Audit reports

The health of the market

Paul Afteni and Jennifer Chan ask how challenger firms in the audit sector are affected by the regulatory and market reforms.

Paul Afteni

Head of Financial Services Professional Indemnity, Willis Towers Watson, FINEX

Jennifer Chan

Associate Director, Claims Advocate at Willis Towers Watson, FINEX

The recent series of high profile audit failures which have led to the collapse of companies such as BHS, Carillion and Thomas Cook have put the spotlight firmly on the UK audit sector and prompted a number of industry wide reviews and recommendations for wholesale reform. This article will summarise the various reports that have been commissioned to review the current health of the UK audit market and the key recommendations that have been proposed. In addition, it will consider the opportunities that this presents for mid-size audit firms who currently sit just below the “Big Four” firms – EY, KPMG, PWC and Deloitte – and the risks that should be considered by such firms before seeking to take advantage of the opportunities for new business that the audit reforms have initiated.

Scrutiny from independent reviews

In December 2018, Sir John Kingman published an Independent Review of the audit regulator, the Financial Reporting Council (FRC) and his recommendations on the need for changes to regulation through legislation. This included a proposal to replace the FRC with a new independent statutory regulator, accountable to Parliament to be called the Audit, Reporting and Governance Authority (ARGA).

In April 2019 came the final report from the Competition and Markets Authority (CMA), which proposed a range of measures to make the system more independent and to increase choice, competition and resilience within audit. The CMA also focused on addressing the barriers facing smaller so-called “challenger firms” from entering the FTSE 350 audit market. Taking account of the recommendations put forward in the Kingman report and following extensive discussions with audit firms, investors and major UK companies, the CMA proposed that there should be a separation of audit from consulting services. In addition, the regulator put forward the idea of mandatory “joint audits”, involving challenger firms, to develop the capacity needed to review the UK’s biggest companies. Further remedies the CMA put forward were: the introduction of a market cap to reduce the number of FTSE 350 audits carried out by the Big Four audit firms; and resilience measures in the event of an audit firm, especially one of the Big Four, failing.

More recently, in December 2019, the Brydon Report, authored by former London Stock Exchange chairman Sir Donald Brydon, contained 64 recommendations as to how to increase confidence in the audit sector and prevent unnecessary collapses. Some of the key recommendations in the report include: ● a redefinition of audit and its purpose, providing greater clarity about who audit is for and reinforcing its role as a public interest function; ● the creation of a stand-alone and transparent audit profession, to be governed by overarching principles; and ● an obligation on auditors to inform, and the need for them to be suspicious as well as sceptical, thus endeavouring to identify corporate fraud.

How are challenger firms affected?

Whilst all these reports promulgate similar intentions to introduce root and branch reform to the UK audit industry, the recommendations they set out also focus on introducing more competition and resilience to the audit market. This provides several new opportunities for challenger firms that represent the next tier of UK audit practices, as well as to those firms that have so far struggled to break the dominance of the Big Four over the UK’s coveted FTSE 350 audit market.

The proposed reforms and stricter regulatory requirements have opened several new revenue streams for challenger firms and exposure to clients who would previously have only considered appointing one of the Big Four auditors. Consequently, numerous practices are positioning themselves to compete for mandates from top PLCs.

The most obvious risk is whether challenger firms have the relevant expertise, requisite skills and sufficient resources to undertake the most complex audits. As highlighted above, a key reason for the proposed reforms, including the introduction of the challenger firm model, is to generate increased capacity to the existing pool of suppliers able to offer complex audit services.

Inherent in this proposed reform is the fact that until now, firms outside of the Big Four have struggled to break into the FTSE 350 audit market and thus will be less experienced in undertaking such work. Industry regulators such as the Prudential Regulation Authority (PRA), which was created following the 2007–2008 global financial crisis to supervise the stability of banks and insurers, requires that an auditor has the “required skills, resources and experience to perform its function under the regulatory system”. The PRA held discussions last year with a number of challenger firms over concerns about their ability to audit a major investment bank.

Following on from this is the question of whether, when considering the potential risks to the business, challenger firms will be able to obtain affordable professional indemnity insurance (PII) cover and at the right capacity level. The PII market is currently in the midst of a hard cycle of increasing rates which does not yet appear to have reached its peak. PLCs, particularly FTSE 350 companies, are likely to require unlimited liability from their auditors, and firms will need to consider not only what PII requirements will arise because of this work, but also assess how large their PII limit. In some cases, this may be multiples of their current limits purchased, and as the additional exposure will emanate from auditing activity, it is likely to result in significant additional costs, perhaps more restrictive cover and higher self-insured retentions.

Insurers rate risks on a number of factors, one of which is the split of work of the practice. For example, tax advice is seen as a systemic risk; i.e. one with a higher frequency of claim notification. However, audit work is one of a catastrophic nature, less frequent but of much greater severity and these are rated accordingly by insurers. Therefore, Until now, firms outside of the Big Four have struggled to break into the FTSE 350 audit market and thus will be less experienced in undertaking such work.”

Author bio Paul Afteni leads a team responsible for the placement and servicing of professional indemnity insurance for large accountants, independent financial advisors and insurance brokers.

Author bio Jennifer Chan is an Associate Director, Claims Advocate at Willis Towers Watson, FINEX. accountancy firms considering undertaking PLC audits face a two-fold issue: scarce capacity and subsequent increased PII costs.

Although there are a good number of insurers approved to provide PII insurance to the profession, many of those have limited or no appetite for practices undertaking audit work (particularly PLC audit), creating low supply for the demand of firms undertaking this type of role.

How will changes be implemented

Whilst the reforms suggest a wider division of labour in the PLC audit sector with co-operation between firms on particularly large audits, they do not provide a clear suggestion of how changes will be implemented or operate in practical terms and this is something upon which the government is actively consulting via the Business, Energy and Industrial Strategy (BEIS) select committee. For example: ● Will the challenger firm work alongside a member of the Big Four as joint auditors? ● Will practitioners and the government back a shared audit approach whereby one audit firm is appointed as the statutory auditor and takes overall responsibility and liability for the audit, whilst another supports the statutory auditor on certain aspects of the audit? ● Will the challenger firm simply operate in an independent peer review-type function once the audit has been undertaken by the statutory auditor, who is more likely to be a member of the

Big Four?

Many in the industry cannot yet answer these questions with any certainty, and all options represent their own hazards and challenges. Indeed, it is currently unclear which should be considered the riskier approach. The likelihood is that this will only become apparent once a period in “the new world” has been completed and a track record is established. However the CMA has made clear in their recommendations that, whilst they supported mandatory joint audits and thought further consideration should be given to the use of peer reviews, they did not support shared audits as they feared these would lead to challenger firms being subordinate to the Big Four statutory auditors – with the latter ultimately dictating how the audit is carried out. Any firm considering entering the audit marketplace will need to consider the implications that this decision will have on their business. Yes, there is undoubted opportunity to develop a greater profile in the audit sector, but there are other important considerations to address. The claims-made nature of PII means that once you have undertaken any kind of business, the risk is considered by PII insurers at every renewal of your PII. Currently, whilst there is limited appetite, cover is available for audit work at all levels for accountancy practices in the PII market. However, a high-profile, significant audit failure claim in the market could result in PII insurers withdrawing cover in respect of audit work going forward, leaving firms with potential uninsured business risk going forward. ●

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