Annual assessment suggests improvement, but PIRC argues for ‘root-and-branch’ review.
Following continued examples of poor-quality audits and facing mounting criticism on its role as a regulator, the UK’s Financial Reporting Council (FRC) has published a blueprint for what audit firms need to do to ensure best practice. The guidance comes at a time when the FRC itself is in the process of being replaced by a new regulatory body: the Audit, Reporting and Governing Authority (ARGA).
The ‘What Makes a Good Audit?’ report highlights six key attributes that should permeate audit firms’ risk assessments, planning, execution, and reporting. These are: assessing firm quality risks; mindset; culture, governance, and leadership; performance monitoring and remediation; quality monitoring; resources, which includes recruitment and training; and information and communications.
“We recognise that auditing requires the application of judgement within a principles-based framework. It is not just a rules-based compliance exercise,” the report noted. “As a result, it is vital that a good audit recognises the need for an audit team to not only have the necessary skills and experience but that it also approaches the engagement with the right behaviours and mindset.”
Quality audits should provide investors and other stakeholders with a high-level of assurance that financial statements give a true and fair view of the company’s performance and governance. This means audit firms must ensure they are conducting robust risk assessments and doing their due diligence. They must also demonstrate a willingness to challenge corporate management to obtain sufficient audit evidence, the regulator added.
Tim Bush, Head of Governance and Financial Analysis at the UK-based independent shareholder advisory consultancy PIRC, was underwhelmed by the guidance.
“Things have come to a pretty pass when a regulator needs to tell the firms this,” he told ESG Investor. “We need a roots-and-branches review of auditing and accounting standards for auditors to follow.”
Comprehensive and reliable audits will become even more important next year when UK-based companies will be required to produce Task Force on Climate-related Financial Disclosure-aligned reports, the FRC noted. Investors will want to be assured that investee companies are committed to fulfilling climate-related targets, such as transitioning to net zero greenhouse gas (GHG) emissions.
The FRC has also published its ‘Developments in Audit’ report, which outlines the latest findings from the regulator’s annual assessment of UK auditing and also identifies areas that need improvement.
“Audit quality remains mixed and inconsistent across the firms and, in some instances, between audits at the same firms,” the second report noted.
Of the 147 audits reviewed, 33% required improvement or significant improvement, compared to 38% the previous year. Although this indicates audit firms are implementing positive changes, the FRC said that there are still too many examples of inconsistencies in audit quality, lack of professional scepticism, poor application of audit judgements and poor assessment of internal controls – including their effectiveness in mitigating fraud risk.
Examples of good practice include delaying audit opinion sign-offs to ensure that there is sufficient time available to deliver quality output and rigorously assessing the risks related to the carrying value of assets that could be impaired.
The FRC has also increased the number of inspections of smaller firms this year, noting that ten out of 16 audits reviewed required improvements. Acknowledging that this level of quality is “unacceptable”, the FRC has committed more resources to supervise smaller firms to drive improvements.
From FRC to ARGA
The FRC has been criticised by industry experts and the UK government on its ineffective regulation of audit quality thus far, prompting plans to introduce ARGA.
“The current [audit] system has been designed defensively by big firm interests,” Bush said. “The FRC has been akin to an open prison run by the inmates. The professional institutes have become trade associations.”
In a 2019 report, the UK Department of Business, Energy and Industry Strategy (BEIS) said the FRC is a “weak and ineffective regulator”.
In March, the BEIS published a consultation calling for an increase in audit firm accountability to shareholders, an expanded scope to include non-financial information such as ESG risks, and announced the development of ARGA. The consultation received over 600 responses, with the majority proving supportive of the new regulatory body.
The government’s response to the consultation is expected to set out next steps and timings for ARGA, but Covid-19 and the UK’s exit from the EU has delayed progress, the FRC said in its ‘Developments in Audit’ report.
“As we continue to lay the groundwork for establishing ARGA our continued objective will be to drive all firms to deliver consistent, high-quality audit to the benefit of all stakeholders and the wider public,” said Sarah Rapson, the FRC’s Executive Director of Supervision.
Audit quality is being looked at internationally, too.
In June, the Monitoring Group, a group of international financial institutions and regulatory bodies looking to improve international audit quality, announced it had developed a transition plan to improve international audit standards and begun work on implementation. The group has a global reach, with members including the Basel Committee on Banking Supervision, the European Commission, the International Organisation of Securities Commissions, and the World Bank.