Quote "WINTER24" for 50% off all services - limited time offer
Frequently Asked Questions - Demystifying audit
Q1: Which groups/companies require an audit?
Actually, every UK company is required to have an audit. It's just that there are exemptions from this rule.
Small standalone companies are exempt. That means not breaching two these: £10.2m revenue, £5.1m gross assets, 50 employees. The slightly strange figures arise because this is based on EU law (set in Euros) - so the UK government has the power to set its own thresholds in future...
If a company is in a group, you need to look at the size of the whole group, applying the same thresholds. Every company in a group breaching the thresholds needs an audit.
Groups that aren't small need to prepare and file group accounts (known as consolidated account) which effectively add together all the companies in the group as though it was one company.
UK based parent companies can give guarantees on behalf of their subsidiaries, which then means they are exempt from audit. But that comes with a host of rules and conditions.
There's also a string of activities that can't take exemptions PLCs, FCA regulated, banking, insurance and so on.
As ever there are some complex rules around this but that's the overview. There are over 4 million companies registered in the UK but the vast majority are audit exempt due to their small (or 'micro') size.
Q2: What is materiality?
Audits are performed using a set of rules called International Standards on Auditing. These require the auditor to set a level of 'materiality' for each audit. This is a number which, if there was a mistake of that amount or lower, wouldn't change the decisions made by people making decisions based on those accounts. It can be based on a % of revenue or profit in a trading company, or a % of assets if it's something like an asset holding company.
The key point is that auditors do not check everything. In fact there could be quite a lot that they don't check.
So materiality will be higher in the bigger companies.
Some payments are considered to be so important that they are material whatever their size - like payments to Directors.
Your auditor should tell you at the planning stage what their planned level of materiailty will be, and how they got to it. If not, ask.
Q3: What is the auditor's responsibility regarding the detection of fraud?
This is closely defined in the auditing rules, International Standards on Auditing. This issue is widely misunderstood and there is a view that auditors are required to identify fraud. Tests are not designed specifically to capture frauds. Highly sophisticated frauds (of which there are many examples), or frauds of low value, may not be caught during an audit. Auditors are then open to whether they were negligent in not identifying a fraud if it comes to light at a later date.
Q4: What were the recommendations of the Brydon and Kingman reviews into the UK audit market?
The reports were comprehensive and the recommendations were extensive. However the reviews were only advisory and some recommendations may not be adopted. Therefore we await the formation of the new regulator ARGA and further notification of the new rules. One theme of the reviews was that the firms (led by Big Four) should proactively take steps to improve the perception of the industry without the need for mandated reform.
Q5: What are the 'rules' of an audit guiding what auditors actually do?
International Standards on Auditing (ISAs UK).
Q6: What is the significance of 'auditor independence'?
This is becoming a bigger issue, especially in light of some recent high profile failings on this front.
If auditors are going to give a fair conclusion to their audit (their 'audit opinion') - they need to be independent of the company they are auditing.
There are lots of things that can happen which mean they aren't independent any more. These are set out in an Ethical Standard which auditors must comply with.
Here are some examples of situations which would bring independence into question:
- The audit firm also gives you help in valuing assets, and then audits those valuations
- You haven't paid your fees for the last three years, but they start auditing anyway
- The former audit partner is now Finance Director at the client
-The audit manager helped the client prepare the accounts and is now auditing them
- The CEO takes the Audit Partner on holidays every year
- The audit fee is much lower than it should be, in the hope of winning some tax work
- the audit partner also speaks on behalf of the client at a commercial court dispute and takes a large fee
Two of the above happened recently on high profile audits. The result was large fines.
At the start of the audit, the auditor should confirm that they are independent. If they are not, they should considering resigning. It's possible that there are actions that can be taken to reduce the threats.
From this year, auditors can effectively not provide any services to listed companies other than audit.
Q7: Why is the the UK audit market in a period of reform?
Too much has gone wrong. If an auditor signs off a business as a going concern, for it to fail the next month, shareholders rightly ask why they can't rely on the system. If auditors fail to remain independent, confidence in the audit profession is at stake. The largest firms have failed to establish sufficient quality in their audit work, so stronger regulation is required to make them.
Q8: How do I choose the right audit firm for me?
Given that there are rules (ISAs), you might think all audits are the same, so the cheapest is best.
Or perhaps mere association with a big name is good for profile, so most expensive is best?
Even though all audits needs to meet the same standards, there is quite a diverse range of approaches that can be taken to achieve these.
And then of course there is the culture and approach of each individual audit firm.
Do they have enough staff? Will they keep sending different staff? Do they have experience in your industry? Are they going to charge you for every small thing that goes wrong? What will the final product be? Will their testing also uncover areas to improve processes within the business? Do they have access to cutting-edge data analytics and CAAT tools?
Q9: What should I ask of the auditor at the tender?
You may know exactly what your last auditor got wrong, but it might not be obvious what to ask from your new one.
Skill and competence when it comes to accounting should be a given, but you won't just be dealing with the senior managers and partners. In fact you might not see the partner very much.
The business model for audit firms is for their junior staff, perhaps even trainees, to do most of the testing. So that's who you're likely to encounter most. So ask your auditor how much contact you can expect with the senior people in the team.
What commitment can they make to your business? You're paying the fees, so what can you expect? Well, a clean audit report hopefully, but how are you going to get there? How much time away from everything else the finance team need to do will this require? Will they stick to the agreed dates? Will the same people come back next year so I don't have to explain everything again? (Will the same people come back next week?)
Do you have experience of auditing a business of this size? In this sector? With these tight deadlines?
Are you independent?
In what circumstances will you charge me additional fees, beyond those we agree to at the start?
Can you help me if I get stuck on an accounting problem?
Q10: How do the audit firms differ? Isn't an audit the same whoever is doing it?
See Q8.
Q11: How do you change auditor?
Once you've decided who to appoint, tell your old audit partner who you have appointed, and that you're happy for them to talk to the new firm.
The new firm then asks the old firm if it's ok to accept appointment.
The new firm will ask you to sign an engagement letter. Read it.
Then you're off and running.
The auditor change may need to be ratified internally, and announced if listed.
Q12: What is a "modified" or "qualified" audit report?
This gets a big jargon-y. We don't have the statistics but we imagine 99% of audit reports are 'clean'. That means the auditor effectively signs off on the numbers.
But there are other situations where other things need to be written in the audit report:
1) "Emphasis of matter" - there's nothing wrong with the numbers but there's something written in the accounts that is so important, the auditor wants to draw attention to it.
2) "Qualification" - the audit opinion is qualified , there's a problem with something, where perhaps the auditor doesn't agree, or just can't get enough evidence to support it. Everything else is ok though - ie this issue doesn't totally ruin the ability to make decisions based on the accounts.
3) "Limitation of scope" - There was something the auditor wasn't able to test, so can't comment. Maybe they were appointed late and so can't test the inventory that was held at the year end. Everything else is ok though, since it's probably a fairly small matter.
4) "Adverse opinion" - The accounts are wrong. You'll probably be needing new auditors - or you may need an accounting top-up yourself.
5) "Disclaimer of opinion" - no audit opinion is given at all, perhaps because a limitation of scope was so damaging to the ability to test the big figures in the accounts. Something has definitely gone wrong.
Q13: What are your top tips for an efficient audit?
Our suggestions are...
1) For a new or growing business, identify and decide earlier whether you will require/desire an audit so that you have lead time to consider and decide a suitable appointment.
2) For those with auditors in situ - when did you last consider your audit firm? Is there an audit committee or other forum to discuss it?
3) There is value in audit relationships (so long as they are independent) - but are there alternative procedures, plans, arrangements, services that can be discussed for next year?
4) The audit market is increasingly competitive. Consider if fees are suitable and if value is being obtained when it comes to industry expertise, audit technologies, responsiveness.
5) Not every client can be a priority. Do you want to be low priority at a large firm, or the most valued client at a small one? Or in the middle?
6) Discuss internally what the most important factor in the appointment is. This will vary. In some cases it may be access to the leading experts in a particular industry and access to specific industry know-how, bench-marking and best practice. In other cases it may be responsiveness or fees.
7) Don't ever view the audit as a low-value service that is simply a requirement. It's an opportunity for all companies to get external input and look at systems and reporting. If it seems a chore, perhaps your current firm isn't the best fit.
8) You Get What You Pay For. This applies to everything and audit isn't exempt.
9) Engage with the process - set aside the time and resource to get the most from it - and if possible avoid a draining and painful few months with teams working through the night to solve problems...
Q14: External audit and internal audit - what's the distinction?
This website deals with external audits. This is where a firm of registered auditors provide an audit opinion of a set of accounts ("financial statements" / Annual Report etc). An audit is a defined and regulated process, so it is important to distinguish what an audit is and is not. There are other forms of assurance that are not audit, but which might appear to be similar from a client's perspective. Other assurance engagements probably do not result in the issue of an audit report - more likely a report of findings, or a statement that nothing came to their attention. An audit results in a positive opinion that the accounts are not materially misstated.
Internal audit is the process of oversight and evaluation of internal processes. For example, a team may test and review on a cyclical basis the procurement systems within a business to check that processes are appropriate, that costs are controlled and measured, that suppliers are appropriately vetted, and so on. Internal audit might be performed by employees of the company in question, or performed by external suppliers. Many of the firms on the Top 35 list will also provide internal audit services as well as external audit. Internal audit is a separate profession and has its own dedicated regulatory bodies, qualifications, directives and careers. However, it faces similar scrutiny since failure of internal audit can lead to corporate failure in the same way as failure of external audit.
Q15: How is audit changing with advances in technology?
Audit is like all other industries, which cannot escape the continuing technological developments. More and more accounting processes are automated and ultimately no doubt the same will apply to auditing, which even up recently was entirely a human endeavor.
The technology used in your audit by your auditor may not necessarily be known to you as the client, since the auditor needs to obtain sufficient evidence - but there can be various ways of doing this. In most cases the auditor is likely to make the most of the technology to add value to you as the client too.
The very large audits with complex datasets and highly automated data capture will rely heavily on bespoke IT infrastructure to help them capture data from their sales cycle, or stock management, for example. Therefore if the auditor satisfies themselves that these processes are good and they capture the right information, this could be good enough audit evidence. So in this case there might be IT technology applied in the audit. This might be called CAAT (Computer Aided Audit Tool) or other names.
Companies with more manual processes might still benefit from advances in technology, though perhaps more through data analytics and Artificial Intelligence processes. There are various third-party services in the market at their early development stage, and the larger firms have been faster at implementing them. These techniques can scour data for anomolies, perform benchmarking, look at processes and get under the bonnet. Their application and use is growing continually.
There will still be audits performed by Top 35 audit firms in the traditional way, which is without these kinds of methods. But the future image of an auditor might start to move away from a graduate with a calculator and a branded water bottle to a sophisticated IT boffin.
Q16: How do firms set their audit fees?
You'll never truly know. But it's likely that the firm in question has set a target level of profitability (audit firms are very profitable). Based on that hourly rates are set each year for all the employees. Based on the expected time the audit will take, a fee is set, again adjusted for the target profit on that assignment.
A problem in the audit market has been the idea of performing the audit as a means of winning more profitable work later. This is because the auditor has a unique insight into the business it is auditing - it can look at the books, ask unlimited questions and have access to the C suite.
But this has led to independence issues, and in some high profile cases firms have been penalised for their greed, having taken fees for services other than audit without thinking about the impact on their independence (see Q6 ).
The reforms currently underway will separate the Big Four's audit divisions and the recommendation is that the audit partners are paid only on the profitability of the audit work - not the lucrative consulting. So expect fees to move upwards, as a trend.
Q17: What is the benefit of an audit?
The largest businesses who are audited every year and have been for a long time will have the audit cycle as a fixed event in the calendar. Where they appoint the same audit firm year after year, the audit may be extremely similar one year to the next. The signed off audit gives reassurance the the Board that everything is in order, as well as the shareholders who then receive audited accounts.
Smaller businesses without sophisticated finance teams and systems may also benefit from the insight of experts in their sector. Companies in this position will benefit from a value-add audit from auditors specialising in that sector.
Audited accounts can help facilitate investment, IPO, exit, debt funding, etc.
Q18: Where is the word audit from?
From the latin 'to hear'.
Q19: How many audit firms are there in the UK?
There are thousands of registered audit firms in the UK and they don't need to be large organisations. Some could be one single practitioner offering local services and for very small businesses this could be a good option. All auditors have to meet the same minimum standards to sign an audit report. This website focuses on the Top 35 because current market reforms mean the market for large businesses is increasingly open and it is the performance of larger businesses that sets the tone for the corporate sector.
Q20: Auditors are paid by the firms they are auditing. So how can they be truly independent?
Good point. It is felt that the integrity of audit firms as well as the Ethical Standards make sure they behave properly. Unfortunately it hasn't always been the case.