On 14 July 2020, the Financial Reporting Council (FRC) released its latest annual audit inspection results of the largest firms. These showed that 33% of the audits required more than limited improvements. Unsurprisingly, the Audit Quality Review team (AQR) concluded that this "remains unacceptable", while the FRC's Executive Director of Supervision stated: "We are concerned that firms are still not consistently achieving the necessary level of audit quality."
Key areas of concern in the audit inspection results
The FRC continues to find that improvements are needed in the same three audit areas:
- Impairment of goodwill and intangibles.
- Revenue and contracts.
- Provisions (including loan loss provisions).
These can be areas of complexity and forward looking judgement and, significantly, the FRC found that the failings often related to insufficient challenge of, and standing up to, management. Over the past three years, 46% of the findings that drove reviews requiring more than limited improvements had been in these three areas.
Hallmarks of a good audit
The FRC has, in the past, suggested the following as hallmarks of a good audit:
- Significant involvement of partner and other senior team members.
- Good use of specialists.
- Consultation on complex areas.
- Challenge of management leading to changes where assumptions are too optimistic.
- Robust quality control procedures.
- Clear and timely communication to Audit Committees.
The more guidance the FRC issues, the greater its expectations will be, if and when enforcement action occurs.
The trend in the FRC's enforcement activity would suggest an increased enforcement appetite. Specifically, with regard to the AQR findings, for the past three inspection cycles the FRC has referred 28 audits across all firms inspected, for consideration of possible enforcement action. This makes clear that poor AQR findings are fertile ground for potential enforcement referrals. Whilst there has been some recognition in recent enforcement activity that swingeing sanctions are not always appropriate, enforcement outcomes from recent years will give auditors some real cause for concern. For example, there has been: (i) a near trebling in annual fines issued by the FRC, from approximately £15.5m in 2017 to £43m in 2018/19, (ii) a 25% growth in the size of the Enforcement division from 2018 to 2019 and (iii) a willingness to use more frequently non-financial sanctions such as exclusions.
The FRC is making a number of significant changes in order to try to improve audit quality. These include firms' audit improvement plans and their processes to analyse the root cause of audit failings. Significantly, some of the bigger picture changes include: increasing focus on proactive supervision of the large audit firms; strengthening the FRC's AQR team to increase the number of inspections in the 2020/21 cycle, and asking the Big 4 firms to implement operational separation of audit practices from the rest of the firm. The implications of coronavirus on audits and value judgments made in relation to this may be of particular concern to auditors.
As readers will no doubt be aware, the FRC has come in for much criticism in recent years and a new body is slated to replace it - the statute based Audit, Reporting and Governance Authority. Irrespective of if, or almost certainly when, that happens, it is clear that audit failings are a significant issue and that the FRC wants to show its teeth. All signs point to more enforcement activity to come. Audit firms and audit partners need to be as prepared as possible in light of the significant changes, micro and macro, coming in this space. And if the FRC then comes knocking in respect of audit failings, our view as enforcement practitioners is that audit firms and audit partners need to take a measured approach. They would do well to concede what it is appropriate to concede, but to stand firm and be robust where that is warranted by the circumstances.