The growing risk of 'audit orphans' in a dysfunctional UK market

The growing risk of ‘audit orphans’ in a dysfunctional UK market

The seemingly endless process of trying to improve the UK audit market is not getting any easier.

The problems are clear. First, there has been widespread dissatisfaction with the quality of audits, including a watchdog relationship between the auditor and company management, following the bankruptcies of companies such as Carillion and Patisserie Valerie.

Second, there have long been concerns about an overly concentrated market: only one FTSE 100 company is audited by a non-Big Four company (and that’s considered progress). About 90% of the top 350 listed companies get their books signed by the Big Four.

Now add a new headache to the list: the growing risk that large listed companies will find themselves unable to find an auditor.

It is a changing market. The government’s long-awaited audit reforms, both watered down and delayed, seek to bolster middle-market challengers, by requiring some of the FTSE 350’s work to be shared with a small business. The theory is that it would gradually improve skills and abilities, beginning to break the hold of the bigger companies in the market.

But the latest quality review by the regulator, the Financial Reporting Council, highlights a problem. The ambitious growth of medium-sized companies such as Mazaars and BDO is already having an impact on quality. Overall, the share of audits reviewed that were rated as good or requiring limited improvement increased for the third year in a row. But the results of these two companies were described as “unacceptable”. Both said they were investing to improve quality.

The regulator flagged another concern. As the Big Four come under pressure to improve quality, they are dropping companies deemed higher risk from their portfolios. This “risk reduction” means that problematic or complicated customers may end up with smaller companies, whose experience and systems may not be up to scratch.

These audit quality snapshots are not a perfect guide to what is going on. They rely on a small sample of work. Many in the market claim that they tend to choose first-time clients or riskier accounts. A project is underway to improve them: one frustration is that the reviews focus on verifying the documentation, rather than on questions of planning, transparency or appeals for judgment which monopolize the audit committee of a company.

It is clear, however, that the Big Four, in preserving their reputation, have become more selective – a trend that is also spreading to businesses.

Auditors begin to decline cases not only where there are concerns about corporate governance or overbearing management, but where an industry with long-term contracts or increased uncertainty means more subjective judgments that can be scrutinized unfavorably with hindsight. Another problem is where companies have a significant portion of their business overseas, especially in developing markets.

One company said it declined to present about twice the volume of business it usually would in the past year because of these concerns. Grant Thornton, the challenger firm criticized for a “serious lack of competence” in its audit of Patisserie Valerie, has stopped competing for new work auditing large companies.

As a result, more companies may struggle to find an auditor or ultimately be left orphaned by the market, as has happened in countries like the Netherlands and Canada.

“The risk is higher than a year ago, two years ago. . . and so on,” said Sir Jon Thompson, chief executive of the FRC, who has some powers to negotiate a solution in this situation. “I fear that we will reach a point where we cannot solve this problem. . . I also fear that the present powers of the Secretary of State are also insufficient to solve this problem.

The government did not have to take action to find an auditor for a UK-listed company, although there were fears it would have to intervene in the case of Sports Direct, now Frasers. In any case, since a company cannot be prevented from resigning from a job, the government would indeed need an audit agreement.

The regulator, Thompson said, is in talks with officials about creating new powers to deal with such a situation. But the idea of ​​appointing auditors centrally is controversial and raises questions about how a company could take responsibility for a customer it doesn’t want.

The government’s delayed reform efforts have yet to address issues identified after Carillion collapsed in 2018, including the need for a strengthened regulator. By the time it does, there could be a whole new source of audit dysfunction to deal with.

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