There are many theories about the purpose of regulation. They include the need to promote competition in markets that fail to operate competitively, and the need to improve quality where a small number of firms control a market.
The concentration of larger listed company audits in the hands of a very small number of large audit firms is an example of the latter. The well-publicised UK audit reform agenda is an attempt to improve competition and choice in the audit market, as well as audit quality.
While progress has been made on audit reform, it has been slow. A draft revised UK Corporate Governance Code has been exposed for comment (read ICAEW’s response), and secondary legislation on a number of reporting issues has recently been laid before parliament.
However, primary legislation is required to establish the Audit, Reporting and Governance Authority (ARGA) as a replacement for the Financial Reporting Council (FRC), as does a requirement for “managed shared audit”. Unfortunately, it now seems unlikely that this legislation will move forward before the next general election.
When regulation and markets collide
The pandemic and a lack of parliamentary time have contributed to this slow progress, but a new problem has arisen that was not foreseen when the Brydon and Kingman reviews were completed, nor when the Department for Trade and Industry report on competition in the audit market was published.
UK audit reform proposals are intended to increase the number of audit firms outside the Big Four auditing larger listed companies. The proposals assume that so-called challenger firms outside the Big Four are, or will in time with appropriate support, be able and willing to conduct or participate in such audits.
ICAEW’s engagement with firms as the audit reform proposals developed suggests that this might not be the case. This calls into question the likely effectiveness of many of the current proposals.
The pandemic gave rise to on-going shortages of staff in many sectors, the accountancy profession being no exception. Staff shortages at the newly qualified level are not new, but they have coincided with an abundance of work available to audit firms, significantly increased regulatory demands, highly publicised regulatory sanctions, and increased segmentation and specialisation in the markets for audit and accountancy.
This unprecedented combination of circumstances has contributed to a shortage of audit firms willing to perform riskier and more complex audits. It also constitutes a significant disincentive to smaller firms considering whether to enter or stay in the public interest entity (PIE) audit market more widely.
These issues are not unique to the UK. In the Netherlands, firms recently withdrawing from the PIE market, partly because of regulatory pressures, have left some listed entities unable to appoint an auditor. This has not yet happened in the UK, but audit fees have risen considerably.
Realities of the audit marketplace
In late 2022, the FRC acknowledged these issues. It is now making welcome efforts to help and encourage firms not already in the PIE audit market to do so. The FRC has also commented on larger firms de-risking their audit portfolios and dropping more challenging audits, suggesting that audit firms need to demonstrate how they fulfil their public interest duties.
In this difficult environment, suggestions have been made to the effect that the regulatory approach, and the reputational risk associated with large complex audits, is contributing to the lack of choice in the audit market.
A Financial Times comment piece in February (“Audit watchdog risks strengthening Big Four’s grip”), asked whether regulators should consider whether their principal focus is sufficiently on systemically risky businesses.
There is a world of difference between a FTSE 350 entity and a small PIE which has listed debt only, and preserving competitiveness in the UK’s capital markets requires proportionality in regulation. It seems unlikely that any firm, of any size, will be persuaded to take on any work that it perceives to be damaging to its economic self-interest.
Some firms are open about their position. BDO in its 2022 Transparency Report confirmed that it was increasingly discerning about which entities it pitched for.
The report states: “Most importantly, we seek to audit entities whose leadership teams strive for effective systems and controls, value the true purpose of an audit and welcome robust challenge from our audit teams. In addition, we only accept requests to tender when we know we have teams with the requisite capability and capacity to deliver.”
BDO also confirmed that it had declined the opportunity to tender for approximately £115m worth of audit fees in its 2022 financial year. During the same period, it resigned from a further 550 audits, equivalent to £28m in fees.
Its report continues: “Our new tender approval platform - established to control the volume and shape of our portfolio growth - assesses factors such as strategic fit, risk profile and economic return to ensure audit quality is not compromised.”
ICAEW reaches out
Calls for the Audit and Assurance Faculty to investigate these issues were made as the UK emerged from the pandemic in 2022. Faculty staff were asked by its Board to reach out to the senior management teams of Top 30 firms below the Big Four.
In total, 18 of those firms responded to our request for an interview, some of them challenger firms, some of them not. The confidential interviews aimed to determine whether what we had been told anecdotally represented more widely held views.
We found that many firms are in the unprecedented position of being offered more work than their resources enable them to perform. Firms of all sizes are also de-risking their portfolios and jettisoning what they perceive to be higher risk and less profitable work, including audit work, to reduce regulatory and reputational risk.
It was also clear that challenger firms take their public interest responsibilities very seriously indeed. The firms we spoke to emphasise the need for competence and independence when taking on any audit. The suggestion that bigger audits are, by definition, better quality than smaller audits was strongly refuted by firms we interviewed, who noted the role of auditors in the large corporate collapses of recent years.
Some challenger firms said they were able and willing to deliver high-quality audit PIE work and engage constructively with the regulator on a journey to facilitate greater access to the market for larger listed company audits. Others told us that they were equally able and willing to perform high-quality audits, but for commercial reasons would not be undertaking PIE audits.
The regulatory burden on smaller market entrants will be crucial in determining the long-term success of measures introduced to increase competition, choice and resilience in the audit market.
While the FRC rightly continues to challenge the profession to raise standards, a balance needs to be struck to ensure that disproportionate regulation does not stifle competition by discouraging smaller firms from stepping up. More challenger firms may retreat from the PIE market if the regulatory approach does not take account of the size, structure and PIE-audit revenue of the firm, or their risk exposure.
Audit and Assurance Faculty staff recently met with FRC and Department of Business and Trade staff to discuss the detailed findings of the 18 interviews and continue to closely monitor market and regulatory developments as UK audit reform inches forward.
We welcome observations on this complex issue, which should be emailed to firstname.lastname@example.org.
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