Addressing external auditing deficiencies

Approximate read time: 15 minutes

On 14 October 2024, the House of Lords will consider the following question for short debate:

Lord Sikka (Labour) to ask His Majesty’s Government what plans they have to address any external auditing deficiencies highlighted by the collapse of BHS, Carillion, Patisserie Valerie, and London Capital and Finance.

1. Background

The collapses of BHS, Carillion, London Capital & Finance, and Patisserie Valerie all raised concerns about the effectiveness of the auditing process in the UK.

1.1 BHS

Founded in 1928, British Home Stores (BHS) was bought by Sir Philip Green for £200mn in 2000. It was sold for £1 to Retail Acquisitions Limited, owned by Dominic Chappell.^[1] In April 2016, it entered administration, with debts of more than £1.3bn and a pensions deficit of £571mn. This led to the closure of its 164 shops and 11,000 job losses. The company was liquidated in December 2016.^[2]

In June 2018, the Financial Reporting Council (FRC), which regulates auditors, accountants and actuaries in the UK, announced a fine of £10mn for PricewaterhouseCoopers (PwC) in relation to the 2014 audits of BHS and the Taveta Group (of which BHS was a subsidiary).^[3] Additionally, it required PwC to review and amend its policies and procedures to ensure that audits of all non-listed high-risk or high-profile companies (including private companies which employed at least 10,000 individuals in the UK) were “subject to an engagement quality control review”. Among several measures, it also sanctioned the then senior statutory auditor for the Taveta Group at PwC, Stephen Denison, with a fine of £500,000 and a condition not to perform any audit work for 15 years.

In June 2024, the high court ruled that Dominic Chappell and Lennart Henningson, who were former directors at BHS, were ordered to pay £110mn to creditors as a result of “breaching their fiduciary duties” by continuing to trade rather than putting BHS into an insolvency process and therefore “failing to promote the success of the company”.^[4] Despite the judgment, Lynn Dunne, a partner in dispute resolution practice at the legal firm Ashurst, stated that although this was a “significant ruling”, it “remains to be seen how much of this the liquidators are able to recoup from the former directors and any relevant [directors insurance] policies which may cover some of the awarded damages”.^[5]

1.2 Carillion

Established in 1999, Carillion was a major British company involved in construction, facilities management and maintenance services. In January 2018, Carillion entered administration before collapsing later that month.^[6] The company was awarded many major construction contracts, including the building of the high speed 2 rail line. Several media outlets have reported that Carillion collapsed with debts of £7bn (more than its annual sales of £5.2bn) and that the collapse resulted in 3,000 job losses at Carillion and had affected 75,000 people working in its supply chains.^[7]

In October 2023, the FRC announced sanctions against KPMG and two of its partners relating to the audits of Carillion between 2014 and 2017.^[8] This included a total fine of £30mn against KPMG (reduced to £21mn to “reflect the firm’s co-operation and admissions”) and financial sanctions against two partners at KPMG, with one partner excluded from membership of the Institute of Chartered Accountants in England and Wales (ICAEW).

1.3 Patisserie Valerie

Founded in 1926, Patisserie Valerie is a high street bakery chain. In October 2018, Patisserie Holdings announced that its board had been notified of potentially fraudulent accounting irregularities. In the same month it suspended trading, closing 70 stores, which led to 900 job losses.^[9] Following the company suspending trading, the Serious Fraud Office (SFO) launched an investigation into the company’s conduct. In March 2019, KPMG, acting as administrators for the company, reported that Patisserie Valerie’s accounts had been overstated by approximately £94mn.^[10] An investigation into the auditors of the company, Grant Thornton, was also opened by the FRC.

In September 2021, the FRC published the findings of its investigation.^[11] It stated that the investigation had revealed “a serious lack of competence in conducting the audit work” between 2015 and 2017, and that Grant Thornton had “missed red flags”. The auditor was fined £2.3mn and was ordered to review its audit quality. In addition, it faced additional monitoring relating to bank and cash audit work and was required to issue three annual reports on the impact of those reviews. Further, David Newstead, a partner at the auditor, was fined nearly £80,000 and was banned from conducting audits and signing audit reports for three years.

In September 2023, the SFO charged four individuals, including the former director and chief financial officer at Patisserie Holdings, Christopher Marsh, with conspiring to inflate the cash in the company’s balance sheets and annual reports from 2015 to 2018. This included providing false documentation to the company’s auditors.^[12] At a trial preparation hearing in November 2023, the SFO stated that it expected to examine almost 3mn documents relating to the case. A trial date was set for spring 2026.^[13]

1.4 London Capital & Finance

Incorporated in 2012, London Capital & Finance (LCF) was an issuer of mini-bonds used to make loans to corporate borrowers to provide capital for further investment.^[14] In December 2018, the Financial Conduct Authority (FCA) wrote to LCF ordering the company to immediately withdraw its promotional materials for mini-bonds, stating that the marketing was “misleading, not fair and unclear”. The FCA also imposed certain requirements on LCF to “further protect investors” and because it had “serious concerns” about the conduct of LCF. Requirements included LCF ceasing to conduct all regulated activity and not to communicate any financial promotions. In January 2019, LCF went into administration. In March 2019, administrators for LCF warned that “at best” bondholders could expect to receive around 20 percent of their money back, but that the process could take two years.^[15]

In May 2019, HM Treasury issued a direction to the FCA to undertake an investigation into the events relating to the regulation of LCF.^[16] In June 2020, the FCA appointed Dame Elizabeth Gloster to lead the investigation. Dame Elizabeth published her report in December 2020. The report was critical of the FCA, arguing that the regulator “did not discharge its functions in respect of LCF in a manner which enabled it effectively to fulfil its statutory objectives”.^[17] Therefore, it made several recommendations. This included calling on the FCA to provide “appropriate” training to relevant teams in its authorisation and supervision divisions on “how to analyse a firm’s financial information to recognise circumstances suggesting fraud or other serious irregularity”.^[18]

In the same month, HM Treasury announced it would be setting up a compensation scheme for LCF bondholders. The scheme would be administered by the Financial Services Compensation Scheme (FSCS) on behalf of the government.^[19] In May 2021, the government set out the legislative arrangements for the scheme by introducing the Compensation (London Capital & Finance plc and Fraud Compensation Fund) Bill in the House of Commons.^[20] The bill gained royal assent in October 2021 to become the Compensation (London Capital & Finance plc and Fraud Compensation Fund) Act 2021. The compensation scheme closed in October 2022. The FSCS reported that it had been able to successfully pay 99.5 percent of customers eligible for compensation, with £115mn paid out from the government’s compensation scheme.^[21]

In August 2024, the FCA fined PwC £15mn for not alerting the regulator to suspected fraudulent activity at LCF.^[22]

2. How are companies audited in the UK?

2.1 Legislative background

Company law in the UK is primarily set out in the Companies Act 2006. Part 15 (sections 380 to 474) of the 2006 act details the requirements for the preparing, distributing and filing of accounts and reports. For example, section 393 places a requirement on directors of a company not to approve accounts unless they are satisfied that they “give a true and fair view of the assets, liabilities, financial position and profit or loss”.

Part 16 of the act (sections 475 to 539) details the requirements placed on auditing companies in the UK. Section 475 places a requirement on all companies to have their annual accounts audited, unless they are exempt from doing so due to one of the following reasons:

• Small companies: Section 477 details that small companies are exempt from the requirements of the act relating to audits. Section 382 of the act defines a small company as one that has a turnover of less than £10.2mn annually, a balance below £5.1mn and no more than 50 employees.
• Subsidiary companies: Section 479A outlines that a company is also exempt from the auditing process if it is a subsidiary undertaking, and its parent undertaking is established under the law of any part of the UK. Subsidiary companies must also meet certain conditions, including that the company must be included in the consolidated accounts drawn up for that year by the parent company.

2.2 Financial Reporting Council

The FRC is responsible for establishing and enforcing high standards in corporate governance, financial auditing and reporting within the UK.^[23] It does this by:

• setting the UK corporate governance and stewardship codes and UK standards for accounting and actuarial work^[24]
• monitoring and taking action to promote the quality of corporate reporting
• operating independent enforcement arrangements for accountants and actuaries
• setting auditing and ethical standards, monitoring and enforcing audit quality and oversight of statutory audit regulation in the UK.

Enforcement action by the FRC is taken under its audit enforcement procedure.^[25] Under the procedure, it will investigate matters relating to the audits of:

• public interest entities, being listed entities, credit institutions and insurance undertakings
• alternative investment market-listed companies with a market capitalisation over €200mn
• Lloyds syndicates

There are up to four stages to the FRC’s audit enforcement procedure:

• Initial enquiries: These are conducted by the case examiner and may be referred to the FRC’s board or conduct committee to determine whether the matter should be referred to the FRC’s executive counsel to investigate.
• Investigation: This is conducted by the FRC executive counsel’s lawyers and forensic accountants, resulting in an investigation report to the executive counsel. At the conclusion of the investigation, the executive counsel will issue a decision notice detailing any findings and sanctions. The subject can accept or reject the findings.
• Tribunal: If the matter is neither concluded nor settled, the tribunal will hear evidence and determine whether or not to make an adverse finding. Where an adverse finding has been made, the tribunal may impose sanctions.
• Settlement: At any time after a notice of investigation has been issued or before a tribunal has made its decision, the parties may agree to a settlement. The executive counsel will issue a settlement decision notice if the terms of the settlement are agreed.

The FRC fined auditors £33.2mn in 2022/23. This was a slight increase on the previous financial year, when it fined auditors £32.8mn. Both of these are higher than the value of fines imposed by the FRC in 2020/21, which was £19mn.^[26]

In recent years, the former Conservative and current Labour governments have proposed replacing the FRC with a new regulator. Further information on this can be found in section 3 below.

3. Recent government policy

3.1 Former Conservative government

The former Conservative government had previously sought to reform the auditing industry. This included proposing the draft audit reform bill and draft reporting regulations.

In 2021, the Department for Business, Energy and Industrial Strategy (BEIS) published a white paper outlining proposals to reform the auditing industry.^[27] The department stated that stakeholder and wider public trust in the credibility of directors’ reporting and the statutory audit process had been “shaken by a succession of sudden and major corporate collapses which have caused serious economic and social damage, including the insolvencies of BHS in 2016 and of Carillion in 2018”.^[28] Therefore, BEIS proposed several measures, including legislation to establish a “strengthened regulator”, the Audit, Reporting and Governance Authority (ARGA), to replace the FCR. It intended the new regulator to be established as a company limited by guarantee. Its general objective would be to protect and promote the interests of investors, other users of corporate reporting and the wider public interest. The ARGA would be governed by a simplified board with “strengthened oversight”, and non-executive members, including the chair, would be public appointments. The department stated that the regulator would be accountable to Parliament, with “strategic direction” from the government. It would be funded by a statutory levy from market participants. The then government also proposed giving ARGA new powers of enforcement, including giving the regulator the power to impose more detailed requirements as to how certain statutory duties relating to corporate reporting and audit were to be met by directors. However, the former government did not introduce the draft legislation.

In July 2023, the Conservative government laid the draft Companies (Strategic Report and Directors’ Report) (Amendment) Regulations 2023 in Parliament. If approved by Parliament, the draft regulations would have created certain corporate reporting requirements for very large companies in the UK, defined in the draft regulations as companies with 750 employees or more, and an annual turnover of £750mn or more. This included requiring the publication of an annual resilience statement in a company’s strategic report, in which companies must explain the steps they are taking to build or maintain their business resilience over the short, medium and long term. The resilience statement would have required summarising the company’s strategic approach to managing risk and building or maintaining business resilience. In October 2023, the then government announced it was withdrawing the draft regulations. It stated that this followed consultation with businesses, which had raised concerns about imposing additional reporting requirements.^[29] It said the draft regulations would have “incurred additional costs for companies” by requiring them to include “additional layers of corporate information in their annual reports”.

3.2 Labour government

The Labour government has also outlined its intention to reform the auditing industry. In September 2023, the Labour Party stated that a Labour government would introduce legislation to reform the UK’s auditing and corporate governance regimes and accused the Conservative government of dropping its plans to introduce a draft bill on audit reform. In an interview with the Financial Times, the then shadow business secretary (now secretary of state for business and trade), Jonathan Reynolds, said that his party felt that the then government had “not just delayed it, we think it’s dead. We think it’s not coming”.^[30] Mr Reynolds further stated that:

We would replace the FRC with the new proposed ARGA, which will be the new body with teeth at the heart of this, which does require legislation. I cannot see an argument for it not progressing […] It is a priority for us and it will be part of our commitments for the next government if we form it.^[31]

In the July 2024 King’s Speech the new Labour government announced its plans to introduce a draft Audit Reform and Corporate Governance Bill.^[32] It said the draft legislation would replace the FRC with ARGA, which would have enhanced enforcement powers to investigate and sanction company directors for “serious failures” in relation to their financial reporting and audit responsibilities. The government stated that this would ensure that “there are consequences for putting forward dodgy accounts”. The draft bill has not yet been published.

4. Read more

4.1 House of Commons Library briefings

• House of Commons Library, ‘Company audits: Issues and proposed reforms’, 19 December 2023
• House of Commons Library, ‘London Capital & Finance’, 3 February 2022

4.2 Parliamentary debates and questions

• House of Commons, ‘Written question: Audit (4286)’, 11 September 2024
• House of Commons, ‘Written question: Companies: Audit (675)’, 26 July 2024
• House of Lords, ‘Written question: Carillion: KPMG (HL1475)’, 25 January 2024
• Oral question on ‘Audit and corporate governance reform’, HC Hansard, 30 November 2023, cols 1038–9
• House of Lords ‘Written question: Audit and insolvency (HL10309)’, 3 October 2023
• Debate on ‘Insolvency law and director disqualifications’, HC Hansard, 14 June 2023, cols 163–79WH
• House of Lords, ‘Written question: Carillion: Insolvency (HL4867)’, 31 January 2023

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Cover image by fabrikasimf on Freepik. This briefing was updated on 13 September 2024.