Small firms threatened with licence reform

The prospect of introducing licenses for auditors won’t come as good news to
small accounting firms, but regulators may feel they’re left with little
alternative after a report found seven out of ten smaller audits are simply not
up to scratch.

The study, by the Financial Reporting Council’s Professional Oversight Board
(POB), held little good news for smaller accountants that audit listed
companies.

“A high proportion of audits reviewed at smaller firms continue to require
significant improvements… The more complex of the other audits reviewed, in
particular audits of multinational groups, required significant improvements in
most cases,” the board said.

POB’s chair, Dame Barbara Mills, went a step further: “Smaller firms should
take more care to ensure that they undertake audits of listed and major public
interest entities only if they have the level of resources and expertise
appropriate to the complexity of the audit concerned,” she said.

“Where our findings indicated that an audit required significant improvement,
act­ion taken by the relevant Audit Registration Committee has included placing
restrictions on the firm accepting further listed and AIM audit clients.”

Competing
issues

The report has revealed an idiosyncrasy of the UK audit market – when it
comes to competition, at the top end there’s a paucity, at the bottom there’s an
abundance.

Regulators now find themselves in the bizarre situation of encouraging
competition
at one end of the audit market, while trying to dampen it at the other.

Indeed, the POB has publicly called for “greater concentration” among smaller
firms and is concerned they may find it difficult to maintain high quality at a
reasonable cost.

They now want firms to build up a “critical mass” of audits before taking on
complex, listed companies.

License to audit

Licensing, or new “competency requirements”, are some options being
considered to lower the numbers of smaller audit firms. Statistics, however,
show audit firms numbers are already in decline, dropping from a 2004 high of
9,950 to 7,843 today.

Jonathan Russell, partner, of Oxfordshire-based ReesRussell, said firms are
increasingly turning down complex, international engagements.

Russell is also vice president of accountancy trade body, The UK200Group,
which requires its member to have regular, independent, quality tests.

He suspects the reason why so few UK200Group firms are on POB’s list is
because they realise “that global audit is not their prime market place”.

Anecdotal evidence sugg­ests smaller firms are jettisoning their
resource-heavy, low-revenue audit clients and concentrating instead on selling
lucrative, but less regulated, advisory services.

Andrew McDaid from Chesterfield-based firm Mitchells Chartered Accountants,
said audit work does not always make financial sense for audit firms.

“For those firms, it is sensible that they do surrender their audit
registration and I know of firms who have done just that,” he said.

David v Goliath

There are also concerns that the POB’s report will reinforce the
“big-is-best” narrative
put forward by the biggest accounting firms.

Smaller firms point out they retain qualified, experienced staff who still
provide a
credible and cost-effective alternative to the top ten players in the industry.

Pressure has also been building on another front – the rising audit
threshold.

The threshold has jumped several times over the past 20 years, and now stands
at £6.5m turnover.

A 2008 government study found there was appetite to raise the threshold
again. Seven out of ten small and medium-sized enterprises (SMEs) said they
would be interested in “a less rigorous and cheaper form of assurance”. For the
vast majority of companies, abandoning an audit would shave between £1,000 and
£5,000 off their annual accounting bill.

The professionals

This year was the second time POB addressed the issue. The body, which
oversees audit quality throughout the industry, will need agreement with the
all-powerful acc­ounting institutes to bring in reform and, so far, those bodies
have indicated the POB’s findings were not indicative of sector-wide practice.

Audit, however, has a reputational value to accounting firms. It remains one
of the few accredited accounting sectors, in which accountants don’t have to
compete with unqualified practitioners for work.

Both the ICAEW and ICAS in particular have warned against drawing any broad
conclusions from the POB report.

The ICAEW pointed to the low number of audits surveyed – it included only 11.

“I don’t think you can draw general conclusions just from 11 audits,” said
Trevor Smith, ICAEW regional director within quality assurance.

However, POB’s Paul George points out that the board has looked at more than
20 audits during the past two years.

“We looked at 11 public interest audits and we looked at a similar number the
year before and, in the context of a number of audits those firms undertake in
that sector, it is beginning to mount up as a reasonable percentage,” he said.

The POB will discuss the issue with Department of Business officials but, in
the mean time, it has urged audit firms to refuse audit work which is beyond
their means.

In the near future, it may be that changes are suggested to auditors’ ethical
guidance, which encourages, but does not force, firms to refuse complex work
beyond their capabilities.

“I would certainly say that it is a fundamental requirement that firms don’t
do anything that they are not competent in,” said David Wood, executive director
technical policy
at ICAS.

“If you’re a small firm, you need to make sure you have inherent expertise or
buy it in.”

What might an audit license look like? The POB highlighted a number of issues
where smaller audit firms might be scrutinised in the future.

The board was particularly concerned when smaller firms audit multinational
companies. The POB found a range of worrying issues, including insufficient
involvement by firms in their own audit; the absence of appropriate reports from
other auditors undertaking work for group-audit purposes; and insufficient audit
evidence on
file to support the group audit opinion.

One firm chose to resign as group auditor following the POB’s review. Looking
ahead, firms may need to prove they have the experience or resources in the
foreign nation where their clients’ sub­sidiaries are based.

They may also need to show they have enough relevant internal expertise to
scrutinise valuation judgments. The POB found an across-the-board failure to
maintain in-house experts to properly scrutinise their clients’ valuations.
Firms instead relied principally on the work of their client’s experts.

The POB found some firms failed some basic audit tests like confirming bank
balances or investments with independent sources.

For the moment, the POB has no interest in letting the issue lie. This was
the first time it has issued a stand-alone report on the issue, a step up from
2009 when it referred to the issue as part of a larger study. Sources say the
body has no plan to let the issue go.

IN OUR VIEW

Audit is one of the few areas where accountants need accreditation, and it is
something of a status symbol at the moment. If accountants are forced into
abandoning audit, in favour of advisory services, they are competing with
unregulated businesses which many argue do not have the discipline and rigour
which comes with having a formal qualification. If regulators are pushing firms
out of audit for listed companies, they need to recover those revenues from
somewhere, and advisory services might be it. Perhaps regulators should also
think about creating more regulation to protect the status of qualified
accountants in advisory services.