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

The seemingly-endless process of trying to improve the UK’s audit market doesn’t get any easier.

The problems are clear. First, there has been widespread dissatisfaction with the quality of audits, including a lapdog relationship between auditors and company management, in the aftermath of corporate failures such as Carillion and Patisserie Valerie.

Second, there has been a longstanding concern about an overly concentrated market: just one FTSE 100 firm is audited by a non-Big Four firm (and that’s considered progress). About 90 per cent of the top 350 listed firms get their books signed off by the Big Four.

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

This is a market in flux. The government’s long-awaited audit reforms, both watered down and delayed, want to bolster mid-market challengers, by requiring that a portion of FTSE 350 work is shared with a smaller firm. The theory is that this would improve skills and capacity gradually, starting to break the stranglehold of the biggest firms on the market.

But the latest quality review by regulator the Financial Reporting Council highlights a problem. Ambitious growth by mid-market firms such as Mazaars and BDO is already having an impact on quality. Overall the share of inspected audits rated as good or requiring limited improvement rose for the third consecutive year. But the results at those two firms were dubbed “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 jettisoning companies seen as higher-risk from their portfolios. This “de-risking” means problematic or complicated clients can end up with smaller firms, whose experience and systems may not really be up to the job.

These snapshots of audit quality aren’t a perfect guide to what is going on. They rely on a small sample of work. Many in the market claim they tend to pick out first-time clients or riskier accounts. There is a project under way to improve them: one frustration is that the reviews focus on checking documentation, rather than on issues around planning, transparency or judgment calls that consume a company’s audit committee.

It is clear though that the Big Four, in safeguarding their reputations, have become more selective — a trend that is spreading to smaller firms, too.

Auditors are starting to decline business not just where there are concerns around corporate governance or dominance management but where a sector with long-term contracts or heightened uncertainty means more subjective judgments that may be scrutinized unfavorably with hindsight. Another issue is where companies have significant chunks of business overseas, particularly in developing markets.

One firm said that it had declined to pitch for roughly double the amount of business it usually would over the past year because of such concerns. Grant Thornton, the challenger firm slammed for a “serious lack of competence” in its audit of Patisserie Valerie, has largely stopped competing for new work auditing big companies.

As a result, more companies could 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 it was a year ago, two years ago. . . and so on,” said Sir Jon Thompson, chief executive of the FRC, which has some powers to broker a solution in that situation. “I am concerned that we will reach a point where we cannot solve that problem. . . I’m also concerned that the secretary of state’s current powers are insufficient to solve that problem too.”

The government hasn’t had to take action to find an auditor for a UK-listed company, though there were fears it would have to intervene in the case of Sports Direct, now Frasers. In any case, given that a firm can’t be stopped from resigning from a job, the government would effectively need an auditor’s agreement.

The regulator, said Thompson, is in discussions with civil servants about creating new powers to address such a situation. But the idea of ​​centrally appointing auditors is controversial, and raises questions around how a firm could take on the liability associated with a client it doesn’t want.

The government’s delayed reform efforts have yet to fix problems identified after Carillion’s 2018 collapse, including the need for a beefed-up regulator. By the time it gets round to it, there could be a whole new source of audit dysfunction to handle.

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