On Friday, the FRC released its 2020 Annual Enforcement Review (the Review), providing a summary of the FRC's enforcement work over the past tax year. The FRC has identified those points on which audit firms most frequently fall short, and the underlying causes for such shortcomings.
While there are a number of these, the report's preface by Executive Counsel Elizabeth Barrett singles out the failure to exercise professional scepticism (ISA 200) as an ongoing issue that continues to feature frequently. Auditors being too close to management (with the concomitant risk to objectivity that this creates) and insufficient escalation to and involvement of the audit partner (as a result of which the significance of issues in the context of the audit as a whole may be overlooked) are highlighted by the Report as two of the main causes for this. Another recurring theme that has featured frequently in FRC investigations is failure to obtain sufficient appropriate audit evidence (ISA 500).
The Review highlights the FRC's focus on these two areas by remarking that "Work in other areas cannot compensate for failings in these areas and it is rightly an expectation of the public that, at the very least, these two aspects of audit are achieved." In light of this very clear statement, it is to be expected that professional scepticism and sufficient audit evidence will be areas on which future FRC investigations will continue to focus.
The FRC expresses its disappointment at having had to conclude that the overall response to last year's Review's message that firms should "identify, remediate and report" has been mixed. In particular, the Review signals that despite insufficient audit evidence and a lack of scepticism being commonly raised in Audit Quality Review (AQR) inspections over a number of years, both Enforcement and AQR continue to encounter deficiencies in these areas. In order to identify the reasons for this, the FRC has analysed its enforcement investigations in audit cases over the past six years and identified six key themes. These are:
- Insufficient involvement of the audit partner and over-delegation to junior members of the team: where junior audit employees are insufficiently supervised, issues have arisen, not so much due to insufficient knowledge on the juniors' part, but due to the fact that where juniors picked up issues or raised concerns, in many cases these were not properly escalated to sufficiently senior members of the audit team.
- Disorganised audit work: this is a particularly prominent issue where, on large audits, there are multiple audit teams involved. In such cases, lack of communication can lead to inquiries not being fully pursued and accounts being signed off without proper testing having been conducted.
- Failure to step back and take an overall look at the financial picture: as a result of 1) and 2) above, the audit partner and team sometimes fail to stand back and ask themselves if the overall picture presented by the financial statements is sound. In this context, the FRC points out that red flags may only become apparent when looking across the audit as a whole. Related to this point, the FRC has observed a "tick-box" culture regarding the audit testing in some cases, with the audit team not thinking sufficiently about the reasons for the testing or the bigger picture.
- Auditor too close to management: although the FRC is seeing a shift in the culture of audit firms, such that auditor's independence is being re-asserted, some of the reviewed audits still show auditor/ management relationships that are too close to enable auditors to exercise sufficient professional scepticism.
- Failure to involve the Audit Quality Assurance partner: the FRC has seen cases where EQCR partners were provided with material so late in the audit process that they were unable to conduct a meaningful review. In some cases, where the EQCR did get the material in good time and raised questions, these were not effectively followed up by the audit team.
- Use of auditors' experts and specialists: in some cases the FRC has observed a lack of proper communication between the audit team and their expert or specialist teams (such as actuaries or IT specialists), as well as a tendency to accept their work unquestioningly.
The year in numbers
In time-honoured fashion, the Review also contains a considerable amount of numbers. In a nutshell, over the past year the FRC's enforcement division has seen:
- 42 current investigations
- 18 referrals to the Conduct Committee
- 14 investigations opened (11 under the AEP, 2 under the Accountancy Scheme and 1 under the Actuarial Scheme) in the year
- 3 preliminary enquiries opened, two of which concern actuaries
- 13 cases concluded: 4 closed with no further action, 8 settled, and 1 decided by a Tribunal
- Financial sanctions of £16.5 million (before settlement discount)
- 2 undertakings to suspend membership
- 32 cases closed in the year where there was no action for the FRC to take under one of its enforcement schemes
There have also been major hearings, including proceedings in the Court of Appeal concerning legal professional privilege (see our article on the Court of Appeal's decision in Sports Direct v Financial Reporting Council here and a seven-week hearing in the independent Tribunal concerning the audit of Autonomy Corporation (the Enforcement Division's longest contested hearing to date).
Over the past year, the Enforcement Division has focussed on early resolution such that 33 cases were dealt with through Constructive Engagement during the year, an increase of 73.7% on the previous year. 24 of those cases involved the "Big Four" accounting firms and 30 involved the "Big Six". Although, in 31 of these cases, the FRC concluded that there was an Allegation (i.e. information which raises a question as to whether there has been a breach of a Relevant Requirement under the Audit Enforcement Procedure (AEP)), and over 75% of those cases involved errors in the financial statements that led to subsequent restatements, it nonetheless proved possible to resolve these cases through Constructive Engagement because the FRC concluded that the errors appeared unlikely to have had a real impact on decisions taken by users of the financial statements.
Interestingly, more than half of Case Examination and Enquiries (CEE) cases opened this year (45 out of 88) resulted from the FRC's enhanced horizon scanning activities. The next largest category (22 cases) arose from other FRC teams, such as AQR inspections, followed by complaints (15 cases), external referrals (4 cases) and whistleblowing (2 cases).
During the year, a range of financial and non-financial sanctions have been imposed on audit firms and individuals, with a key objective of driving audit quality. Of these, 11 were financial (5 against audit firms and 6 against partners) and 27 non-financial. The FRC uses non-financial sanctions to drive long-term change. It has required firms to undertake training, to conduct and report on quality performance reviews and to monitor regional offices more closely. As regards the financial sanctions, the level of discounts offered has increased from 15% to 32% reflecting improved co-operation and earlier settlement by firms.
Clearly, there is significant focus within the FRC on Constructive Engagement, as well as wider deployment of non-financial sanctions and encouragement of audit firms to make full and frank early admissions demonstrating cultural change by firms and acceptance by both firms and individuals of areas where they have fallen short of the applicable standards.
The Review concludes with a very clear statement that improving the speed of investigations and enforcement action remains a key priority for the FRC. In the past year, the FRC has met its target of completing the investigation stage of the process within two years, in 44% of cases (compared to under 35% in the previous year). Whilst speedier investigations are to be welcomed, in our experience the two year timetable has led to a number of cases where unrealistic deadlines are imposed seemingly as a result of wishing to meet various key performance indicators (presumably in place to seek to ensure that the two year timetable is met).
Finally, it is notable that the FRC's Enforcement Division has increased in size by 14% over the past year and is planning significant further expansion of its forensic accounting and legal teams. This in part reflects the continued political and parliamentary focus on the role of auditors. Going forwards it seems unlikely that the level of investigations being opened will slow as the FRC morphes into ARGA.
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