Against a volatile geopolitical and economic backdrop, 2023 is shaping up to be another critical year for the audit industry. Following three years of pandemic-induced restrictions and disruptions to “traditional” working patterns and practices, a renewed push for audit reform and elevated fraud risk will be key themes for audit professionals over the coming 12 months.
Uncertainty remains a key concern
Ongoing economic uncertainty, driven by inflationary pressure and continuing geopolitical conflicts, continues to put pressure on companies’ financial stability. In a recent statement regarding its supervisory focus for the year ahead, the Financial Reporting Council (FRC) said: “Given the difficult economic conditions that are currently being experienced, we recognise that many companies, in many different sectors, are currently under particular commercial and financial pressure.”
Significant increases in interest rates and a slowing economy – compounded by the cost-of-living crisis – have led to growing fears that this year will see a wave of corporate failures. Latest figures from the government reveal that there were 1,964 registered company insolvencies in England and Wales in December 2022, some 32% higher than the same month in 2021, and 76% higher than the number registered three years previously.
In turn, the FRC explained that it plans to “be especially careful over the coming year in monitoring where these pressures are being felt most acutely, and tailor [its] selection of company reports for review and audits for inspection accordingly.” The regulator has already highlighted several sectors it deems to be high risk in the year to come – including the travel, hospitality, leisure, retail, construction and industrial transportation industries.
The ongoing war in Ukraine, meanwhile, remains a major concern and continuing source of political volatility, sanctions and capital market constraints, as well as supply chain issues – all of which could impact revenues, working capital and companies’ access to funding.
Combined, these factors will create additional pressure on already strained management teams looking to meet their debt covenants – a breach of which could trigger material adverse change clauses and result in the loans becoming repayable on demand.
Within this context, auditors should carefully consider companies’ financial stability, whether any loans are set to reach maturity over the next 12 months and whether they need to (re)finance during this period. Crucially, they should also be prepared to see a potential rise in claims as stakeholders look for someone to criticise and blame.
Audit progress despite continued delays
On the regulatory front, preparations for the FRC’s much anticipated transition to the Audit Regulation and Governance Authority (ARGA) will continue into 2023, with the switch now expected to take place in April 2024 – significantly later than originally planned.
The FRC has been criticised in recent years with ARGA hoping to tackle these concerns head on. The transition will provide the regulator with greater enforcement power and a better ability to tackle audit reform and reduce the concentrated power of the Big Four. To meet these new objectives, the organisation is also expected to progressively increase its headcount – with staff levels growing from the current forecasted number of 486 in March 2023, to 533 in March 2024.
In the meantime, the FRC is continuing to push ahead with the changes it can implement with the powers it currently has. Revisions to International Standard on Auditing (ISA) 600[i] introduce a risk-based approach to the audit of groups, with increased focus on identifying and assessing the risks of material misstatement.
These changes have been made to ensure the standard remains fit-for-purpose, especially given changing work environments resulting from the pandemic and group auditors’ inability to travel to the component teams. In turn, ISA 600 imposes enhanced responsibilities for direction, supervision and review of the work of component auditors.
Effective for audits for periods beginning on or after 15 December 2023, this marks the third major revision to ISA guidance in three years, following revisions to ISA 315[ii], which deals with identifying risks of material misstatements, in December 2021 and ISA 220[iii], which deals with quality control, in December 2022. The revisions to ISA 315 were implemented to enhance risk assessments and ensure they obtained a detailed understanding of a company’s IT environment and internal controls commensurate to its size and nature. ISA 220 revisions were aimed at strengthening quality management by the whole audit team and emphasising the importance of professional scepticism and auditors’ judgement.
Staying vigilant
Reviewing these auditing standards at regular intervals provides a valuable opportunity for the industry to reflect on past experiences, address situations that were not envisaged when the standards were drafted and adapt guidance for the future.
As work practices evolved to adapt to the pandemic and today’s hybrid working environment, management teams may have taken advantage of this time to override controls, manipulate financial statements, and to conceal or misrepresent information about their financial performance.
Together with an ever-evolving economic and regulatory environment, audit professionals must remain vigilant to the risk of fraudulent financial reporting. Audit firms should be taking a proactive approach in their communication with clients and regulators to spot and address any such inconsistencies or errors in reporting. In what is set to be another challenging year for the industry, auditors must remain on high alert for any threats to the financial reporting ecosystem.