Global regulation in Auditing

W

hat is being proposed:

Last month the Department of Business, Energy and Industrial Strategy (BEIS) set out a package of measures intended to improve the UK’s audit, corporate reporting and corporate governance systems. It is a wide-ranging consultation which builds on the work previously carried out by Sir John Kingman, Sir Donald Brydon and the Competition and Markets Authority addressing different aspects of corporate governance and audit reform.

One of the key aims of the consultation is to increase the choice and quality in the audit market, establish clear responsibilities for the detection and prevention of fraud and to ensure that the audit product and the audit profession are fit for the future.

To that end, the following key measures have been introduced in the consultation paper:

• Challenger audit firms will be required to conduct a meaningful portion of the audit for UK’s largest companies (managed shared audits)
• If audit competition does not improve a market cap may be placed for FTSE 350 audits by Big 4 firms
• An operational separation will be required between audit and non-audit arms of the same firm
• Establishing a new regulator looking at audit, corporate reporting and governance will replace the Financial Reporting Council.

Given that 97% of the FTSE 350 are audited by a Big 4 audit firm who also compete for often hugely more lucrative ‘other professional services’ with the same client, the introduction of these reforms will have a significant impact on how these firms conduct audit and non-audit business, which will have knock on impact on the choice, quality and availability of audit services in the market.

Whilst the initial response from the audit firms has been encouraging, some of the smaller firms (the ‘Challenger audit firms’) have expressed the view that the managed shared audit requirement falls some distance short of the CMA’s envisaged joint audit approach. In addition, the proposed time period (5-9 years) over which the progress of market capture by challenger firms would be monitored is potentially way too long and appears incremental in nature as opposed to transformative.

However, before some of the challenger firms can take on large and complex audits, they would need to invest in their audit capability to give confidence in their ability to audit some of the most complex business. Making such investment may not be financially feasible for firms of a certain size, which therefore could see less challenger firms entering the space that they are supposed to fill.

It is also possible that some of the challenger firms may not want to enter such a highly regulated space and increase the risk if not matched by the reward. On the reverse side, Big 4 firms may choose to leverage their large client base and focus on non-audit services rather than audit – this will depend on how the ‘separation’ actually plays out in reality, after all both the audit and non-audit firms will need revenue.

Separation of the audit and the non-audit arms of big 4 firms is aimed at addressing the perceived conflict of interest when auditing a client where the firm is either currently engaged to provide non audit services or has provided such services in the past. However, to achieve the intended results, there would need to be true separation between the two business activities and therefore the regulator should ensure that the separated businesses are not under the same management or one that could have influence over the decisions of the other.

There are other consequences to consider such as an audit/ non-audit separation cannot be achieved without impacting the availability of suitably qualified audit professionals who want to pursue a long term career in audit, as the demand for such professionals will likely increase as a result of the new proposals. Staff joining big 4 firms currently enjoy flexibility of having the choice of working on audit and non-audit engagements, which goes to provide a more well-rounded professional experience. However, such flexibility is unlikely to be available under the proposed approach and therefore could lead to some staff deciding not to join the audit arms of the business.

It is also anticipated that due to the operational separation of the audit and non-audit arms, overhead and other business costs will generally increase for the firms. In addition, increased regulatory focus would likely lead to increased cost of audit which may be passed onto the business.

Additionally the reluctance of some challenger firms to enter the complex audit space and some other firms wishing to focus on non-audit services could result in less choice for businesses, which is counter to the intended outcome of these proposal. The impact could become even more starker when, in due time, the elements of the operational separation requirement are also applied to challenger firms.

Right now business would be advised to take action themselves and focus on audit independence as a key risk to manage for both:

• the independence of the current audit firm; and also
• the independence of the ‘pool’ of future auditors (don’t taint the pool of possible future auditors with non-audit work now).

The proposals are wide and will change how things are done now. Audit firms need to consider how to separate in a manner that manages the actual separation and the perceived separation (the latter is likely to be more of a challenge).

Challenger audit firms need to start to evaluate the investment needed to be able to take on more complex and demanding audits and start to plan on how to position themselves for the future.

For truly independent advisory firms who do not audit (such as Theta Global Advisors LLP), this is a time to support businesses who need to manage independence risk.

Final point:
The consultation period on this paper ends on 8 July 2021, which will provide time and opportunity for all concerned to contribute their thoughts, which may have an impact on the final form of the rules, that are likely to be implemented in a phased manner. However, the achievement of the overall objective will depend on the view accounting firms take of the audit services as a long term business and also how the government enables a truly competitive audit market and enforces the spirit of the rules.