Regulating the regulator: how the FRC should transform itself
This article was first published in Financial Director
As the UK’s regulator of the audit and accounting industry, Financial Reporting Council’s (FRC) objective is to promote transparency and integrity in business. Its primary customers are investors and others who rely on company reports, audit and risk management information to make decisions about investments. In the UK audits of companies are dominated by the Big Four, who audit 96% of FTSE 250 companies.
Following the recent collapses of BHS and Carillion, accountancy firms and the FRC are facing growing criticism over their failure to identify the risks facing these organisations. Stephen Hadrill, the CEO of the FRC has been quoted stating that the regulator may force the Big Four to hive off their audit and consultancy businesses. At the same time, the FRC itself will be subject to an independent review of its handling of recent failures and effectiveness as a regulator.
How can the FRC transform itself into a more effective regulator of the audit and accounting industry to restore customer confidence?
By learning from the experiences of other industry regulators, including within Financial Services and utilities, the FRC can be reformed. Its focus should be on understanding how it can implement outcome-based regulation, enforce better handling of conflicts of interest through separation of functions, and encourage competition within the audit market.
Following the financial crisis of 2008, the UK’s Financial Services Authority (FSA) faced criticism that its ‘tick box’ approach to regulation was not effective. In response to the failings identified, the FSA was split into two regulators, with related but clearly differentiated remits. This shift has enabled each regulator to clearly articulate its purpose and focus, achieving good outcomes for consumers (The Financial Conduct Authority) and promoting market stability (The Prudential Regulation Authority).
In examining the FCA’s business plans in recent years, including its 2018/19 plan published in April, its focus on outcomes rather than rules is clear. This shift away from ticking boxes is critical for better regulation, as firms must proactively work to achieve the outcomes intended by the regulatory guidance, discouraging the use of loop holes which previously enabled firms to continue with poor practices whilst maintaining compliance.
First things first
Firstly, the FCA prioritises its work based on the potential for consumer harm. If the FRC prioritised its work in the same way, decisions could be focused scrutinising the audit firms and audits which have the biggest potential impact (e.g. firms with significant public funding such as Carillion).
Secondly, the FCA puts significant effort into identifying emerging trends and risks before they materialise, doing this through forward-looking market studies and use of data to identify trends. For example, in 2017 the FCA’s risk outlook identified risks to consumers stemming from the increasing levels of consumer debt, and this has been translated into thematic reviews on debt management services and reviews of motor finance. Similarly, the FRC should also look to understand the data it has, and how it can work proactively to identify risky trends which may impact the quality of audit services.
Following the Enron scandal in 2002, a number of the large accountancy firms established new companies to separate consulting and audit services. Over the intervening years, in search of higher profits and to capitalise on the opportunity to be a ‘one stop shop’ for clients, this separation has reversed with all of the big four accounting firms offering a variety of professional services including consultancy and audit.
A question has been raised as to whether the FRC should force the split of consultancy services from audit providers. There is likely not yet sufficient evidence to support such a move, and further, there are other approaches used in industries such as water which provide an example for how separation of functions can be achieved without splitting organisations.
For example, the establishment of a non-household retail water market has required water companies to separate the retail business from the wholesale business. However, in this sector the regulator allowed firms to deliver this separation in a variety of ways that didn’t enforce physical separation of the businesses. The success of this indicates that the ‘Big 4’ could be encouraged to separate their audit and consultancy businesses without forcing a full split of the organisation.
An important element of change when it comes to handling conflicts of interest, is encouraging a fundamental shift in the culture of accounting firms. In response to the growing criticism, in April the FRC announced new plans to enhance its monitoring of the six largest accounting firms. A key aspect of this work will include heightened scrutiny of the leadership and governance within the firms, with a focus on the appropriateness of appointments to firms’ non-executive directorships, heads of audit and ethics committees. In the immediate term, this is a welcome development.
The FRC could take lessons learned from the implementation of culture and conduct changes in the financial services industry which has focused extensively on ensuring that senior managers within the industry have appropriate skills and independence for their roles. Changes have also been implemented to ensure that senior managers are personally accountable for issues within their firms. The effectiveness of these changes is not something that will be immediately evident, but in the first year of the regime we have already seen the first fine issued, to Jes Staley for his attempts to identify a whistleblower.
In the UK, both the FCA and PRA have been given specific objectives to encourage competition in financial services, where retail banking in particular is dominated by a small number of large incumbents. Enhanced competition leads to greater consumer choice and outcomes. The FCA and PRA have implemented initiatives which include supporting new market entrants through the authorisations process; forcing incumbents (such as RBS) to fund specific innovation/ competition funds as part of penalties for mis-behaviour. This is increasingly important as smaller audit companies have announced plans to exit the Audit market for FTSE companies due to the high cost of bidding and low rate of success (Grant Thornton).
There is a lot for the FRC to learn from the economically regulated sectors, which have different levels of competition remits, e.g. CAA must be sure competition is not effective before it acts, whereas Ofgem is required to use competition where it best serves customer interest. We are also seeing increasing prescription by regulators to create competition, e.g. by running their own competitive processes to appoint new providers. The FRC could consider whether a similar approach for audits is possible, for example whether competitive processes could be run for the auditing of large public sector bodies.
What is clear is that the FRC should focus on regaining trust. This is a path well-trodden by other regulatory authorities who have focused on defining priorities based on outcomes, adopting innovative solutions to addressing decreasing trust, separating businesses without breaking up the business, or addressing competition. Applying these approaches to the audit market could contribute to increased confidence in the system and higher quality audits.
Sam Walsh is a regulation and transformation expert at PA Consulting Group