Statutory Auditors and Third Country Auditors Regulations 2016

Lord Hodgson of Astley Abbotts Excerpts

Monday 13th June 2016 Lords Chamber

[The Earl of Courtown (Con)]

My Lords, effective financial reporting underpins the success of every business. It helps inform decision-making, improve performance and promote confidence in a company’s future. For many businesses, audit is essential to provide assurances that financial reporting to shareholders is honest and accurate. Government activity in this area should improve trust and transparency, but without placing excessive or undue burdens on business. The proposed regulations implement the 2014 EU audit directive, which amends a directive adopted in 2006, and the EU audit regulation. They apply to a wide range of businesses that require audit services. However, the most significant changes to the status quo will apply to public interest entities or PIEs, as I will refer to them in this debate. For the purposes of these EU reforms, PIEs are banks, building societies, insurers and other companies listed on a regulated market.

The audit directive and regulation came about due to recognition that action was needed to improve confidence in audit quality and assure auditor independence. The final legislation, which was passed with UK agreement, represents a workable and positive outcome for UK negotiation. The directive and regulation take further steps to harmonise audit regulation across the EU but also allow member states sufficient flexibility to regulate audit services in ways that reflect the national systems that they have built up over time.

The key priorities for the United Kingdom, in the negotiation of this legislation and its implementation, have been to help secure high-quality audits and independence in auditor judgments across the EU, and to help avoid excessive concentration of large firms in the audit market. The profile and importance of auditing in UK business means that we have consulted extensively on the implementation of the EU audit directive and regulation. BIS published a discussion document in 2014 to get views on our approach to implementation. Responses to that document informed a technical consultation in 2015. Both consultations showed general support for our approach to ensure maximum flexibility for auditors and their clients. The majority of the stakeholders who responded had practical experience of preparing or auditing accounts. The responses have been published online.

The regulations before us will amend the Companies Act 2006 and other related legislation on the current audit framework. I am aware that they may appear complex but the effects should easily be understood with the help of guidance. We have tried to keep additional costs as low as possible. Our impact assessment is publicly available but I acknowledge that the majority of the costs will impact on PIEs. These are the most important businesses and effective financial reporting in this area is crucial. The regulations implement the requirement to identify a single competent authority for the regulation of statutory audits. The Financial Reporting Council will fulfil this role. This is consistent with the Written Statement to the House last July. The FRC will delegate tasks to the existing recognised supervisory bodies, for example the ICAEW or the ACCA. These delegations will include approval of individuals and firms as eligible for appointment as auditors, inspections, investigations and enforcement. The FRC will retain the task of inspections and investigations of PIE audits.

As I have mentioned, the regulations introduce provisions to secure auditor independence. Most significantly, this includes a framework for the mandatory rotation and retendering of audit engagements for PIEs. This will require all PIEs to put their audit out to tender at least every 10 years and change their auditor at least every 20 years. This will apply in respect of financial years beginning on or after 17 June 2016. Currently, there is no maximum duration for an audit engagement and annual reappointments of the same auditor can continue indefinitely. So we have spent considerable time analysing how to make maximum use of the flexibilities provided in the regulation to reduce disruption to the market.

The requirement on retendering and rotation will be introduced on a phased basis. Some engagements will be given a further four or seven financial years after the regulations come into force, depending on how long they have already been in place. That engagement must then be brought to an end.

This wider requirement is intended to be as consistent as possible with the requirement introduced by the CMA. As a result, and so that the initial implementation of the framework is simple to follow, we have not taken up the member state option to incentivise “joint audit”. The practice of appointing more than one audit firm is not followed in the UK, and the CMA did not consider it would improve competition in the audit market. We will of course keep this decision under review.

Another change made by the regulations will benefit the full range of businesses that use statutory audit services, including limited liability partnerships. Businesses will no longer be able to sign effective agreements that restrict their choice of auditor. The regulations also contain changes that are likely to have a deregulatory effect. These include changes to make cross-border provision of audit services more straightforward in the EEA. As well as having the potential to increase competition in the UK, this mandatory EU requirement will be reflected in similar provisions in other member states and should open up opportunities to UK firms.

This Government believe that a non-statutory approach to implementation of EU legislation should be adopted wherever possible. The implementation of ethical and technical requirements in the directive for auditors will be covered by revised FRC standards. This approach reflects that taken to implementing the 2006 audit directive, where the requirements in the directive were implemented in UK law as requirements on the content of FRC standards.

Many of the requirements of the EU regulations will also apply as part of the standards. This includes a black list of services that auditors will not be able to provide alongside the audit to avoid overfamiliarity between the management and auditors of PIEs. It also includes additional requirements on the content of the audit report for PIEs, which supplement further harmonisation in the directive. This is not expected to significantly increase the length of audit reports but is likely to increase their value to users.

In conclusion, the regulations will strengthen standards for the audit of PIEs and make audit reporting more informative. They should also improve confidence in the independence of auditors and avoid excessive concentration in the audit market. They open up opportunities for smaller audit firms that are not as well established as their larger competitors. I beg to move.

[Lord Hodgson of Astley Abbotts (Con)]

My Lords, “Statutory Auditors and Third Country Auditors Regulations” is not an exciting title—it will certainly not have them dancing in the saloon bar of the Dog and Duck—but this is important to the country, to the companies in this country and indeed to our capital markets. I want this evening to question the extent to which these regulations will achieve the very wide-ranging and important objectives the Government expect from them and whether there may not be perverse and unintended consequences, possibly just maintaining the status quo and the risk of a further increase in the regulatory burden, which my noble friend referred to in his opening remarks.

I hope that the House will forgive me if I take a minute just to lay out my case. I make these remarks drawing on my experience as a non-executive director of a public company from 2002 to 2014. I ceased to be a director two years ago, so I do not have a direct interest to declare, but I should draw the House’s attention to my past record. The company was what they call a FTSE 250 company—that is to say not in the top 100 but in the next 250, so one of the 350 largest companies in the country.

What are the Government seeking to achieve? I draw the House’s attention to page 1 of the impact assessment, where it says:

“What is the problem under consideration? Why is government intervention necessary?”.

It goes on to say:

“The financial crash in 2008, led to calls for greater scrutiny of the audit profession. The belief was that the accounts of several financial institutions had been given unjustified ‘clean’ audit reports and so potentially misled investors and regulators, undermining confidence in the financial system as a whole and affecting the efficient allocation of financial capital”.

In reading that, one could only conclude that the fundamental purpose behind these regulations is to address issues of systemic risk. If this were not the case, why would the impact assessment focus so heavily on undermining confidence in the financial system as a whole?

If we are addressing systemic risk, there are relatively few companies that are large enough to pose a systemic risk in this country: the banks, certainly, along with other financial institutions, and some of the biggest industrial and commercial companies. How many? Possibly 50, but probably no more than that. However, the regulations, as my noble friend has told us, apply to every company called a public interest entity—a PIE. When I read the policy background on page 2 of the Explanatory Memorandum, it was clear that it applies to all listed companies of whatever size, from the biggest to the smallest. Just for the record, it would be helpful if my noble friend could give an assurance that the regulations do not apply to companies listed on the AIM. If he cannot give that assurance, I will be seriously upset.

What additional reporting requirements will be imposed on PIEs? According to paragraph 7.6 on page 3 of the Explanatory Memorandum,

“The Regulations make changes to audit reporting requirements, including the reporting of irregularities; auditors of PIEs will be required to submit an additional report to the audit committee of the audited entity”.

In order to try and tackle the challenges—or possibly the failures—of auditing the 50 or so companies which pose a systemic risk to the British economy, we are proposing to require all listed companies to prepare further reports, for which of course they will have to pay, directly or indirectly.

I have heard many politicians on both sides of the House deplore the emergence of private equity at the expense of the public stock market. Such people seem to worry about what may be happening behind the green baize door of a private company, away from the public gaze. As it happens, I do not share that view—I think there are good and bad everywhere—but I share it in one respect, which is that the man in the street cannot and probably should not invest in private equity in the way he can and should in shares traded on public markets such as the London Stock Exchange. In order to encourage general faith and confidence in the fairness of our liberal capitalist economy, we need a healthy, growing public market in which all our fellow citizens can participate. Every time the Government come up with another set of regulations to be complied with by public companies, they give another boost to the growth of alternative funding mechanisms and therefore accentuate the different investment opportunities available to different parts of our society. If the Government said: “These regulations apply only to companies which pose a systemic risk to the UK economy”, I would be entirely supportive, but I fear that is not the case.

How do the Government think that this can be remedied? My noble friend referred in his opening remarks to excessive concentration. I return to the impact assessment:

“The market failures are due to misaligned incentives, conflict of interests and lack of competition. Companies infrequently tendering audit appointments or changing auditors cause there to be little opportunity for new entrants to compete for contracts, leading to a lack of competition in the market for the provision of audit services”.

Lack of competition? There are only four major firms in the PIE space—all other auditing practices are at present effectively also-rans—so there are only four entrants to the race, one of which must be ruled out because it will be the current auditor and another may be ruled out because it is providing corporate finance or other services. We have a race of only two horses. This is what we call competition. There is bound to be the effect of taking in each other’s dirty washing or passing the buck around when you have that limited a number of participants.