DACB’s Audit Liability Round-up for 2020

Both at home and abroad, auditors have appeared near the top of the business headlines. Underlining the centrality of financial reporting to the major economic issues of the day, audit enforcement forms part of the narrative of two of the major economic developments of our time – the pandemic and the rise of China.

• In a rare example of bipartisanship, both the US House of Representatives and Senate passed a bill that would require Chinese companies to meet US accounting standards if seeking a US listing. Perhaps this is understandable following the accounting scandal at Luckin Coffee earlier this year. Western investors have long shirked Chinese stocks due to the high risk of fraud. This creates an uncomfortable situation for Chinese corporates seeking capital, with the dangers of seeking finance from public markets at home illustrated by the recent state intervention in what would have been the record-breaking Ant Group IPO. UK PIE Auditors may benefit from such high risk opportunities, with Chinese corporates seeking to tap international investment through a London listing. Such audit clients may prove one of a number of catalysts for higher audit fees – see below.
• The economic pain from the pandemic is yet to be truly felt in the UK, with corporates being kept on life support by government furlough schemes and an array of other business relief measures. Nevertheless, as the adage goes, when the tide goes out the markets see who has been bathing naked. As further corporates run into cashflow difficulties, we can expect more accounting scandals to follow. Every generation has its own Enron, and this generation may be unfortunate enough to see several.
• We could see a long tail of civil claims brought by insolvency practitioners, proceeding over a course of years in much the same way as structured finance litigation proceeded after the financial crisis.

Meanwhile in the UK, the Financial Reporting Council (FRC) has been engaged in a flurry of activity.

• Leaving aside the possibility of future “Enrons”, the audit market is likely to see some high-profile FRC investigations coming out of the pandemic. Those businesses which are most at risk in the pandemic are also those which the public is most likely to know and care about – high street retailers, travel and restaurants among them. The FRC has a mandate to focus on investigation of such audits, and has done in the past (there are investigations already underway into the audits of Thomas Cook and Patisserie Valerie among others). After all, these businesses are big employers, have numerous smaller creditors, and may have defined benefit pension schemes to boot. That is, there are large classes of people relying on their financial statements, and historically the FRC has seen investigating such business failures as central to its role.
• Undoubtedly, what is in part driving caution within the world of Big Audit is the drumbeat of investigations and financial sanctions which continue to multiply. In one case this summer, we read about a fine of no less than £15.75 million plus the FRC’s costs to pay in the sum £5.6 million. Up until now, the fines for all cases have headed in one direction, upwards.
• But it is not only in the biggest cases that the impact of investigation costs and fines is being felt by the industry. We have witnessed increasing numbers of cases brought under the FRC’s Audit Enforcement Procedure, with the threshold for commencing these investigations being lowered to breaches of audit standards rather than the old, higher, threshold of professional misconduct. These lesser cases may not hit the national headlines, but they are expensive and damaging to those concerned.
• The cost to audit firms in higher insurance premiums could put the brakes on their development at a time when audit has never been more important or high-profile, and we can but hope that the powers that be recognise this fact – which is especially important for challenger firms and the increase of competition in the audit market.
• There are signs that the regulators are listening. The FRC announced this summer that it had resolved a record number of cases through constructive engagement. A cynic might suggest that this number simply reflects the fact that the Case Examination team opened 90% more cases year-on-year – showing the effect of the lower hurdle for enforcement action under the Audit Enforcement Procedure and the activities of the Audit Quality Review team. However, we are not so cynical. The very fact that the FRC is trumpeting its focus on constructive engagement is a good thing in itself. And the wide range of non- financial sanctions which the FRC has imposed shows an increasingly thoughtful approach to regulatory enforcement, targeted at driving up audit quality across the board.
• We are witnessing a new era of caution on the part of Big Audit, as the Big 6 sense audit risk must be managed rather than simply accepted as part of the job. Increased regulatory scrutiny and a seemingly ever more exacting set of demands on audit firms, linked with the decrease in non-audit services which firms can offer audit clients, is affecting audit firms’ bottom line.
• There seems to be a recognition across the market, shared by the FRC, that audit fees should increasingly reflect an audit client’s risk profile. We do not see an increase in audit fees as a way of diverting cash from UK Plc to the pockets of audit firm partners. Audit is an industry serving the public interest, in much the same way as transport or water or energy. The public has complained at audit failings, and wants financial statements to be subject to greater scrutiny. An increase in audit fees across the board is on the way. This will lead to greater audit resource and may enable the challenger firms to resource themselves properly and increase competition in the PIE audit market.
• We note that the FRC has launched a consultation on the auditor’s responsibilities relating to fraud. It remains to be seen whether an auditor will still be considered a ‘watchdog not bloodhound’ when it comes to fraud.
• Finally, with the Big 6 willing to say “no” to taking on high risk audits, this will present challenger firms with opportunities, albeit high risk ones. This may lead to increasing use of Limitation of Liability Agreements. Such agreements have been permitted under the Companies Act since 2008, but market pressures have dictated their relatively sparing use. That may change over the coming years, and maintaining access to PI cover is likely to be a key reason.