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How are Challenger Firms in the audit sector affected by the regulatory and market reforms?

Financial, Executive and Professional Risks (FINEX)
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By Paul Afteni and Jennifer Chan | July 15, 2020

The recent series of high-profile audit failures has put the spotlight firmly on the UK audit sector.

This content is based on an article originally published in the International Accountant on the 1st July 2020.

Prior to the Cornonavirus (Covid-19) pandemic, the series of high-profile audit failures which led to the collapse of companies such as BHS, Carillion and Thomas Cook put the spotlight firmly on the UK audit sector and prompted a number of industry-wide reviews and recommendations for wholesale reform. In this article, we 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, we 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 Review1 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).

Then came the final report from the Competition and Markets Authority (CMA) in April 20192 which proposed a range of measures to make the system more independent and to increase choice, competition and resilience within the audit market. The CMA also focused on addressing the barriers facing smaller so-called “Challenger Firms” from entering the FTSE 350 audit market. Taking into account 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 competition regulator put forward the idea of mandatory ‘joint audits’, involving Challenger Firms, to develop the capacity needed to review the UK’s biggest companies. The regulator also suggested the introduction of statutory regulatory powers to increase accountability of companies’ audit committees as regards their choice of auditor. Two 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 Brydon3, contained 64 recommendations on how to increase confidence in the audit sector and prevent unnecessary corporate 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
  • An obligation on auditors to inform, and the need for them to be suspicious as well as sceptical, thus endeavouring to identify corporate fraud
  • A clarification of the opinion given by auditors and greater granularity of information about estimates.

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 who have collectively 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 audit practices are positioning themselves to compete for mandates from top PLCs, with January 2020 bringing news that one such Challenger Firm, Mazars, has been selected by AIG to audit its UK operations – a move which marks the first time the global insurance group has looked beyond a Big Four accounting firm to vet its books.4

This may look like an opportunity with no downsides for Challenger Firms. However, when it comes to each firm’s own business risk it is important to consider whether the implications and possible new exposures that such opportunities will bring have been properly examined.

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. History has shown, with examples from Enron to Carillion, the impact of a poorly conducted audit. Furthermore, 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”.5 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, given events over the first half of 2020, 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 is to give them some comfort. 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 applying to PLC audit work.

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, 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 has been 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 audit firm supports the statutory auditor on certain aspects of the audit? or
  • 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 out6.

A further key consideration for Challenger Firms is how liability would be assessed within a joint audit relationship between more than one practice. Would this be as a formal joint venture and would a proportionate fee be charged? Depending on the arrangement, it could be considered that a participating Big Four firm would carry a greater share of the liability if they are doing more of the actual investigatory work. If this is the case, it is important for the Challenger Firm to secure the most appropriate terms of engagement with the client and any joint-venture partner, and ensure that they are only held liable and accountable to the level fitting to the work that they are undertaking.

Conclusion

In light of COVID-19, and the adverse impact that this has had on economies around the world, we understand that the industry reforms referred to above are likely to be delayed by the government. For instance, the BEIS select committee’s deadline for the call for evidence for their inquiry on Delivering Audit Reform has been delayed from 4 May 2020 to 31 July 2020.7

Nevertheless, in early July 2020 the FRC published a 22-point plan to bring about the operational separation of the audit units of the Big Four in addition to other commentators urging that reforms should not be slowed.8 Moreover, the FRC itself has also advocated that government act quickly to bring forward primary legislation to replace the organisation with the ARGA.9

Regardless of how the government decides to proceed in the medium term, firms considering entering the audit market-place (FTSE 350 or otherwise) need to consider the implications that this decision will have on their business overall. 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 un-insured business risk going forward.

Footnotes

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/767387/frc-independent-review-final-report.pdf

https://assets.publishing.service.gov.uk/media/5d03667d40f0b609ad3158c3/audit_final_report_02.pdf

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/852960/brydon-review-final-report.pdf

4 Kinder, T. and Pooler, M. (2020, January, 16) “Insurer AIG picks Mazars for UK audit”. Financial Times. Retrieved from: https://www.ft.com/content/d1dbfaf8-37ae-11ea-a6d3-9a26f8c3cba4

5 PRA Rulebook (Section relating to Auditors - Rule 3.1 (1)) )) http://www.prarulebook.co.uk/rulebook/Content/Chapter/211457/21-02-2020

6 “The Future of Audit” Nineteenth Report of Session 2017-19 House of Commons Business, Energy and Industrial Strategy Select Committee. (2019, April, 2). Retrieved from: https://publications.parliament.uk/pa/cm201719/cmselect/cmbeis/1718/1718.pdf

7 https://www.icaew.com/insights/viewpoints-on-the-news/2020/apr-2020/financial-reporting-and-audit-reform-delayed-not-forgotten

8 https://www.frc.org.uk/getattachment/281a7d7e-74fe-43f7-854a-e52158bc6ae2/Operational-separation-principles-published-July-2020.pdf; https://www.ft.com/content/4464e0a3-9ba2-47d2-9f85-3f2912a22f25 ;

9 https://www.accountancyage.com/2020/07/07/frc-urges-government-to-implement-audit-reform/

Authors

Head of Financial Services PI


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