. We are therefore looking to extend public interest entity status to the largest private companies, making sure their audits are of high quality and their reporting is within ARGA scrutiny. We will also seek to ensure proper accountability for company directors. We will therefore look to give ARGA powers to investigate and sanction company directors for serious failures in meeting their existing duties and responsibilities relating to accounts, corporate reporting and audit.
Regulatory oversight can help build and maintain trust in the profession. We want to ensure that professional bodies are properly accountable for their roles in regulating their members, with ARGA able to step in to tackle serious breaches of standards. We are also looking to improve the UK’s insolvency regime, including significant reforms to the regulation of insolvency practitioners.
Thirdly, we want to help the audit market work better. We want to address the lack of choice and resilience in the audit sector. Many noble Lords have mentioned the big four firms, PwC, KPMG, Deloitte and EY. They audit almost all the UK’s largest listed companies. We will look to find a balance in the PIE market between choice, resilience and quality. There are complex choices involved and we expect extensive engagement on these issues.
The Government set out in the King’s Speech their intention to publish a draft Bill on audit and corporate governance in this parliamentary Session. I look forward to this House’s expert scrutiny of our proposals in due course. I will of course update noble Lords on progress on the Bill, as the Government carry out their mission to go for growth at every opportunity.
I now turn to some specific points raised during the debate. My noble friend Lord Sikka asked about standards. Global standards make it easy to compare information across different regions, thereby facilitating the international movement of capital. These standards are assessed for their suitability and adoption in the UK. The UK has been a leading proponent of the use of IFRS. The UK also supports the development of international standards covering sustainability issues by the International Sustainability Standards Board. We will assess these standards for their suitability for adoption in the UK and consider how this affects non-financial reporting.
My noble friend Lord Sikka asked about audit competition—I mentioned the big four earlier. We are analysing all potential regulatory barriers to competition in the market before deciding how to proceed. Decisions on whether to remove any regulatory requirements that might be a barrier to competition will need to take account of any risk to other objectives such as higher audit quality and auditor independence.
My noble friend Lord Sikka and the noble Lord, Lord Livingston, asked about audit committees. The Government intend to give ARGA the power to set minimum requirements for audit committees in the appointment and oversight of auditors. These requirements will be enforceable. My noble friend Lord Sikka asked about the oversight of various other accountancy bodies. This is part of the Kingman review and there are still three outstanding recommendations that are yet to be adopted, on the oversight of the accountancy profession and the independent auditor’s report. Work is under way to address them.
The noble Lord, Lord Shipley, asked about local audits of public bodies. The backlog of publication of audited accounts of local bodies and public sector bodies in England has grown to an unacceptable level. The number of outstanding opinions peaked in September 2023 at 918. As of 31 December 2023, the backlog of outstanding opinions stood at 771. The local audit system is broken. This is evidenced by only 1% of local bodies having published audited accounts on time for the financial year 2022-23. The Government will update Parliament in the autumn.
I thank the noble Baroness, Lady Ford, for her work on corporate governance and congratulate her on her appointment as chair of the Centre for Public Interest Audit. We look forward to the findings of the PIA audit research later in the year.
My noble friend Lady Warwick asked about the timeframe and whether we are going to give priority to this draft legislation. As she noted, this Government announced an ambitious plan for legislation in the King’s Speech. As she knows, we have announced our intention to publish this Bill in draft and for it to be subject to pre-legislative scrutiny. I would therefore like to reassure her and the House that we fully expect to publish our draft legislation in line with the intentions announced in the King’s Speech.
My noble friend also asked whether we can ensure that all directors in the UK will face consequences if they neglect their duties. I can assure her that, as announced in the King’s Speech, the Government intend to provide the regulator with powers to investigate and sanction companies for serious failures in relation to their reporting and audit responsibilities. There are consequences for putting forward dodgy accounts.
My noble friend Lord Davies of Brixton asked about actuaries. The FRC has statutory duties and responsibilities for audit, delegating some of those functions to professional bodies while overseeing the accountancy and actuarial professions on a largely non-statutory basis. The Government will set out their approach to the regulation of actuaries in due course.
The noble Lord, Lord Livingston, asked about FTSE companies and I think the noble Earl, Lord Effingham, asked about sharing auditors. We are considering carefully the possible impact of shared audits for any companies, especially listed ones, and changes to the operating structures of audit companies, as part of our policy development on competition, choice and reliance in the market.
The noble Earl, Lord Effingham, asked about the legal and enforcement powers of ARGA. As I said earlier, we will look to give ARGA appropriate enforcement powers, including the power to investigate and sanction company directors for serious failures in meeting their existing duties and responsibilities relating to accounts, corporate reporting and audit.
The noble Earl also asked whether the Government would force large UK-listed companies to provide an annual resilience statement. Our overall aim is to make corporate reporting simpler, proportionate, useful and effective, but we may consider new reporting measures if they contribute to this aim. On company culture, ARGA will have appropriate powers to scrutinise the audit industry. I fully agree that a culture of professional scepticism should be built in.
The noble Earl asked whether the Government would commit to meeting senior representatives of the big four and other stakeholders. We will listen carefully to stakeholders on the substance and language of the planned draft Bill. We may consult formally on some related issues and will update the House in due course on any plans to do so.
I was asked what the Government would do to ensure that all companies of a certain size, not just auditors, focus on strong controls and corporate governance. We intend all companies above a certain size to have the extra scrutiny and accountability of public interest entities.
I thank all noble Lords once again for their contributions to today’s debate, and I look forward to keeping the House updated as we work towards the publication of our draft Bill.