Accounting threshold shifts risk lasting damage to audit profession

Earlier this month, on 6 April, a new EC directive quietly slipped into force.
The less than snappily titled Companies, Partnership and Groups (Accounts and Reports) Regulations 2015 – the UK’s implementation of the EU Accounting Directive – passed onto the statute books with barely a whisper.

But despite its low key entry, it’s set to cause significant disruption for firms and practices that undertake audit. Under the directive, already voted through the European Parliament in 2013, member states had the option to significantly raise the thresholds of businesses not required to file full, audited financial statements for those with a turnover below €12m (£10.3m) and a balance sheet below €6m.

BIS, after consulting on the proposed new regime for small companies in 2014, has now ratified the raised accounting threshold to its maximum amount, while limiting the information that can be required in small company accounts.

Lynton Stock, of Shelley Stock Hutter, the central London practice he co-founded in 1989, is convinced it will send seismic ripples through the wider profession. “I think this will have a significant effect on the audit community, certainly for those firms that are registered to do audits, because there will be polarisation,” he says.

“Smaller firms will have to decide very seriously whether they retain their licences if they’re only auditing one, two or three companies because the regulation required to be a licenced firm, and the resources required to do so are so onerous.”

He stresses that while there will “clearly be losers” within the profession, firms will have to come up with additional added value services such as outsourcing, cash-flow management and management accounting to make up for the loss of audit-derived revenue.

Less audit work could also lead to a cull of audit partners, albeit in the guise encouraging them to take early retirement. “When there’s less of a market you do tend to get rid of people who specialise, because you just don’t need them anymore,” Stock explains.

Cruel irony
Ironically, what’s most interesting about the threshold changes, according to Stock, is that while the regulations surrounding audit “have become more onerous”, the number of companies requiring one is less.

“The dichotomy is can you really be bothered to carry on with the resource, coupled with the fact that if you stay in the game, the likelihood is that the regulatory bodies will require a much higher standard than has ever been the case,” he explains. “Inevitably, the smaller firms will probably fall out of the game, and the bar will be raised considerably.”

Stock suggests that the Big Four will probably escape any major impact from the changes because the bulk of their audit clients will fall above the threshold, but firms below them – in the Top 50+50 will suffer.

“The number of firms that continue to be registered as auditors will reduce substantially. Maybe that’s what they want.”

Such sentiment is borne out by recent data from the FRC’s most recent Key Facts and Trends report, which reveals that the number of registered audit firms “continues to decline”, “albeit at a slower rate than previously”.

As at 31 December 2013, the number of registered audit firms was 6,962, a double digit fall of 11.2 % over the previous five years. Given that the new legislation is only a few weeks old, that historical trend of terminal decline looks set to accelerate.

Accountancy Age’s own Practitioner, is so unenamoured with the state of the audit sphere that his firm is considering relinquishing its audit status.

“We have told the institute of our intention and are waiting to hear back from them. “We only have a handful of audit clients remaining, and given the strict CPD requirements imposed on us, in just seems like the right thing to do,” he tells Accountancy Age.

“I’m convinced the firm isn’t making a mistake with this, and I certainly won’t shed a tear when we make the final decision.”

He says the firm’s audit work has almost dried up over the past five years. “Firms just don’t volunteer to have an audit, really. It’s a rare thing for us.”

The final nail in the coffin for the audit practice was when the team realised that to meet all the onerous criteria for its one remaining audit client who had an overseas asset, they would have to travel abroad to verify it. “It simply wasn’t worth it. What with all the CPD we have to do, the cost of the audit was greater than fee.”

Glenn Collins, head of technical advisory at ACCA, adds that audit will continue to become more specialised as time goes on. “Firms who have certificates may continue with them for a while, but will not undertake audits. Certificates will certainly be retained by those firms working in the specialist reporting areas which can still be very lucrative,” he says.

“Audit costs will continue to rise and choice will diminish. Those taking the biggest hit from this will be sectors like charity and other not-for-profits, which work to a much lower audit limit.”

At the upper end of the profession, the new competition and audit reporting rules imposed by regulators and politicians in the UK and Europe has actually helped to stabilise fees. But for those lower down the pecking order, the seemingly relentless shift ever upwards will only toughen the bleak business arena in which they now find themselves.

The latest Top 50+50 figures reveal that audit fees for the top 50 firms – based on 39 submissions – increased to £3.65bn from £3.47bn in 2013, and £3.38bn in 2012. The Big Four firms of PwC, Deloitte, KPMG and EY improved fee income by 4.9% to £2.7bn, while the top six firms including BDO and Grant Thornton posted a 5.9% rise to £2.97bn.

But the biggest players are now used to working in an environment of increased tendering, thanks to EU diktats that large-listed companies must rotate the firms that scrutinise their accounts on a regular basis – and one that requires enhanced reporting by auditors and audit committees.

The end is nigh
It is at the smaller end of the profession that Fiona Hotston-Moore, tax and business advisory partner and forensic accountant at Ensors, believes will “simply stop doing audits”.

Small practices will instead, she says, nurture favoured relationships with larger practices who will do the audits on those clients that need it. The former Mazars partner stresses that while the ongoing fallout of the threshold changes may not be quite as dramatic as seeing the four horsemen of the Apocalypse cantering across the audit horizon with demonic intent, the effect will, while not biblical, be significant.

She says a lot of practices are quiet bullish about the impact, believing that clients no longer requiring – or wanting – an audit will buy additional added value professional services, but she’s less convinced that such optimism is well placed.

“In my experience when clients realise that they don’t need an audit anymore, they probably immediately expect a reduction in fees,” she says.

At the same time, compliance work is increasingly being devalued because clients can do the work – they can produce a set of accounts, do the tax computation and file a lot of the basic work online themselves.

“You have the audits falling away and compliance work has been reduced. It will impact on the profitability of small regulated practices, meaning they’ll have to focus on consultancy-type work,” she explains.

Unfortunately auditors and audit skills don’t always translate particularly well into consultancy type work.

“It’s better to take auditors fairly soon after they qualify because after a period of time they’re ability to look outside the box and do project work diminishes. Audit is very formulaic,” Hotston-Moore says.

Another potential fall-out from the legislation is on recruitment.

“If you’re not a licensed auditor how attractive is the firm going to be in attracting good staff?”, posits Stock.

Hotston-Moore says it “will clearly change the landscape of the people who are training, because more staff will be training in firms that aren’t doing audit so they’ll be trained as pure accountants with another section training solely as auditors”.

And while there are plenty of trainees with “some” audit experience, smaller firms are unlikely to do audits going forward. People training in those firms will not get that audit experience. Another consequence, says Hotston-Moore, is the “danger that the quality of information that goes on public record will be diminished”.

“We see that already, unfortunately, through our forensics work. Sometimes we’re being asked to help clients who have a problem and it’s solely due to the quality of information that’s being filed. We get clients who have an HMRC inspector of taxes investigation and you realise as soon as you look at the accounts, that they don’t balance.”

There’s also a risk to a company’s credit rating and ability to leverage and secure debt given that historically banks like to see audit reports.

“If they’re going through a sale, historically purchasers probably place some reliance on the fact that their accounts have been audited,” adds Hotston-Moore.

While BIS and the EU legislators were clearly aiming to slash the red tape that can so often afflict and strangulate entrepreneurial flair, they may have cut deeper than they could ever have imagined and set in train a series of events cripplingly damaging to the UK audit market.