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Comment: The Brydon audit review: Groundhog Day for investors?

A new set of recommendations but it’s déjà vu all over again

The Brydon Review is out. Commissioned by the UK government, it completes a trilogy of soul-searching studies about what is wrong with the audit industry.

In the aftermath of the accounting failures of Carillion and BHS, first came the review of Legal & General Group Chairman Sir John Kingman.

The Kingman review concluded that the Financial Reporting Council has for too long been a weak and ineffective regulator and recommended that it be replaced by a new one with true teeth: the Audit, Reporting and Governance Authority or ARGA.

The recommendation proved right those who had been concerned for too long about whether the FRC was fit for purpose. 

The tribulations of the audit industry should (and could) have been tackled long ago.

In April this year, the Competition and Markets Authority published its study. The CMA addressed the market failure that cripples the audit industry that is monopolised by just four players who serve about 97% of the FTSE 350. 

Sir Donald Brydon, former London Stock Exchange Group Chairman intended to focus more on the purpose of audit. 

That includes the decades old “expectation gap” audit problem. The 1974 paper by Carl D. Liggio, The expectation gap: the accountant's legal Waterloo?, is often cited as having coined the expression.

But the problem is older than that and comes down to the situation when a firm is given a clean bill of health by the auditor … and nonetheless collapses.

The best contemporary example, stemming straight from the global financial crisis, is the audit report of Lehman Brothers for which EY reached a meagre $10m settlement with New York’s Attorney General seven years later. 

The UK trilogy makes the headlines as something radical and innovative but investors should be aware that it’s Groundhog Day for the audit market.

The tribulations of the audit industry should (and could) have been tackled long ago.

Let’s take two of the recommendations that the CMA made to the Government. One is the operational split between the Big Four’s audit and non-audit business. The other is mandatory joint audits to give other players an opportunity to grow. 

In addition, let’s consider Brydon’s recommendation for segregating the audit and accounting professions.  

These ideas and many other more ambitious ones were already suggested by the European Commission back in 2010. 

With the financial crisis hitting markets hard, the EU kick-started its audit reform with a green paper entitled Audit Policy: Lessons from the Crisis

The EU was already exploring the idea of going further than an operational split, by breaking-up the larger accountancy firms to create “‘pure audit firms’ akin to inspection units”. 

The EU said then: “Since auditors provide an independent opinion on the financial health of companies, ideally, they should not have any business interest in the company being audited.”

But by 2016 the Audit Reform concluded with legislation that had either been killed or saw these proposals watered down. 

The Big Four, particularly from the UK-based partnerships, were very successful in lobbying against it. Their lobbyists massively outnumbered those of other stakeholders in Brussels.

"I question the independence of this report, it glosses over the issues"– Prem Sikka

Ironically, at a time when the UK is leaving the EU, the British government will be considering some suggestions that can be traced back to the time when Europe’s Chief Brexit Negotiator, Michel Barnier, was the Commissioner for Internal Markets and Services. 

Only a devastating corporate failure such as Carillion has made the UK reconsider those ideas. But the UK trilogy of reports are just that: recommendations that can leave informed investors with a feeling of déjà vu, especially if deep reforms don’t make it to the statute book. 

According to Prem Sikka, Professor of Accounting and Finance at the University of Sheffield, the Brydon report is at best putting “a tiny bandage” and “lot of gloss to save the audit industry”. 

The bottom line, he told RI, is that “we’ll still be talking about this in another 10 years”.

Sikka takes issue with the fact that the industry body, the Institute of Chartered Accountants in England and Wales (ICAEW) provided £500,000 (€587,761) for the review. 

“I question the independence of this report, it glosses over the issues. It doesn’t make recommendations about liability laws. It doesn’t even acknowledge that some of the audit work is outsourced, so it hasn’t even looked at the business model of big accountancy firms.”

When it comes to the scope of the audit, the Brydon report mentions fraud by recommending a duty on the auditor “to state how they have assured the directors’ statement on material fraud”.

Brydon said this challenges the perception that auditors have no obligation to detect fraud. “I consider that they should endeavour to,” he wrote.

Sikka told RI that a court case from this year involving the audits of AssetCo Plc is more progressive than that. “Judges said auditors were negligent because they failed to report on fraud,” he said.

Paraphrasing Lord Denning, in the 1958 court case of Fomento plc v Selsdon Fountain, Sikka added that an auditor should come to the audit with an enquiring mind, not suspicious of dishonesty but suspecting that someone may have made a mistake somewhere.

Referring to some of the recommendations of the Brydon report, Sikka said: “Sorry, all that was already established 60 years ago.”