Business secretary Kwasi Kwarteng recently let the UK know that the government would reform its audit regime after numerous occasions of company audit failings came to light. He claims that it is clear the UK’s audit regime needs to be modernised with a package of “sensible, proportionate reforms”. He went on to suggest that by restoring trust in the corporate governance regime and encouraging “greater transparency”, it will provide investors with “clarity and certainty” whilst protecting jobs across the country.
The reform was split into three sections, focusing on improving the audit market, reinforcing investor and public confidence, and increasing director accountability. As part of the changes, companies would be required to use small “challenger” firms to conduct a large portion of their annual audit to increase competition. Additionally, the ‘Big Four’ will also face a cap on market share, and a new regulator, the Audit, Reporting and Governance Authority (ARGA) which is currently being established to replace the Financial Reporting Council (FRC).
Furthermore, to regain confidence in business, new reporting obligations will be introduced. Audits will be able to extend beyond financial results, and ARGA will be backed by new legislation. Finally, directors of large businesses could be held accountable for “serious failings”, with a focus on increased transparency also targeted.
Lord Callanan, minister for corporate responsibility, says that audit failure isn’t an abstract problem, it has “real life” consequences. “Auditors and rogue directors who have been asleep at the wheel must be held accountable. As part of our plans, we will look to ensure the new regulator is fully equipped to take action where serious lapses have occurred”, he concludes.
Impact of the reform on mid-tier accounting firms
Julie Matheson, accounting advisory partner for Kingsley Napley, recently released a report detailing the impact the reform would have on mid-tier accounting firms.
In her report, she estimates 97% of audits of FTSE 350 companies are carried out by the Big Four firms. Matheson suggests that there are a couple of principal proposals which will affect mid-tier firms, one of them being the extension of the Public Interest Entities (PIE) market; and the managed shared audit requirement.
Under the proposals, large private companies, AIM listed companies and possibly also third sector organisations may fall under the PIE umbrella, she says. This could lead to up to 120 accounting firms auditing PIEs and, as a consequence, falling within the regulatory requirements of the future ARGA. Matheson warns that if mid-tier and smaller firms choose to remain in the PIE market, they could be subject to an “additional level of scrutiny”.
However, she says that under the managed shared audit proposals, mid-tier firms may have the opportunity to build upon their skills and experience by becoming involved in the audit of FTSE 350 companies, which are currently dominated by the Big Four.
The Department for Business, Energy and Industrial Strategy (BEIS) expresses that the larger audit firm should include a smaller firm to carry out a small part of the audit, for example to audit a subsidiary company. Whilst the aim of this is good, Matheson claims that some mid-tier firms may “shy away” to avoid the increased “scrutiny” involved in the audits of high profile companies.
Steve Gale, head of audit at Crowe UK, argues another challenge mid-tier firms may face is that they will need to commit “time, energy and money” into ensuring that they have the necessary resources and infrastructure that will support that.
He adds that one of the greatest barriers for the challenger firms to date has been the “unwillingness” of PIE audit committees to make appointments from outside the Big Four firms. He suggests there are a number of reasons for that including misconceptions around the “experience, expertise and resources” within the challenger firms. He also explains that there is also a lack of knowledge in some quarters of the audit firms outside of the Big Four.
Robert Holland, an audit expert at Kreston International, argues that bigger companies will always tend to “play it safe” and default to using the Big Four, which means that there aren’t enough players in the field, yet the reform could create more opportunities for mid-tier firms to breach the market.
Commenting on the reform, Simon Hayden, a partner at Perrys Chartered Accountant, believes that “these reforms alone won’t create a level playing field”. However he says anything which “dilutes the dominance” of the Big Four and provides opportunities for other auditing firms should be welcomed. Potentially these changes will be of most benefit to mid-sized audit firms. However, if they get a “foothold in the audit” of FTSE companies it may open the door for smaller firms further down the food chain, he concludes.
How accounting firms can get around the challenges of the reform
Holland suggests that some of the challenges inflicted by the reform on mid-tier accounting firms will be aided through the creation of the new regulatory body ARGA. The new regulator could help set out better auditing standards and provide positive input into the global standard setting process. Matheson agrees with Holland’s view and suggests that ARGA will allow other firms to “step up” and carry out the FTSE 350 audits whilst “levelling the playing field”.
She says, one of the main purposes of the reforms was to ensure that there is greater competition in the PIE market. To that end, firms will need to be reassured that any initial mistakes in the up-skilling phase will not necessarily lead to “significant enforcement action” against them, she continues. A positive and constructive use of a firm’s relationship with ARGA would be a useful first step, along with an undertaking to continue with the focus on constructive engagement with firms, when breaches of the audit standards are found, instead of the presumption being that enforcement action will follow, Matheson adds.
Gale concludes that the audit reform could present opportunities for mid-tier accounting firms and management of larger listed businesses by helping them gain exposure to the capabilities of challenger audit firms whilst still being able to retain the larger audit firm as the principal group auditor. He says that challenger firms, meanwhile, would gain expertise and experience they are thought to lack and all the while growing their presence and reputation within the market.