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Statutory Auditors and Third Country Auditors Regulations 2016

Volume 773: debated on Monday 13 June 2016

Motion to Approve

Moved by

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.

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.

If the Government really want to increase competition in the audit space, they need to encourage the profession to find ways to develop more effective challengers. I do not doubt that the profession will say, “Not our business, guv, nothing to do with us. It’s up to the clients”—the companies whose accounts are to be audited—“to make their choice”. It will go on to say that the companies are entirely free to make their choice of any firm, however big or small.

That is a false premise. I go back to my experience. When the company of which I was a director put its audit out to tender, I got the agreement of my board colleagues to include a leading mid-sized firm in addition to the ever-present big four. The mid-sized firm took a lot of trouble over its presentation and presented well, but the killer question was: “How many other FTSE companies do you audit from the Birmingham office?”. The answer was none. That was not surprising, because 97% of the FTSE 350 companies are audited by the big four; only 10 have an auditor that is not one of the big four. It is a very big ask to suggest to a public company board that it take the risk in these circumstances of appointing such a firm, however good its presentation. The risk/reward ratio is not in its favour.

The challenge to the Government and the profession is: how do you achieve break-in to the magic circle? One way would be to encourage joint auditing. In response to the question I posed earlier to which the answer was none, the answer could become, “We do not audit any alone, but we are joint auditors to one”, or two or three, so beginning to build confidence in the wider audit market.

Of course, this will not be popular with the four oligopolists. They will see a threat to their position and their response will be couched in terms of risk to the standard of British auditing, and so on, but in fact, if they can think more long-term and creatively, such a development will effectively buttress their position. I invite the House and the Government to think what happens if four becomes three when one of the existing four firms collapses—we have had collapses in major auditing firms—and we therefore have intense market concentration.

Extraordinarily, in the regulations, as my noble friend has told us, the Government are missing a chance at the margin to encourage the emergence of joint auditing as an interim step in the break-out and so create a more competitive market. Paragraph (20) of the preamble to the directive reads:

“The appointment of more than one statutory auditor or audit firm by public-interest entities would … help to increase audit quality … the presence of smaller audit firms in the audit market would facilitate the development of the capacity of such firms … broadening the choice of statutory auditors and audit firms for”—


As my noble friend said, elsewhere in Europe joint auditing is much more prevalent. As a result, there are derogations in the regulations to give additional protection. I do not understand why the Government have not taken this up, except for the hallowed phrase used by my noble friend: “That is not the way we do things here”. They have chosen not to do it, and I think that is a mistake. So despite all the stuff about the need to increase competition, the effect of the regulations that we are discussing this evening is to reinforce the oligopoly of the big four.

Just before I finish, I shall say a word on the regulatory burden, to which my noble friend referred. The impact of each individual regulation is of itself unobjectionable. It is like barnacles on a boat; one barnacle makes little or no difference, but 10, 100 or 1,000 do make a difference. The practical example that I can give of the extent of the imposition of barnacles in the corporate sector is of the company of which I was a director. When I joined the board of that company in 2002, the annual report was 61 pages long. In the last financial year to 30 September 2015, it was 128 pages long—more than doubled. The accounts and notes had risen from 27 pages to 66 pages and the remuneration committee report went up four times from five pages to 19 pages. Others must judge whether that is likely to have been a productive use of resources. It will have been welcomed by the professional services and advisers, who will have more work to do and more work to check, but whether it will advance commensurately the overall prosperity of the general population of the UK is in my view more doubtful.

These regulations are the produce of tired thinking. It is a shame that the profession and its regulators have not been able to think more creatively about the real issues and, instead, have fallen back on the old policy of, “If in doubt, stick in another regulation”. They represent missed opportunities: a missed opportunity to improve the competitive nature of the audit market; a missed opportunity to focus reform on the areas that need it; and, above all, a missed opportunity to think of better, more focused and more meaningful ways in which to measure the performance of British industry and commerce, on the success of which our country’s prosperity depends.

My Lords, following that speech, I think that the Minister will be delighted to know that we welcome these regulations, and particularly what they seek to achieve. I am a little surprised that, today being 13 June, they come into operation on 17 June—so we are cutting it fine. Nevertheless, the content is important to improving audit, and is another welcome initiative by the EU, further proof of how our membership of the EU enables us to develop rules across the whole of the EU, which will ensure that the public can be assured that company accounts really mean what they say. We particularly welcome the increased oversight of the auditing of quoted companies, credit and insurance firms, all of which are vital to the health of UK plc. I think even the noble Lord, Lord Hodgson, would agree with that. We especially welcome strengthening the independence of auditors from their clients, including independent members having to form a majority of an audit committee. We strongly welcome the audit firm rotation, with at least 10-yearly public tendering, and an upper limit of 20 years for appointments, and we welcome the restrictions on the supply of non-audit services, including at certain points tax, legal, and internal audit functions.

The questions that I shall pose to the Minister are about the governance of the competent authority—the FRC; the delegation to, and recall back from, an RSB; and the potential exclusion from membership of an accountant from a professional body. First, I recognise the detailed work that the FRC has undertaken in preparing for these regulations, and in preparing itself for 17 June. However, could the Minister confirm that involved in that planning were not only the regulated community but representatives of the wider community, which particularly depends on high-quality auditing—consumers, investors and employees?

That brings me to the second question about the FRC—its future accountability and governance. I note that in its response to our Secondary Legislation Scrutiny Committee, BIS said that the Government and the FRC are likely to review the current accountability framework. Will the Minister confirm that in any such discussions and review the Secretary of State will take seriously the need to include these wider interests of consumer, investor and employee representatives in the governance of the FRC? I should perhaps say that, although it is quite out of date, I used to chair the FRC’s actuarial stakeholder group. This wider input to professional, ethical and enforcement standards remains important, and I would like to build it into any such review of governance.

When we look at BHS or many other examples, we are often left wondering what on earth the auditors did not see or did not choose to report. A proper audit might have led to different outcomes. It is essential that in fulfilling its bigger and, indeed, powerful role, the FRC will work not simply with its regulated community—that is, the audit firms and the RSBs—but with these wider interests who are dependent on high-class auditing for the future of their jobs or their investment or, indeed, for the purchase of goods and services in their role as consumers. Will the Secretary of State consider their interests in looking at future governance?

Secondly, in relation to the delegation from the competent authority to an RSB and the recall of those delegated powers, the regulations define what cannot be delegated from the competent authority—the FRC—but allow the retention of some tasks. They also allow for some tasks to be reclaimed. Will the Minister confirm that, so that the FRC can concentrate on the systemic risks in the audit market, it will leave the other bits of the regulation of audit to the existing regulatory supervisory bodies? I assume that he agrees that the FRC should really concentrate on the bits that only it can do and leave the RSBs to use their experiences and skills where that is appropriate.

That brings me to the part in the draft regulations that state that something can be reclaimed if the FRC considers that the RSB is unable to carry out the task. However, we know nothing about how that would be defined and what the barrier is. Will the Minister outline the governance mechanism and the criteria behind a judgment that an RSB was not able to carry out a task? Will there be transparent criteria for that decision on its competence? Will there be any appeal mechanism against such a judgment?

Thirdly, if I and others have read this correctly, an important area is the potential expulsion by the competent authority—the FRC—of an accountant from his or her professional body. I think the Minister knows that RSBs are concerned about the FRC taking power to exclude members from their professional body. The ICAEW asked whether it really was the intention to allow the FRC to exclude an ICAEW member from membership of the ICAEW or whether it was really simply for the FRC to be able to exclude a member from holding an audit licence issued by their professional body. That is quite a big difference. Our legal friends who are in the House tonight will know the difference between being and not being a member of their professional body. It would be unusual for an outside body to take away their membership of the Law Society or the Bar Council.

The BIS response on that question to the Secondary Legislation Scrutiny Committee seemed to be that the former was the intention—that the FRC would indeed be able to exclude an auditor from membership of an RSB—because the definition seems to encompass that. It refers to the definition of an auditor in Regulation 2 as being the same as in the Companies Act 2006. If so, that in effect would enable the FRC to strike someone out of their professional body, which is not in the original EU directive’s list of five sanctions that have to be imposed by a competent body; it will be the Government who have added that. I do not like to use the word “gold-plating”, but it comes to mind with regard to the Government adding that when it was not in the original list of five sanctions that a competent authority could impose. It also seems slightly illogical because the five prescribed sanctions under the directive are very much targeted at stopping poor-quality audit work. That is where the FRC’s sanctions should be targeted.

If the FRC is not to be given the power to exclude someone from their own professional body, it is hard to imagine what the regulations mean. A professional body cannot partially expel a member; it cannot expel them just for audit, if you like. Either you are a member of a professional body or you are not. So it sounds as if the FRC is being given that power. It is hard to know why because under the regulations the FRC can already prohibit someone from signing an audit, which really ought to be sufficient. Any question of expulsion would then fall to the professional body. If the FRC found someone who had not been competent as an auditor, I imagine that the professional body would then hold a hearing and decide whether or not they should be expelled. However, the regulations as written seem to preclude that second stage, and seem to allow the FRC to expel someone from a professional body.

I have one more question. First, are the Government confident that the regulations will indeed improve the role of auditors through the increased supervision by retendering that, and that auditors will be more independent of their clients? I hope they are going to say yes, they are confident, but that leads on to how they are going to monitor that to ensure that when we look back in three, four or five years, we can see some improvement. Any comments that the Minister can make on monitoring will be welcome. However, contrary to the earlier speaker, we welcome the thrust and aims of the regulations and we wish them well.

My Lords, I thank my noble friend and the noble Baroness for their contributions to this short debate. I know both of them feel that effective financial management underpins the success of every business, and the quality and reliability of financial reporting in the UK is well regarded. Consequently, it will also be a priority of this Government to maintain the rigour and integrity of the UK’s audit regime. Although the regulations are largely regulatory they should place very low additional costs on business. Furthermore, compulsory retendering of audits should increase competition—notwithstanding what my noble friend said—and choice in the marketplace.

Although the application of the requirements to auditors of LLPs goes beyond the minimum requirements of the audit directive and regulation, it will implement the recommendations of the Competition and Markets Authority and meet the understandable desire of users and preparers of accounts for consistency in financial frameworks.

My noble friend and the noble Baroness, Lady Hayter, asked a number of questions. I will deal first with the questions asked by the noble Baroness. In her first question she asked whether the regulated community was involved in planning but also representatives of the wider community—consumers, investors and employers. As I said in my earlier speech, the Government have conducted two full public—I emphasise “public”—consultations on implementation. Respondents included representatives of companies and investors who are also effectively the consumers of audit services in this context. I am not aware at this stage of interest from any employee representatives but the ability for representations to be made in both consultations was there at that point.

The noble Baroness also asked about the need to include wider interests such as consumer, investor and employer representatives in the governance structure of the FRC. As part of current discussions relating to the status of the FRC as a public body the Government and FRC are likely to review the current accountability framework and to consider whether changes are needed following the implementation of the directive and regulation. I am sure that interest from these groups will be considered where it is expressed. It is fair to say that the interests of investors in particular are of great concern to the FRC and all its work.

The noble Baroness also mentioned leaving the regulation of audit to the existing regulatory supervisory bodies. The experience and skills of the professional bodies are vital to the quality of audit and accounting in the United Kingdom, which is why the United Kingdom successfully made the case in Brussels for their continued involvement in audit regulation. However, we also support independent oversight of the profession as envisaged by the directive and regulation. The FRC therefore has had to have power and discretion to reclaim tasks from the RSBs where necessary.

The line in the EU reforms is between PIE audits, where inspections, most investigations and enforcements cannot be delegated, and other audits, where these tasks can be delegated. The regulations place the FRC as a competent authority in charge of delegation decisions. We do not want to tie its hands unduly. The FRC works closely with other regulatory authorities such as the Financial Conduct Authority and the Bank of England to identify areas of risk. We would expect any such areas of concern to be identified through consultation. This would all be subject to a direction from the Secretary of State which will oblige the FRC to work on the basis that it will delegate all tasks wherever possible.

The noble Baroness also asked whether I could outline the governance mechanism and criteria behind such a judgment and whether there would be any transparent criteria upon which any RSB competency would be judged. The FRC will delegate tasks on the basis that it can update from time to time the conditions which it will set when making the delegation. We will expect any conclusion that an RSB is unable to carry out tasks for a particular type of audit to be based on whether these conditions are met. The conditions will be set out in written delegation arrangements, which the FRC is currently discussing with the RSBs.

The noble Baroness also asked about an appeal mechanism for an RSB against such a judgment. There is no prescribed appeal system, but if the RSB considered that the FRC had acted unreasonably, it would have recourse to judicial review.

The noble Baroness also asked whether there would be some form of continual review of this matter. There will be continuing discussions on these regulations between the FRC and the Government.

My noble friend Lord Hodgson, with all his experience—

If the Minister is moving on from the points that I made, the one that he has not addressed is about the power which appears to be given to the FRC to expel a member from their professional body. If he does not have that information in front of him, maybe it will be possible to at least give an undertaking that discussions on that will take place, because clearly it is a key concern for the professional bodies.

My Lords, I thank the noble Baroness, but I thought that I had covered that issue. Rather than repeat what I said, I will write to her and put a copy of my response in the Library.

As I was saying, my noble friend, with all his experience in business, made some important points. Perhaps the most important question that he asked, right at the beginning, related to the Alternative Investment Market of the London Stock Exchange and public interest entities, and I hope that my answer will satisfy him. The definition of a public interest entity does not include companies unless they are banks or insurers that have securities listed only on the Alternative Investment Market of the London Stock Exchange. These companies will not be required to retender or rotate auditor appointments, or to be subject to any of the statutory provisions on audits of PIEs introduced by the regulations or to the provision of the EU regulation. Nor will they be subject to the FCA’s or PRA’s rules on audit committees.

My noble friend asked why these regulations do not apply to the small number of companies that pose a systemic risk. This was a source of concern in the negotiations in Brussels, where the list of criteria for a company to qualify as a PIE was reduced considerably. The definition of a PIE focuses on an EU-regulated market, not the AIM, and that may illustrate the concern in Brussels to apply some harmonisation across this area.

My noble friend also mentioned enabling more entry to the PIE audit market for mid-sized firms. The prohibition of restrictive clauses in, for example, loan agreements will help to achieve this, as it will not be possible for third parties to require other audit firms to be excluded from tenders.

I think my noble friend made a number of other points and if I have missed any, I will of course respond to them in writing, ensuring that the noble Baroness has a copy and that a copy is placed in the Library.

Finally, the Financial Conduct Authority has amended its rules to reflect changes to the framework in the directive on audit committees. The directive also requires rules on audit committees to be applied, for the first time, to unlisted banks, building societies and unlisted insurers—something the Prudential Regulation Authority has already done in respect of its rules. As noble Lords will note, overall this represents an extensive package of changes, of which these regulations are an important part. I commend them to the House.

Motion agreed.