A potential auditor independence solution

The amended APES 110 independence standard threatens to wipe out SMSF audit revenues for many accounting practices. Kevin Bungard, Australian General Manager at Workspaces, looks at how exchange programs may help, and outlines the strict requirements they must meet, in allowing firms to retain their SMSF audit businesses.

The APES 110 Independence Guide, released by the APESB in May 2020, has had huge implications for SMSF auditors and industry estimates are that 200,000 to 300,000 funds may be affected.

MyWorkpapers surveyed its client base in September 2020 and the results showed just over 60 per cent of accounting practices are impacted by the prohibition on ‘in-house’ auditing of SMSFs. The survey also showed that, on average, in-house audits made up just under 80 per cent of audits for the firms conducting them.

If these percentages are reflected across the entire industry, then 290,000 SMSFs will need to put in place a new audit arrangement effective from 1 July 2021.

Under the new standard, firms must outsource the audit of SMSFs they administer, and many firms have been looking for a way to avoid cutting staff that would be made redundant by this measure and get a return on the investment put into building that part of their business.

After exploring the use of exemptions, business restructuring and the possibility of spinning out or selling their audit divisions, many firms remain deeply frustrated with the options available.

One option firms have explored is pooling or exchanging audits among a group of practices. Before exploring the dos and don’ts of how audits might be ‘exchanged’ between firms, let’s quickly cover off some of the other options firms may have considered and rejected.

Exemptions and restructuring do not work

Much has been written about the routine and mechanical exemption. Many firms had hoped there was a way to split responsibilities within the firm or restructure related businesses so a firm or group could continue to do both the accounts and the audit for their SMSF clients.

Not only does use of the exemption and business structures not work, but attempting to do so is also clearly against the intent and spirit of the new standard. The relationship between the accountant and auditor must be truly independent and, as such, even a partial ownership in the new business would put you in breach.

You need to completely separate the businesses via a sale or spin-off for a restructure to be compliant.

Too late to spin off

If you had acted within the first couple of months of the new guide coming out in May 2020, then you could have spun off your audit division into a separate business and may have been able to meet the requirements of the independence standard that would allow you to perform audits for your former firm after 30 June 2021.

If, however, you had not acted by 30 June 2020, then the compliance challenges become significantly harder. The closer we get to 30 June 2021, the more impractical a stand-alone spin-off of the audit division becomes.

The standard’s two-year rule, which prohibits a former employee from auditing any work that was performed at their former employer while the auditor was previously employed there, is likely to become an insurmountable challenge.

A more realistic option would be to sell the SMSF audit division into a larger SMSF audit firm, but, unfortunately, the timing for doing that is not great either.

Timing poor for SMSF audit arm sell-off

Firms that have looked at selling their audit division have reported great difficulty in doing so, especially as it is essentially a forced sale. Feedback from those firms that have tried this is that simply getting a valuation equal to a single year’s revenue is challenging.

When you consider specialist SMSF audit firms are expecting huge growth from accounting firms being forced to outsource the audit of perhaps 200,000 to 300,000 SMSFs across the country, it is easy to see why specialist audit firms are unlikely to be motivated to buy in-house audit businesses now.

On the other hand, it seems the valuations of established, independent audit businesses will in all probability have increased significantly given the extraordinary growth they are expecting in coming months.

Outsourcing is possibly best option

The obvious option is for a firm to wind up their SMSF audit business and simply outsource the audit of the SMSFs they administer to a specialist auditor.

This option can meet some important goals for the business. Firstly, the firm is likely to retain the revenue, albeit at a different level of margin.

The revenue is kept because it is common practice for the accounting firm to bill the SMSF for the audit, either as a discrete service or as part of an administration package, rather than the fund paying the auditor directly – nothing in the new standard prohibits this practice continuing.

Secondly, this approach also allows the accounting practice to mark up the price of the audit and recoup the expense of engaging and managing the audit relationship and doing the extensive preparation work that is required to streamline and minimise the cost of getting an external audit done.

In the survey of MyWorkpapers users from September 2020 there was a difference of 32 per cent between the average fee a fund paid for an audit ($706) and what was paid to the outsourced auditor ($536).

It also seems likely firms could justify an audit fee increase by explaining to the trustees that the amended standard has forced them to outsource the work and incur the additional costs of doing so.

In summary, outsourcing to a specialist auditor is the most straightforward solution while still offering the firm an opportunity to retain revenues, recover costs and make at least some margin.

Outsourcing best option for subscale audit divisions

Outsourcing is probably the best option for firms that are not really committed to auditing as a service line. Certainly, for a practice performing less than 50 audits a year outsourcing is probably their only real option – other firms are generally reluctant to outsource their audits to someone who only does a handful of audits, so sub-scale firms are not good candidates for the exchange services we are about to discuss.

Firms don’t want to give the audit away

Firms that have built a great SMSF audit team are, understandably, reluctant to downsize and most business owners would agree writing off a hard-won book of business should only be a last resort.

The independence standard means outsourcing itself is inevitable; you simply cannot audit your own funds. But what if your business could get something back for outsourcing work to another firm? Doing this is the objective of an audit exchange program, and doing it in a compliant manner is the challenge.

Chaining, pooling and other ways to exchange audits

Under the independence standard, reciprocal audit arrangements are not allowed; directly swapping audits with another firm does not deliver independence.

Some auditors have discussed the possibility of creating a chain of firms or creating pools of audits to avoid the direct swapping of audits between firms.

There are various models to consider when looking at doing this, but some of the simpler ones present both independence and operational challenges.

Chaining

If you have three or more firms, you can chain them together to avoid direct swaps. In this model, Firm A does audits for Firm B, which does Audits for Firm C, which then does audits for Firm A.

Unfortunately, this model is unlikely to meet independence requirements for a number of reasons:

• Networks are not allowed – the arrangement may be viewed as a network. The definition of a network is very broad in the standard: “a larger structure that is aimed at cooperation” and “is clearly aimed at profit”, is sufficient to meet the definition of a network, and ‘in-network’ audits are not allowed.

• Familiarity risk – if the parties all know each other, and particularly if they are from the same geographic area, then there is a familiarity risk to independence, which is highlighted in scenario 10 of the guide.

• Fee dependency – if the auditors are not generating enough other revenue outside of the audits gained via this chain, then they may be viewed as fee dependent on the arrangement. Under the standard, one referrer providing a large portion of an auditor’s work is seen as a self-interest and intimidation threat to independence. Operationally, this model is limited in that:

• Size matters – ideally each firm should be the same size and if they are not, then the exchange size is limited by the smallest party. For example, if firm C is half the size of firm A, then firm A will get back only half the audits they were expecting.

• Weakest link – if one party decides to not participate, then the whole chain may collapse.

Pools

Another approach firms have explored is pooling arrangements. A pooling arrangement is where a group of accounting firms, having previously relied on Chinese wall arrangements to meet auditor independence requirements, place their SMSF audit clients into a pool to have them redistributed among the members of the group.

Pooling can address both of the operational challenges that chaining has around size and dropouts, provided there are enough participants in the pool.

Pools can also address the fee dependence issue as long as there are enough firms to meet the requirements. The approach here is to allocate funds from enough other firms that the percentage of work coming from any one referrer is below the required threshold.

Pools may still have the familiarity risks and network problem that chains have, but before we look at those issues, let’s look at an operational challenge that is unique to pools.

Random audit pools are not practical

A simplistic model for pooling might work by randomly allocating audits to a wide range of participating auditors each year (while avoiding reciprocal swaps, of course).

This approach would be inefficient and costly because:

a. an administrator does not want to deal with too many separate audit firms that may all have different processes, and

b. an auditor does not want to audit new SMSFs every year. Auditors typically perform a number of tasks when they first audit a fund and these go into a permanent file that is referred to in subsequent years and may only be revisited periodically thereafter. For example, once a trust deed has been reviewed, unless it changes, legislation changes or there is some other reason to review it, an auditor does not need to do so in each following year.

Matching and introductions versus audit pooling

Rather than a random pool, at the individual audit level:

a. an administrator would like to have as small a number of auditors to work with as possible (there is some debate in the industry about the benefit of panels and of being able to spread work across multiple firms, so the ideal number may not be one), and

b. an auditor, once assigned to a particular fund, would generally like to maintain that relationship in future years. Instead of pooling individual audits, a more practical and efficient model is one where firms wishing to exchange audits are matched and introduced to other firms while meeting the above criteria.

Familiarity risk and co-ops versus independent operators

The familiarity risk can be a factor in chains or pools using cooperative arrangements to exchange funds between firms. This risk can be eliminated by ensuring that rather than being run as a cooperative of firms that all know each other, the program should be run by someone independent of the participants.

Additionally, the participants in the program should only know the other parties they directly interact with and ideally the parties should not be from a single region to ensure they are less likely to have other commercial or community relationships.

Networks and ongoing programs

Whether a program is pooling audits individually or matching them at the firm level, there is still a risk of failing the independence standard if the arrangement is seen as being a network.

The network constraint is a significant problem for any program that has centralised and ongoing control.

Additionally, if an operator in one these ongoing models controls who gets what business over coming years, then they become the effective referrer of that work.

As noted above, a large referrer represents a self-interest and intimidation threat to the independence of the program participants. For example, an auditor may fear being expelled from the network if they did not toe the line when pressured to do so by a pool operator.

There may be ways to overcome these concerns and satisfy the regulators that an ongoing program does not compromise independence, but more straightforwardly, if there is no ongoing central operation at all, then there is no threat to independence.

The ongoing network can be eliminated by having the exchange program operator match and introduce firms based on what they contribute to a pool, but once introductions are made, the exchange operator plays no part in the contract the parties sign and has no further involvement in the future of that relationship.

Essentially, the exchange operator acts like an external sales agent, introducing parties but having no ongoing account management role.

The critical aspects of a compliant exchange program are:

• It should be run by an independent operator to avoid familiarity risk,

• It must not create an ongoing network – the arrangements, once established, must be truly independent of one another,

• The parties must not be dependent on one another for any other reasons, such as having community or other commercial links, the level of referrals received from one source should be taken into consideration to avoid fee dependence, and practical matching and allocation are required – random allocation of audits should be avoided.

Is exchanging audits in the spirit of the standard?

The stated goal of the standard is to address threats to independence in relation to audit, review and assurance engagements. Further, it makes clear the goal is to deliver actual and perceived’ independence.

If an exchange program delivers clearly independent relationships and addresses all the risks and threats outlined in the standard, then it should be compliant in both the letter and the spirit of the standard.

What about regulators?

MyWorkpapers is the operator of an exchange program that follows the principles discussed in this article. In that role, MyWorkpapers is committed to ensuring compliance with all aspects of the independence standard.

In addition to seeking professional advice around compliance, MyWorkpapers also asked the ATO to review what it was planning to do. Without implying, in any way, that the ATO has any position on the detail of what MyWorkpapers is doing, the regulator was kind enough to review and provide feedback on the plans.

The result was the regulator had no substantial objection to exchange programs that meet the principles that we have outlined.

The industry needs something like this

Firms currently doing in-house audits have few viable options available to them to retain their SMSF audit business. The loss of this business, in the current pandemicaffected economy, could be devastating to those firms.

If, as estimated, upward of half of all SMSFs need to change auditor this year, then virtually all specialist auditors would, on average, need to double in size to meet demand. Understandably, there is grave concern in the industry about whether all current specialist auditors can grow that quickly.

Is it practical to assume the auditors displaced from in-house audits will find a place with specialist auditors and if not, where will the required staff come from? If demand outstrips supply, what does that mean for the price of independent SMSF audits?

Audit exchanges offer a compliant way to lessen the business loss across many accounting practices, to act as a catalyst to restructure the industry around independence and to reduce the incredible demand that is expected to be placed on specialist auditors picking up displaced audits.

Conclusion

Outsourcing your SMSF audits in exchange for audit work from other firms in a similar situation can, with care, be done in a compliant manner.

Accounting firms and the industry need a solution like this to have a hope of dealing, cost effectively, with the impact of the new independence standard in the time frame required.