Oral evidence: Future of Audit, HC 1718
Oral evidence, 30 January 2019.
Witnesses
David Dunckley, Scott Knight, Clive Stevens and Jac Berry.
Chair
Thank you very much for coming to give evidence to our Select Committee this morning on the future of audit. We have two panels to take evidence from this morning, the challenger firms first and then the Big Four accountancy firms. We have a lot of questions and I expect in some answers you may agree, so if you do agree you do not need to say that. If you have a strong disagreement, it would be good to hear that. If there are issues that we have not been able to cover, we will follow up in writing to you later on, if that is okay. I will start with a question to Grant Thornton and to you, David. We will go through the CMA’s individual proposed remedies later. As a package, do you think they will reduce the barriers to entry you face at the moment in picking up FTSE 350 work?
David Dunckley
Taken as a package, they could well do that. There is no single measure that would fix it, so you are right to ask the question around there being a package of measures. There is Kingman as well, so we need to see all these things together.
Chair
Do you have the resources? At the moment, if I am correct, you are not bidding for this work.
David Dunckley
No, that is correct. We took the decision not to proactively bid until there is a change in the buy-side environment. Kingman and CMA together go some way to dealing with that. We have capability to do this level of work. We do not have the capacity to do it at the moment.
Chair
How do you know that, Mr Dunckley?
David Dunckley
We do audits for Birmingham City Council, which has tens of thousands of employees and more than £6 billion of assets. We already do FTSE 350 work.
Chair
But, by nature, Birmingham City Council is not a global business. It is local.
David Dunckley
No, but it is complex and we have complex work. We are capable of doing complex work. The issue for us is that we will need investment and time to invest to do it at scale.
Chair
You think that, if these measures were introduced, you would be able to bid and win this sort of work and then carry it out to a high enough standard.
David Dunckley
We do. It is not going to happen overnight. For instance, if mandatory joint audit came in, we would take a period of time to invest in technology and people, to be able to do the level of work that is required.
Chair
Scott Knight, do you think that BDO would be able to do this level of work? Would it be able to do it across the whole range of FTSE 350 businesses?
Scott Knight
We currently do. We act, up until 31 December, for FTSE 100 and a handful of FTSE 350 clients.
Chair
When you say a handful, how many fingers on the hand would make up your total number of FTSE 350 clients?
Scott Knight
There are a couple that have not announced they have moved their audit to BDO.
Chair
At the moment, right now, can you tell us how many?
Scott Knight
Four.
Chair
David Dunckley, Grant Thornton?
David Dunckley
Six.
Chair
Jac Berry?
Jac Berry
None.
Chair
To you, Clive Stevens, you have expressed concerns about unlimited liability, regulatory fines and issues like that that deter smaller firms from entering these markets. Do you think the CMA and Kingman measures, without those other reforms, would truly open up the market to the firms we have in front of us today?
Clive Stevens
I am more sceptical about that. I welcome the broad measures, but there is an opportunity to provide a pipeline that will take probably 10 or 12 years to get in place. Certainly, my members would probably, as it is, not want to enter the market with joint liability because of that. They could well, if, in addition to all the other measures, we adopted a shared audit approach. It would enable them to get experience, maybe not at a parent company auditor position but lower down, and that takes time.
Chair
Okay. We will come on to some of those issues. I am particularly keen to hear from Jac Berry and others on joint and shared audits. If I ask you, Scott Knight, one of the things the CMA questioned was whether auditors were displaying enough professional scepticism and challenge to managers. In the work you do for the small number of FTSE 350 businesses at the moment, obviously you are keen to win more of that work, but what challenge therefore are you giving to the firms you audit, particularly those bigger ones?
Scott Knight
The challenge breaks down into two parts. It is the ability to identify problems, and that is based upon a deep understanding of the business, and ability to benchmark against competitors. Then, having identified the issue, it is having the resilience and toughness to be able to follow that through to its ultimate conclusion and report that to the audit committee, and if it is in the audit findings as required. It is finding the issue and then following it through to the ultimate conclusion.
Chair
I cannot really ask this question to David Dunckley, because you are not bidding for FTSE 350 work. Jac Berry, are you still bidding for FTSE 350 work at the moment?
Jac Berry
Yes, we are.
Chair
When you are bidding, are you asked during audit tenders to provide evidence of your ability to challenge?
Jac Berry
We are, generally.
Chair
What sorts of questions would they ask you? What sort of evidence would they wish you to provide?
Jac Berry
It is difficult to give evidence on what it looks like, but they ask whether we are willing to stand up, to show them examples of how we stood up, what we expect from an audit committee, not to help us do that challenge, but to support us to do that rigorous job. As I said, we are clearly not in the 350 at the moment. We are tendering for them, but we do a lot of similar international clients. You can take across a lot of what you do on scepticism and challenge there so, yes, they are interested.
Chair
What is the balance like when you are bidding for work, between, say, that professional scepticism and challenge, compared with the cultural fit we hear quite a lot about? I will maybe ask you, Scott Knight. There are those two, in some ways and at some times, conflicting roles of an auditor. How important are those two skills?
Scott Knight
I have seen quite a lot about choosing the right team and the right personality. I am not sure that should be given any significant prominence by audit committees. If there are characteristics you are looking for, they should be robustness, tenacity and the ability to follow it through.
Chair
We probably agree on that, but we are trying to establish what audit committees are looking for, rather than what they should be looking for. What do you think they are looking for when they are assessing your bid compared with somebody else’s?
Scott Knight
I think they are looking for an understanding of the business, that you have spent time, through the tender process, getting under the skin of the business, that you understand the industry and the benchmarks in the industry, what is normal and what is not, that you have the tenacity and robustness to follow things through. I think audit committees look at quality measures such as AQR scores and the individual’s own personal track record, but I would like to see that given more prominence.
Chair
You think that too much weight at the moment is given to the cultural fit and relationship. You would like to move it more to looking at the AQR scores and the challenge.
Scott Knight
It varies, because all audit committees are different, but we have definitely seen examples of that, where we would push for quality to be given far more prominence than any kind of cultural fit or personality fit.
Chair
David Dunckley, how do you deal with conflict or management pushback during an audit and how do you document it?
David Dunckley
It is documented as we go through in working papers. What, necessarily, the outside world will not see is the level of challenge that goes on before accounts are published. There is often a challenge and there may be adjustment.
Chair
Who sees that? You say it is documented as you go along.
David Dunckley
The audit committee would clearly be aware of the challenge, as would management. If there is a disagreement, you would need to qualify the accounts. We qualified 60 of our audits in the last 12 months.
Chair
Of how many?
David Dunckley
7,000.
Chair
Okay. How do you deal with any pushback?
David Dunckley
Ultimately, it is a matter of judgment. If you cannot agree then you qualify, and your ultimate recourse would be to resign, which is a real rarity.
Chair
You said you qualified 60 out of 7,000, so just under 1% you qualify.
Stephen Kerr
My question is about the proposed operational split between audit and non-audit. David Dunckley, you have said that you are against this.
David Dunckley
I have.
Stephen Kerr
It would prevent you from re-entering the FTSE 350 market and you do not think it would increase competition or choice, but would it not focus minds on audit? Would it not lead to better quality audit?
David Dunckley
I am not sure it would directly lead to better quality audit. I can explain the rationale for us opposing it. The paper talks about potential structural and operational split of the Big Four. My belief is that, shortly afterwards, whether it is through regulation or market forces, challenger firms such as ours would have to do similar. For us, that would prevent us providing the investment I talked about in my first answer to re-enter the market. It could be a genuine barrier for Grant Thornton re-entering the market if we were a split operation.
Stephen Kerr
It is not viable for Grant Thornton to operate in an audit‑only role.
David Dunckley
Yes, if you are talking about the PIE audit.
Stephen Kerr
Yes.
David Dunckley
Our public interest audit is around about £10 million of turnover. To ring-fence that and have it separately would really inhibit our ability to invest to deliver the quality the market wants.
Stephen Kerr
Can you help me understand why that would be?
David Dunckley
To invest to work at scale, we need more people and more technology. You would have to invest in advance of the turnover and in advance of the fee income to prove you have the credentials. If you ring-fenced us and I had a profit pool just based on public interest audit, there would be insufficient profits to allow me to invest.
Stephen Kerr
Let me turn to Jac Berry. You support the CMA’s operational split, its proposal, initially for the Big Four.
Jac Berry
Yes.
Stephen Kerr
Is this because you believe it will deliver better quality audits, and if so, how?
Jac Berry
It is part of the measure. I absolutely understand the costing element of it. Although PIEs are what we are focusing on here, all audits are important. If you look at stakeholders, all the audits that are being signed off affect tax revenues, pensions, people’s jobs, et cetera. I have not limited it to the PIE split-off. It was an audit split-off I was thinking about, which I think was in the proposal. The challenge is, as well as the economics of course, that part of what we need to do to get quality better, in my view, is people. There are lots of tools you need, et cetera, but you need the people to do it right. To get people wanting to be in audit, you have to have the best. There is a tension here, but part of the benefit of having wider experience is that auditors learn to challenge. There is a cultural difference sometimes with non-audit services. I am an auditor. I have been an auditor for 30 years and I learned a lot of my challenging of other auditors and management by due diligence exercises. It is a bit of a roundabout way—
Stephen Kerr
The evidence we have had suggests there is little transfer of talent between these different sides of the business.
Jac Berry
I am not sure that is right. I think it has increasingly become the case, and I do not think it has helped quality. As an auditor, you want to be able to understand things and to be able to challenge people, understand the business, et cetera. There are skills you learn that you get from due diligence in particular.
Stephen Kerr
Having said all that, you are in favour of separating auditing from other operations.
Jac Berry
There is sense in that.
Stephen Kerr
How does it improve the quality of the audits, separating it?
Jac Berry
We have said that there are both elements of it. Independence is a mindset as well as a reality. If you are trying to concentrate on a certain level of profits for the partners, there is a seepage there into being truly independent.
Stephen Kerr
Thank you for that. If I can turn to Scott Knight, you are broadly supportive of operational ring fencing. Is that right? However, you have reservations.
Scott Knight
I have reservations. Legal separation undermines the viability of both our audit practice and non-audit practice because the cost synergies and having to hire deep specialists would be a problem.
Stephen Kerr
That is what David Dunckley was saying, but you are in favour of it.
Scott Knight
There are steps that could be made. There is an issue here that needs addressing. You could address the cultural aspects by moving the audit practice into a separate subsidiary that produces its own financial statements that shows it is suitably profitable and there is no cross-subsidy. It should be governed largely, more than today, by auditors of the audit practice. One of the issues when we talk about culture is this. In some firms, the audit practice is less than 25% of the total practice. It is becoming too small. You need to have governance by auditors of the audit practice, in terms of the admittance of new partners, and really focusing the mind on what is important for audit. You can achieve that quite quickly without economic separation or legal separation. You just put the audit practice into a separate subsidiary. That becomes a regulated entity. The financial statements are available to the regulator. It deals with the issue of whether there are cross-subsidies, et cetera. The final aspect that people look at is this. Is there subsidisation within a client relationship? Is the audit a loss leader for other services? The idea that people do audits because there are big consulting contracts has gone. The rules are so complicated now that it takes too long to explain them. You have to say, “If you do the audit or the PIE, you do not do anything else”. It is pure and simple. The profession should get ahead of regulation and start to restore trust by, rather than having complicated explanations, simply saying, “If you do the audit, you do not do anything else”.
Stephen Kerr
You seem to be calling for stronger regulation. You are looking for a stronger regulator. That is what Kingman is recommending, right? You are supportive of a stronger, more US-style regulatory body.
Scott Knight
In terms of the Kingman recommendations, it was an excellent report. It identified the issues. I strongly support most of the recommendations. It is an excellent piece of work.
Stephen Kerr
Let me ask a general question to all three of you before I turn to Clive Stevens. You were describing this culture, Jac Berry, in relation to a commercial mindset, audit versus non-audit services. Help me understand how a senior partner in audit is incentivised to challenge.
Jac Berry
You have to make this a reality rather than a structure. The reality has to be that you take it very seriously. It has to be demonstrated as well, so people have to get paid based on the quality of their audit. We can talk about how that is calculated, but they have to genuinely get paid based on the quality of their audit. As an auditor, you should also get remunerated on how you develop people and bring them on. You can build great tools and methodology, et cetera, but it is only when you are in an audit team and people recognise what you are doing as a partner that they learn to take it seriously. It needs to go through to money, unfortunately, but that is part of it.
Peter Kyle
I think I am correct in saying that all of you are broadly supportive of the CMA’s drive for greater oversight of audit committees. Is that correct?
David Dunckley
That is correct.
Peter Kyle
Could I turn to you, Scott Knight, first? Do you think the CMA’s proposals on greater scrutiny of audit committees are going to drive a culture of greater independence?
Scott Knight
Yes, I think they will. Audit committees range from some that perform excellently, to others that need more of an intervention and more of a nudge. It will work with the latter group to create that independence from management, to focus the mind for appointments on looking for quality rather than anything else, really driving the right behaviours and removing what we sometimes describe as the demand‑side bias. That is critical to any package of measures.
Peter Kyle
That is very helpful. Thank you.
David Dunckley
Can I just agree with that? If there is an independent regulator or observer on the audit committee, in our view, they can bring knowledge that the audit committee may have, whether that is positive or negative, about the firm, so I agree with that.
Peter Kyle
Thank you. That is helpful. Jac Berry, you are in agreement there. Is there any other angle you would like to add to it?
Jac Berry
No, I agree.
Peter Kyle
Thank you. That is very helpful. If I could turn to you, David Dunckley, we cannot talk directly about Patisserie Valerie. Could you talk us through, specifically, what measures you take as an auditor when you are undertaking an audit to expose criminal activity going on within companies, and to make sure fraud, should it be happening within a company, is discovered?
David Dunckley
That is the very heart of the future of audit. As you say, I cannot talk about Patisserie Valerie. There is a live investigation, which we will co-operate with. There is a clear expectation gap. An audit fundamentally gives a reasonable opinion on historic information and does not look for fraud. The market expects that it is doing all those things, so we have that expectation gap that needs to be fixed.
Peter Kyle
Are you confident that your systems are robust at the moment?
David Dunckley
I am confident in our systems. We have invested heavily in our systems and in our quality, such that, yes, I am confident.
Peter Kyle
I am not an accountant. I am not an auditor. I have a question that I need to have answered to myself. This is hypothetical. This is in general. When you have a company that is getting towards year‑end, does not have enough money in its system, writes a cheque from a current account that does not have enough money in it, deposits that cheque in another of its own company’s accounts, and then takes the money that has been deposited, even though the money does not exist and the cheque will bounce several days later, and then adds it to its balance, is it not extraordinary that the auditor would not pick this up? Would the consumer not—
David Dunckley
Absolutely, the consumer would expect that to be picked up. In a hypothetical situation, you would ordinarily expect the auditor to pick that up.
Peter Kyle
What are the implications for an audit company if it did not pick that up?
David Dunckley
The company would have to look at its own systems and the acts of the individuals at the time.
Peter Kyle
Of course, the audit company is not committing a crime in that case, but its fingerprints would be all over the crime scene.
David Dunckley
We have a set of regulations as auditors. There are two issues. First, there is a set of regulations. The regulator asks, “Have you fulfilled the regulations?” There is a separate question as to whether the regulations are fit for purpose and delivering what the market wants. That is the core of this.
Peter Kyle
If an audit company is not picking up on this type of behaviour, what is the point of audit in the first place.
David Dunckley
The Brydon review is really important in addressing the point of audit and delivering on market expectations.
Peter Kyle
I want you to tell me, because you run one of these companies.
David Dunckley
I do, absolutely.
Peter Kyle
What is the point of an audit company if this kind of behaviour is not exposed?
David Dunckley
As I said, we audit 7,000 companies. There were some individual issues in the past and there is a current one that I cannot discuss. We have invested hugely in our quality to deliver a service and we have many, many satisfied clients.
Peter Kyle
If I was chair of a company, why would I hire you? It is like being a principal of a school and not being able to trust Ofsted when it comes in and does an inspection. The point of audit, the point of inspection, is to uncover these types of behaviour. Why would I hire you?
David Dunckley
There is a clear expectation gap in the market as to what we do by reference to regulations, and whether the regulations are fit for purpose. That is the core of what we, as a UK plc, need to sort out. There is a clear expectation gap there. The audit, even done well, is not delivering on what the market needs.
Peter Kyle
Bearing in mind what you have just said, are you saying the market is fit for purpose now?
David Dunckley
The market needs to change to address the expectations.
Peter Kyle
You have just dodged the question, so the answer is no.
David Dunckley
As I said, there is an expectation gap that auditors are doing something. We are not doing what the market thinks. We are not looking for fraud. We are not looking at the future. We are not giving a statement that the accounts are correct. We are saying they are reasonable. We are looking in the past and we are not set up to look for fraud. That is the fundamental expectation gap in the market.
Chair
Can I just ask you a couple of other questions? When you are auditing a company, are you confident that you see all the bank accounts in that company’s name?
David Dunckley
That I would have to get back to you on. Intuitively, yes. I am not an auditor by nature, but part of our normal systems would be to look at the bank accounts.
Chair
Jac Berry, you are an auditor.
Jac Berry
I am an auditor.
Chair
You have 30 years of experience. When you are auditing a company, would you be confident that you have looked at all the bank accounts in that company’s name.
Jac Berry
It is critical.
Chair
It is definitely critical, but would you be confident that you have?
Jac Berry
Yes, I am.
Chair
Scott Knight, are you an auditor?
Scott Knight
Yes, I am.
Chair
When you are auditing a company, would you be confident that you are looking at all its bank accounts?
Scott Knight
Yes, but there is always the risk that there are hidden bank accounts with banks that you do not circularise and get confirmations from. You search for unusual transactions where money is coming in and out of bank accounts.
Chair
There is this issue about the expectation gap. I will maybe ask you, David Dunckley. Do you think the public are right to expect more from an audit than they are getting at the moment?
David Dunckley
Like in any expectation gap, both sides probably need to move. The audit profession needs to move and deliver more on the public’s expectations.
Chair
You think the public should also move in what they expect from an audit.
David Dunckley
There has to be an acceptance that, if there is a sophisticated fraud happening in the business, the audit, as is now, and maybe as is in the future, may never see it.
Peter Kyle
What about an unsophisticated fraud? Should they have a right to expect you to expose that?
David Dunckley
The audit is not, in its core systems, set up to look for fraud.
Chair
Do you offer your clients anything above and beyond this very unsatisfactory audit model? If there are things that you think the public and shareholders would rightly expect, do you ever say to a company, “We know that the audit is not fit for purpose. We all agree on that. Here are some things we think should be in an audit that are not currently. We can offer those to you”?
David Dunckley
You would, within the boundaries of what the ethical guidelines allow you to do. In a PIE audit, no, you would not, but we are supporting a clear delineation between audit and non-audit.
Chair
You are delivering to firms something you recognise is not satisfactory and that is just what the audit is.
David Dunckley
We are delivering something that, as we have been speaking out about for some time, needs to be amended. We are hugely supportive of the Brydon review, because that is really important for the future of our industry.
Chair
I know, but it is sort of like asking somebody else to fix it.
David Dunckley
It is asking someone else, but we have already written to him. We are very keen to help and support in that review. It is not just standing on the side lines.
Vernon Coaker
Can I pick up what you said, Mr Knight? You are saying it would be normal to see the bank accounts, but of course there is always the possibility of hidden bank accounts. People deliberately hide accounts from you. Can you say a little more? I think people would be astonished. You are the auditor. You go in and raise the issue of hidden bank accounts.
Scott Knight
You would look at all the known bank accounts. You would circularise the company’s bankers, et cetera, and get confirmations of the balances at the period end. If a company or an individual, unbeknownst to anybody on the board, had opened a bank account with a completely separate bank, you do not circularise every single bank in the country, asking whether there is a bank account with that particular company. In order to identify if there are any bank accounts that are not on the balance sheet, not in the company’s records, you would look for movements between different bank accounts to identify any transactions.
Vernon Coaker
If you were auditing someone, would you not expect that, if they are hidden, the implication is that they are hiding them for a reason? Why, if you are auditing a company, would somebody not say, “These are all our accounts. These are all our financial transactions and dealings. We need to be open”?
Scott Knight
It is highly unusual.
Vernon Coaker
How many times have you come across this?
Scott Knight
I have never come across it in 25 years. It is highly, highly unusual.
Vernon Coaker
Why do you raise it if you have never come across it?
Scott Knight
It was raised in a hypothetical scenario.
Sir Patrick McLoughlin
Can I ask both Scott and Jac whether they agree with what David Dunckley said about not looking for fraud in an audit?
Scott Knight
You look for material frauds. In a lot of companies, there will be small frauds. They should not be of particular interest to shareholders. If they are sizeable and material, you have to look for them. An audit follows through not just on representations. You look for evidence from third parties, so you look to follow that through.
Sir Patrick McLoughlin
You have to check it is a true account of what the company is doing financially.
Scott Knight
Yes, you should, but in a large organisation there will be petty frauds that are ongoing. That is not something an audit is designed to wheedle out. If they are material to the financial statements and of relevance to the shareholders, you should be expected to find them.
Jac Berry
Very simplistically, my job is to support a true and fair view, as an auditor. As part of that, we can talk about expectation gap, and it is important, but what the public expect is to be able to rely on a set of accounts. Clearly, there are lots of things about materiality, et cetera, but anything of significance that will affect what the users of the accounts see in those accounts is of interest to me as an auditor.
Chair
There is a bit of a difference, then, on the panel about whether detecting fraud is part of the job of an audit. Scott, you think it is part of an audit to detect material fraud.
Scott Knight
Yes.
David Dunckley
When you sign off the audit, you are not signing off to say there has not been a fraud. If there is a fraud that affects the materiality of the accounts, you will want to find it. My point was that the nature of an audit itself is not designed to target fraud necessarily, and there is an expectation from the public that it is.
Chair
As Jac Berry has said, you would expect to detect a material fraud that affects the true and fair accounts, because that will have a material impact on whether those accounts are true and fair.
David Dunckley
If people are colluding and there is a sophisticated fraud, that may not be caught by normal audit procedures.
Chair
But it should be, and that would be part of what an audit was looking for.
David Dunckley
In an ideal world, you would absolutely want it to be and you would want to be able to rely on it. In the real world, for a sophisticated collusion, it might be difficult. It might not be spotted by ordinary audit work, which is in accordance with our standard regulations.
Chair
Yes, but in a shop that sells teas and cake you would think that sort of thing might be spotted. It is not a multinational complex organisation.
David Dunckley
As I said, it is not for me to comment in this forum on that particular matter.
Clive Stevens
But you are right. In the planning stage, auditors really should plan their tests with a reasonable expectation of picking up major fraud. It is not an absolute guarantee because things can be sophisticated. Obviously, it is an offence, as we know, for people to lie to auditors if they do that. That is one of the things the Companies Act legislates against. In the rare circumstance that there is a major fraud, and I hope it is rare, there is legislation there, but the tests should be designed with a reasonable expectation of picking up something. It is not 100% guaranteed.
Chair
The FRC ISA 200 rules from June 2016 say an audit must pick up material misstatements, whether due to fraud or error. Do you agree with that ISA 200 rule, David Dunckley?
David Dunckley
I am not aware of that specific rule. Audit is not my fee‑earning activity.
Chair
But you are the managing partner of an audit firm, Mr Dunckley.
David Dunckley
I am managing partner and clearly I have a head of audit. We have chosen not to bring the head of audit here because this involves our entire firm, not just our audit practice. The point I am making is that, if there is collusion, your ordinary audit standards may not actually spot it. That is at the heart of the expectation gap.
Chair
Yes, they may not spot it, but the FRC ISA 200 rules of what you expect an audit to do say an audit must pick up material misstatements, whether due to fraud or error. You can ask a friend and ask the audience, but that is what an audit is expected to do.
Antoinette Sandbach
Mr Knight, one investment fund manager told us that auditors are failing to ensure that companies adhere to a fair and true view of their financial accounts, or to the capital maintenance regime requirements. Obviously, the capital maintenance regime requirements are a legal requirement under the Companies Act. Is this a fair criticism?
Scott Knight
I think it is more aimed at the financial reporting standards, rather than the audit regime. The financial reporting standards that include fair values create profits that are not realised.
Antoinette Sandbach
We saw that in Carillion, did we not, to dramatic effect? The requirements of sections 830 and 831 of the Companies Act are that the company can only pay dividends out of past realised profits available for distribution. That is not really around accounting standards, is it?
Scott Knight
Also, that rule relates to the company rather than the group, so it is a—
Antoinette Sandbach
I am sorry; it is a legal obligation relating to the financial accounts. Are you saying that is not something that you should audit?
Scott Knight
No, it is something that is audited, but it is in relation to the company, rather than the consolidated financial statements. It is whether the company at the top of the group that is paying the dividend has sufficient reserves to pay that. That is different to whether the group reporting has, on the consolidated basis, sufficient reserves.
Antoinette Sandbach
Are you saying that requirement in the Companies Act does not apply to all the subsidiaries as well?
Scott Knight
No, because they are not paying the dividend. The dividend is coming from the top company at the top of the group.
Antoinette Sandbach
Are you not required to check the veracity in order to know whether that is a fair and true picture?
Scott Knight
Yes, you are.
Antoinette Sandbach
Can any of you define what counts as realised profits in company law? What is the difference between that and reported profits?
Jac Berry
Sorry, I just wanted to clarify something. I absolutely agree that it is very complex and there is a difference between group and the rest, but the ability for a company to pay a dividend or not pay a dividend is a legal requirement. It is a law. As an auditor, part of the role is to make sure they adhere to laws and regulations. I just wanted to say, to clarify, it is complex but, yes, it is part of making sure the company was acting lawfully.
Antoinette Sandbach
Is the reality not that the expectation gap is actually what is not being looked at. Audit companies are reporting to financial standards and not to the legal standards that apply to the companies.
Jac Berry
But they should not do, sorry. It is very complex, but the reality is that there is an accounting framework. They have to adhere to that. There is also a Companies Act and a legal framework, and they have to do both.
Antoinette Sandbach
Looking at the high-profile failures we have had over the last two years, do you think you can say that audit companies are doing both?
Jac Berry
There are a lot of assumptions in financial statements now. Because of the accounting standards, there are a lot of very important things to do with companies that are not in their financial statements anywhere. Even if we assume the financial statements were perfect, management can do an awful lot to destroy a company’s operations that is current not reflected in there.
Antoinette Sandbach
Would you support full disclosure in the accounts of distributable reserves, how they are calculated, and the same for realised and unrealised profits?
Jac Berry
Absolutely. It is complex, but it is something I would expect management to do, to have a record so they know they are legally making distributions properly. I do not understand why it is not a legal requirement. Some people do it voluntarily.
Antoinette Sandbach
Do you agree with that, Clive Stevens?
Clive Stevens
Capital maintenance and paying dividends out of realised reserves covers the whole market, private and public. I know that when the audit partners in my firm look at that it is a prime consideration for them. Certainly, in the private market we work to make sure the accounts are presented in such a way that they meet the standards and dividends are paid out of realised profits. I believe that is part of the job.
Antoinette Sandbach
So you think there should be disclosure in the accounts of distributable reserves, how they are calculated, and the same for realised and unrealised.
Clive Stevens
I do, yes. Then it comes back to the challenge. If something is wrong in the balance sheet or in the accounts, that produces some other result.
Antoinette Sandbach
If there is a new regulator, do you think it should ensure that audit companies are complying with the Companies Act requirements, or auditing the Companies Act requirements on firms as part of the standard practice of their audit?
Clive Stevens
Yes.
Scott Knight
It should even go further, in that the current responsibility is to ensure there is the legal ability to pay the dividend. As I think we have seen in some failures, it is not just whether there is the legal ability but whether it is sustainable. You look at whether it creates pressure on working capital within the next year, but are the dividend levels reaching a point that it is impacting on the business model? As we look at the future of audit, there is an expectation that auditors are considering the business model, including the level of dividend.
Antoinette Sandbach
I am going to move on now to, potentially, the independent appointment of auditors. Mr Dunckley, I know Grant Thornton has argued strongly in favour of independent appointment of auditors.
David Dunckley
We have in the past, yes.
Antoinette Sandbach
Do you think this is more likely to incentivise auditors to provide more challenging audits than the CMA’s preferred remedies?
David Dunckley
We made some quite public statements, based on our experience in the public sector, that an independent body could change the buy-side environment. Reflecting back on the suggestions from the CMA, there are some really good suggestions there. It may get to the same result, which will deliver that independence that the independent body might otherwise have done.
Antoinette Sandbach
Do you agree with that, Ms Berry?
Jac Berry
If what we want is a quality job and openness in the market, the other remedies are better. If there is a mentality of forcing people to have particular auditors, et cetera, I am not sure that helps to build a greater quality. That is my view.
Antoinette Sandbach
What is your view on that, Mr Knight?
Scott Knight
I believe that, in the most part, audit committees do a good job. They understand the company, the sector, the environment. They are in a good position to select the most appropriate auditor. We believe the best intervention is regulatory oversight, rather than taking that decision away from them. We are against a public appointment authority. I think, over time, it would morph towards a procurement agency, whereas the best skills for appointment sit with audit committees.
Antoinette Sandbach
In terms of the length of term that auditors are currently able to hold, it is 20 years before they have to rotate. Do you think this time period should be reduced?
Jac Berry
Yes.
Antoinette Sandbach
Where would you suggest it should be set at?
Jac Berry
It is really difficult, because we are trying to get to a safe set of accounts, which has a safe audit opinion underpinning it. There is a tension there between too short and too long. Obviously, we will come on to joint audit shortly, but a staggered approach helps a bit. I would say seven years or something like that.
Antoinette Sandbach
Does anyone want to bid any higher or lower than seven years?
David Dunckley
We said five to seven years in our written submissions.
Scott Knight
The UK is ahead of the rest of the world in terms of rotation. Although 20 years seems like a long period, there are companies that have just had their first audit tender that have been in existence for more than 100 years. The amount of change that has gone on in the last few years is really significant. I would like to give time for that to bed in, but I think 10 years is the right period for rotation; 20 years still feels too long.
Antoinette Sandbach
What about you, Mr Stevens?
Clive Stevens
Clearly, 20 years does seem too long to me. There is a familiarity threat there. It is one of a number of packages. If you want to broaden out and open up the market, on its own there is no evidence, from the changes we have had, that that would actually increase the entrants into the market. There are other things that have to be around it.
Antoinette Sandbach
It needs to be part of a package.
Clive Stevens
Yes.
Mr Liddell-Grainger
Can I ask BDO and Grant Thornton about joint audit? I think you have differing views on this. If it was introduced, how ready are you to deal with joint audit?
David Dunckley
We said we would be supportive of joint audit. It would depend on the nature of the business. Right now, are we in a position to do a joint audit of some of the largest FTSE 100 companies? No, we are not. That would take a considerable amount of time and investment of specialist skills to do. There is a whole range of companies where we could be in position in relatively short order. If there is going to be a shift of up to 20%, which has been talked about, and 80% market cap, we are talking about a period of investment that could be three or four years to be in a position to do that.
Scott Knight
When I describe a joint audit, it is definitely close to a joint audit, not an 80/20 split. Things like that concern me. That is not a joint audit. It needs to be closer to a proper joint audit. I agree with my colleague that, for firms such as BDO, the top 30 of the FTSE 100 would be a challenge for us in any significant role, and there I am talking about a proper joint audit. From that level down through the FTSE 100, we have the capability. The capacity depends on how quickly the changes are brought in. Once you get into the FTSE 250, we have the capability to audit any FTSE 250 business, and in a joint audit we have the capability and the capacity. We have an audit practice in the UK of £200 million, with 2,000 auditors. We have the capacity and the capability to move quickly there. However, I have concerns about joint audit as a remedy.
Mr Liddell-Grainger
Surely, joint audit is splitting away services from audit, so why do you have a concern about that?
Scott Knight
I look at it through two lenses, both quality and competition. In terms of quality, I have yet to be convinced that it is a superior product. It creates issues, potentially, of things falling through gaps. Secondly, I like the correlation between the auditor’s reputation and when things go right or wrong. In a joint audit, that becomes muddied and if things go wrong there is finger pointing. I prefer a direct correlation. In terms of competition, it locks in the current market structure. In 10 years’ time, if we looked at the FTSE 350 auditors, for the majority auditor, it would look pretty similar to today, dominated by the Big Four with the likes of BDO and Grant Thornton in a smattering. Then you look at the minority or the junior auditor and it would be a series of challenger firms. It would be difficult for firms to break out of that minority role into the majority role. I do not think it solves the competition angle and I am not sure it is a superior product in terms of quality.
Mr Liddell-Grainger
Given Peter’s questions, that is a strange answer. Can I come back to David? You are not auditing anything in the FTSE 250 at the moment, are you?
David Dunckley
I think we do one.
Mr Liddell-Grainger
You do one.
David Dunckley
We do one. We do six in the 350.
Mr Liddell-Grainger
If there was a joint audit, David, would you then get back into the 250?
David Dunckley
We would. The reason we withdrew is that we pitched, we thought we had good capability, it cost us a significant amount of time and money to pitch, and there was just a bias: “Why would someone move away from the Big Four firms?” If there is a mandated change in the buying behaviour, that would give me a business case in which to provide the investment to do that. We have capability to do it in a limited way, in terms of volume of resource. The issue we need to address is increasing the volume of resource to do more of that work.
Mr Liddell-Grainger
You are sort of arguing against yourself where joint audit is concerned. Getting in with a joint audit would not make a difference on that.
David Dunckley
Can I just say I think it would? If we were doing 20% or 30% of a significant audit, we could work with them to build up our capacity to do more of that work.
Mr Liddell-Grainger
All right, yes. Mazars, you do joint audits, do you not?
Jac Berry
Yes. I personally have done joint audits as a partner for 20 years.
Mr Liddell-Grainger
You obviously favour them.
Jac Berry
We favour them.
Mr Liddell-Grainger
What are the counterarguments? You have heard from David and Scott. Come the other way.
Jac Berry
I will come back to specifics if you need. From a reality perspective, in the French stock exchange index, CAC 40, joint audits have been in place for longer than I have. We do a third of the joint audits there. Each of the Big Four does joint audits there and I have worked with all of them on joint audits. It is a practice that seems to work. From a quality perspective, it works. I can explain why. From a significant audit failures perspective, it seems to work, in that there has not been that perception. I would disagree with the junior role and I would disagree with the proper or improper joint audit role, if you need details. It seems to work from a reality perspective, and I have seen it work from my perspective, in terms of bringing the challenge and everyone just trying to get to the right answer.
Mr Liddell-Grainger
Does it increase costs?
Jac Berry
Is that to me?
Mr Liddell-Grainger
Whoever. I am interested to know. Does it increase costs if you do a joint audit?
Jac Berry
It is very hard to decide. There is a lot of data out there. In our view, it does not significantly increase them, but it increases quality. I guess my closing remark would be that Sarbox increased costs enormously, 30% to 40%, depending on what number or statistic you look at, but the quality in the US market has gone up.
Mr Liddell-Grainger
They are not great taxpayers in the UK.
David Dunckley
The answer has to be yes. It must increase costs; that would be our view.
Mark Pawsey
We had Sir John Kingman give evidence to us last week and I want to ask you about some of his proposals for improving the situation. Scott, you referred to it. Does everybody support the Kingman proposals?
Scott Knight
They are very good.
Mark Pawsey
How would a new regulator, a more powerful regulator, help the perception of your profession, just quickly? How would that help?
Jac Berry
There would be greater understanding of what the regulator should do and what they bring, and how they actually do it. At the moment, it is a hard job, I am sure.
Mark Pawsey
What, being the regulator?
Jac Berry
Being a regulator, I am sure, is a hard job. Let us be clear; it is a hard job.
Mark Pawsey
They have been a bit cosy with your profession up until now, have they not?
Jac Berry
There is an argument for that. That is certainly not what we have found. There is a difference between challenger forms and other firms, perhaps. I do not know. We were reviewed last year. The grades were good. They need to be very clear on what they are doing from a practical perspective, in terms of challenging audit firms.
Mark Pawsey
Mr Stevens, one of Sir John’s proposals was greater transparency when a regulator carried out an audit. That is getting more information about failures out into the public domain. Is that a good thing?
Clive Stevens
It is. There are two roles for a regulator. One is to make sure that if work is deficient it is called out, because I do not think anybody in the profession wants poor work to continue.
Mark Pawsey
Is the profession happy for its failures to be publicised?
Clive Stevens
It is happening at the moment.
Mark Pawsey
So it will not make any difference.
Clive Stevens
In an airline-type situation, where we are learning from that, that is a good thing. The other element where the regulator could work with the profession is to support new entrants and get people up the learning curve, so as to improve the range of the market.
Mark Pawsey
Is there a way in which it might help new entrants? The regulator has power to apply fines where it recognises wrongdoing or there has been poor performance, but the fine is not related to the size of the company. Would it make more sense for the fine to be proportionate to the size of the audit firm? It is particularly relevant to you three, as challenger firms, because a big fine will be a bigger proportion of your income than fir a much larger organisation.
David Dunckley
I absolutely endorse what you have said: a firm regulator that has an objective around broader learning. Where they enforce, it has to be proportionate, or else it is going to be a disincentive for firms like ours to be in this market.
Mark Pawsey
Jac, presumably you would go along with that.
Jac Berry
The penalties have to be fair and they need to take into account the facts of the case. Wantonness is obviously more important. They need to be fair.
Mark Pawsey
May I also ask you about his thought that auditors should use graduated findings? I was very interested, David, when you said that 60 of your 7,000 clients had been qualified. We have been told that qualification of accounts is pretty much a nuclear option. You are implying, if that is 1% you have qualified, that 99% have essentially been passed, but one assumes there was quite a spread of quality within that 99%. Do you think it would be better to be able to have a graduated indicator of how a company is being managed?
David Dunckley
We still grade it through that. I would say, on the qualification point, that you do not see the many, many conversations where we have suggested an adjustment and the adjustment is made, and therefore there is no need for a qualification. A lot of the auditors’ work does not get seen.
Mark Pawsey
How often does that happen?
David Dunckley
I would genuinely have to come back to you in writing, given there are 7,000.
Jac Berry
It happens in a significant number.
Mark Pawsey
Is it two-thirds? In two-thirds of accounts the accountants would identify something that they would suggest to the company as an improvement.
Jac Berry
I would not say two-thirds. Sorry, I cannot give you a real answer.
Mark Pawsey
Come on; you guys are doing this all the time. Mr Knight, give us a figure.
Scott Knight
It is really difficult. I am not being evasive. It is really difficult to put a finger on, because it varies from company to company. I would say the product today that involves a binary decision of a qualification or a clean audit report is lost in the past. There need to be more tools in the toolbox. It goes to the expectation gap. If it is in relation to funding, the auditor’s role is not to stop companies going bust. Sometimes they need to go bust, but the signs should be there. The signposts should be there. There should be disclosures of risks, prudency in the balance sheet.
Mark Pawsey
It is an indication of concern.
Scott Knight
Yes, signs should be there.
Jac Berry
I think this is relevant to your question. I will be quick. Part of it is transparency and allowing people to have the knowledge. To the point about where they were wrong but you made management change something, at a completion stage, every firm does something called an audit committee report. That enables people to see clearly what the judgment areas were, what the difficulties were, what was adjusted and unadjusted. They are made public in the public sector and I think that would help people.
Mark Pawsey
May I also ask you about what Kingman had to say about fees? Fees are negotiated, with a figure that you tender, and you get paid that fee regardless of how difficult and complicated the audit is. It is a set amount, and he spoke about a graduated fee and perhaps some hourly billing. I have a question for Mr Dunckley. In a situation such as Patisserie Valerie, where something may be there, does the situation not militate against delving deep? You are being paid a set fee for the audit, rather than being able to spend extra time on it at the client’s cost if you find something untoward.
David Dunckley
It is a very fair question. In our experience, no, it does not. Quality is so important to us, and there are individual assessments of individuals and partners working on an individual case doing that extra work, even if there is not capacity.
Mark Pawsey
So there is a danger of running an audit at a loss.
David Dunckley
You would flag issues as you go to the audit committee, that you have had to do more work.
Mark Pawsey
In the real world, if you know you are being asked to do a whole load of extra work at an extra cost, no organisation wants to make a loss on something, so is there a danger that that deep dive will not happen?
David Dunckley
In our experience, generally not, because we assess quality so strongly and it impacts the individual so strongly.
Mark Pawsey
Mr Stevens, does that apply across your profession as a whole?
Clive Stevens
That is also a role for the audit committee. My experience is that audit quotes may well quote a fixed price, but it will be subject to a number of provisos. If there is more work or there is something extraordinary, it is the auditor’s responsibility to go along to the chair.
Mark Pawsey
How often does that happen?
Clive Stevens
That happens commonly and a lot, in my experience. Whether the auditor then gets the figure they want—
Mark Pawsey
The auditor goes back to the company and says, “We have discovered one or two things. We want to increase our fee”.
Clive Stevens
It is not necessarily a confrontational thing. In my experience, the best clients welcome some challenge and want ideas. That is the other thing about it. They want that from their auditors. Provided the relationship is great, that is a discussion and a commercial discussion. There can be extra fees. As a chair of a charity, it is a conversation I know my finance people have with our auditors every year.
Vernon Coaker
We have heard this morning of a number of issues with respect to the future of audit, and we have the Brydon review. We have heard about trust, culture, competition, the inability to break into the Big Four market, whether we investigate fraud. Then we have these various reviews. For the people watching this or reading it, Kingman has made recommendations; the CMA has made recommendations. Should we wait for Brydon, or should we just get on with it? How is this going to happen? We all say there has to be change and we are all wringing our hands. What is going to happen?
Scott Knight
The biggest risk is no change.
Vernon Coaker
What are we going to do about that?
Scott Knight
You could wait for all these reports and then further consultation, and it gets kicked further down the road. I think the public want to have confidence and need to see change in the next couple of years. A lot of these changes can be implemented quickly. They should not be delayed.
Vernon Coaker
We need to get on with it.
Scott Knight
Yes, definitely.
David Dunckley
I agree with that. The sooner Brydon can report, the better.
Vernon Coaker
We should not wait for Brydon to report.
David Dunckley
No, we should not. Kingman chapter 7 already lists some matters that can be proceeded straight away. If the buy side conditions change, firms like us will see a business case to invest.
Vernon Coaker
Will the Big Four agree with you when we ask them later? Will they all agree to get on with it?
David Dunckley
I will let them answer that question.
Vernon Coaker
Okay, but that is your message to them: “get on with it”.
David Dunckley
Yes.
Jac Berry
I agree; we need to make change now.
Vernon Coaker
Now, get on with it and you are going to work to drive that. The public can be reassured from everyone. You are saying this in front of the Committee, but change is going to happen.
Jac Berry
Absolutely.
Clive Stevens
I have some sympathy for your view and statement as well. Brydon can deal with the expectation gap. It is not good enough to say there is an expectation gap. If, as a result of that, something else is required of audit or the profession develops to deliver something else, so be it. The rest of the package probably should go forward. The flaw at the moment is that they do not go far enough in opening up the market if you want competition. If you take a joint audit approach, as the CMA has suggested, you may well have three or four entrants to that and you may feel that is enough. But you have the opportunity to do something more and develop a longer pipeline through adding a shared audit approach and giving audit committees the choice of being able to do that.
Vernon Coaker
That message from all four of you is very clear: let us get on with it.
Chair
Thank you very much for coming to give evidence to our Committee this morning. Examination of Witnesses
Witnesses
David Sproul, Steve Varley, Bill Michael and Kevin Ellis.
Chair
Thank you very much to all four of you for coming to give evidence to our Select Committee this morning. Can I start by asking whether you think that, taken as a package, the Competition and Markets Authority’s interim suggestions on reform will improve or reduce the quality of audit? Let us start with you, Bill Michael.
Bill Michael
Good morning. My view is that they will, as a package. Again, how we implement these things I am sure we will talk about, but in terms of the key findings of the CMA—
Chair
We will come on to those, but overall you are saying—
Bill Michael
Overall, I am supportive. It is the right direction of travel.
David Sproul
We agree with the policy objectives the CMA has, in terms of choice, quality and dealing with conflicts. We think some of its proposals will be very positive in that regard and some of them will have unintended consequences.
Chair
Taken as a package, you are not so sure it will improve the audit quality.
David Sproul
We are sure of many of them, but not all of them.
Kevin Ellis
I and my firm are absolutely up for change. We support the idea of a new, robust, statutory appointed regulator responsible to Parliament. We absolutely support more choice in the marketplace, as proposed by the CMA, and we support a fundamental review of audit as it is now and in the future.
Chair
What about as a package, Mr Ellis?
Kevin Ellis
As a package, we support the changes as put forward in those areas.
Chair
You think the CMA measures will improve audit quality, taken as a package.
Kevin Ellis
Most of the points in the package will improve audit quality.
Steve Varley
At EY, in reviewing the CMA’s package, we believe that five out of the seven remedies would improve choice and, if implemented correctly, would sustain or improve audit quality. Two of the remedies we do not believe would improve choice and would definitely put audit quality at risk.