Is the number up for audit?

Financial reporting is one of the toughest of conundrums for accountants. The problem is that there are two types of financial reporting. There is a neat statutory reporting of financial facts and figures, and there is the need of investors to understand the more tangible factors by which a company can be measured.

There is a huge difference between what a company appears to be worth on the stock market and what it appears to be worth in an annual report and accounts.

Accountants produce annual statutory figures because that is what the law demands. However, within the legal framework we must try and make the figures useful. More robust and transparent reporting of intangibles for example – something of significance in the pharmaceutical industry where millions of pounds of investment in new drugs is hardly reflected in traditional figures. Bridging the gap between balance sheet net assets and stock market value would be an extremely useful expansion of information to shareholders.

It cannot be correct for companies as diverse as property companies, e-commerce start-ups and advertising agencies to use the same financial reporting models. Auditors advocate a full and fair value to be used. This narrow view of financial figures is not just relevant on the basis of valuations, but equally of importance when a corporate collapse occurs.

When investors search for value in a company they look at the detailed non-financial information; where the quality is highly variable and comparability low. Auditors need more guidance to help them report on accounts which will help bridge the gap between market value and book value.

All of this adds to the audit debate of life after BHS, Carillion and Patisserie Valerie, and whether there is light at the end of the tunnel. Auditors acknowledge this is a watershed moment and embrace the need for change. Effective measures are required which will improve quality and increased choice in the market, which ensures that audit meets the future needs of the British economy and wider society.

The accounting and audit profession has worked its way through a number of crises of trust, from Maxwell to Enron to banking, and now face a new round of corporate failures. The issues have mainly revolved around the process of validation of companies’ financial rigour and future performance.

Time for intervention and reinvention

Many organisations and stakeholders hold some blame for what has happened to the sector leading to 2008 and beyond. Investors, regulators, politicians, and bankers share some fault, not simply companies and accountants. They must all have a contribution to make for fixing this sector.

The reinvention of accounting and auditing must be based on one key objective: accounts should reflect the real performance of the business, and audits robustly validate the company’s stated position.

We know that accounts do not always reflect a true and fair view of the company, and are often prepared to ensure that they maintain technical adherence to accounting standards, rather than to ensure that they reflect the underlying business performance.

Certainly at the top end of the market, audit firms need to develop far greater transparency around their activities and be able to explain how remuneration is not only driven by profit per partner, but also by the quality of the audits they deliver. There are teams of auditors that are capable technically, but do they really understand the business or sector.

Digitisation of audit is an area that has seen many public declarations by the biggest firms announcing that new analytics and forensic tools further driven by AI will ‘improve’ audit’s rigour. But there is concern that this direction will further dislocate audit teams from understanding clients’ governance and culture – keeping them away from the coalface. Digitisation may see firms drive for efficiency; namely fewer audit staff and as a consequence shrink the pool of top talent.

Share and share alike?

Joint/shared audits might reduce the monopolistic position held by the global audit practices. However joint audits will result in joint responsibility on audit opinions and joint liability for the larger and smaller practices. There is considerable risk for the smaller firm, and for many this will be too big a leap.

And where is the mass, the alternative audit firms below the top six? There are currently 36 firms undertaking audit for public interest entities in the UK according to the Financial Reporting Council’s (FRC) 2018 report Key Facts and Trends in the Accountancy Profession. However, 14 of these firms have only one PIE client, while a further 13 have less than ten. Below the top six firms there are a handful of next-tier practices with PIE clients in double figures.

Shared audits, with one main auditor and the smaller firm giving an opinion on specific aspects of the file, is a potential option. This would give the smaller firm experience on dealing with listed clients, without exposing it to excessive liability.

However, the statistics above show there are few to choose from, and potential audit market growth would require some smaller firms to really up their game – likely changing their strategic and operational models.

There would be serious ethical and financial risks in handling bigger clients, requiring them to also remould their governance and due diligence. We have recently seen major auditors start to veer away from audit clients in volatile or problematic sectors. Why would smaller firms want to take on any of that risk?

We have seen in recent months that the biggest audit firms are reviewing audit client lists over concerns about conflict and reputational risk. Grant Thornton is stepping down from the Sports Direct audit, citing disclosure of a potentially huge tax liability. Other major firms said they were conflicted from taking the audit on, while PwC was reluctant to engage based on its ownership structure.

On a wider scale, swathes of ‘un-auditable’ PIEs will destabilise the financial markets, and could subvert audit reform.

Tough at the top, squeezed at the bottom

So, if there are difficulties in broadening the base of firms that can deal with bigger clients, what is going on at the other end of the market? Well, the latest information is not encouraging.

A key issue for mid-size and smaller practices is the audit exemption threshold, which has impacted the number of firms holding an audit registration. Even where exempt clients still require an assurance review, pricing pressure impacts all levels of the market. And this pricing issue will be exacerbated if proposed regulatory changes stop firms from being able to offer value-added support to audit clients.

The number of firms available to undertake audit has also been driven down by ongoing practice consolidation.

Thirdly, and with major reviews of audit commonplace, the bar for technical stringency may have to be raised – how will this hit the smaller end of the market? Any changes to auditing standards are likely to demand a significant increase in the requirements of all audits. Standards should be scalable, as flagged by the ACCA in its ‘Thinking Small First’ report into better auditing standards for less complex entities.

Where will it end for the audit process? Hopefully better quality of reporting and greater choice for the audit client. But we will get what we deserve.
Phil Shohet is a senior consultant at Foulger Underwood

Auditing numbers

The current audit exemption threshold means no statutory audit is needed where two of the three must be met for exemption: Turnover of not more than £10.2m; a balance sheet total of not more than £5.1m; and/or not more than 50 employees.

The impact of regular threshold rises has been stark. The number of registered audit firms continues to fall. The Key Facts report shows 1,179 ACCA audit firms at the start of 2018, down 140 on the previous year. ICAEW-registered audit firms fell to 2,948 from 3,121 (11.9%) in the same period. In 2008 there were 2,697 and 4,526 (5.6%) respectively.