Five key takeaways from the FRC’s audit sector report

Louis Ashworth
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Big Four Accounting Firms Come Under Government Scrutiny
KPMG, one of the Big Four audit firms, has been criticised for its “deteriorating” audit quality (Source: Getty)

The Financial Reporting Council (FRC), the audit sector’s watchdog, released its annual Developments in Audit report yesterday, outlining key challenges faced in the sector and assessing the current state of the profession.

Audit is under close scrutiny at the moment, as politicians and regulators look closely at the dominance of the Big Four audit firms Deloitte, EY, KPMG and PricewaterhouseCoopers (PwC). Meanwhile, the FRC itself is facing a review, looking in part at claims that it is too ‘toothless' to hold the sector’s biggest players to account.

The report is extensive and detailed, offering a wide-ranging state of play look at audit. Here are five key takeaways:

1. People are losing confidence in audit

Political pressures The sector has drawn significant political attention following the collapse of Carillion, the construction giant. A joint report by the Business, Energy and Industrial Strategy and Work and Pensions Parliamentary Select Committees, released earlier this year, was damning of the sector – which Beis chair Rachel Reeves, a Labour MP, described as a “cartel”. The FRC said political interest “has reopened the debate about whether what audit is currently designed to do is sufficiently responsive to the needs and expectations of stakeholders”.

Moving backwards The FRC’s research agrees with the politicians’ basic premise: “The results of our audit inspections suggest that recent progress in improving audit quality has not been maintained, and in some areas has reversed in the last 12 months.”

The usual suspects In a section of investor feedback, the FRC said that many of those it had spoken to were becoming frustrated with the sector’s ongoing issues – bear in mind audit was already the subject of a regulator review in 2013, and a House of Lords investigations in 2011. “[H]igh-profile failure has taken its toll, with a majority of those we spoke to telling us that they were more concerned about audit quality than they were a year ago,” the report said. “Many also expressed frustration that issues impacting on audit quality and confidence in audit continually recur.”

Read more: Pressure mounts on the CMA to break up accountancy’s Big Four

2. Consulting for audit clients could be banned

Splitters The FRC said it was launching a review of its 2016 guidance on ethical standards in audit, to ensure rules on independence are working. Currently, firms face a 70 per cent cap on fees for selling non-audit services to their audit clients. Working with the Competition and Markets Authority (CMA), which is watching the sector closely, the FRC plans to look at whether these rules need to be tightened.

Bad reputation The FRC said: “If auditors cannot demonstrate their independence, they cannot address the perception held by some stakeholders that auditors are sometimes driven more by their commercial considerations, and the sale of non-audit services than they are by acting in the public interest.”

All part of the service Forcing companies to choose between offering audit or consultation is a long-standing suggestion in the sector, aimed at reducing conflicts of interest among auditors, who some say sell audit services to get their foot in the door at the largest firms, before selling them more lucrative products.

Big deals The big auditors have long denied that they use audit as a get-in, but the FRC wants to revisit the issue. If they crack down on the sale of non-audit services, it could force a major shake-up as companies reassess what is most worth selling.

Read more: Labour mulls break-up of Big Four accountancy firms

The collapse of Carillion has prompted a sector shake-up, with politicians calling for audit challengers to have a clearer shot at the biggest contracts (Source: Getty)

3. KPMG is still in the doghouse

Keeping up the heat The FRC already slammed KPMG over the summer, saying the firm’s audits had seen an “unacceptable” decline in quality. It stuck the boot in today, repeating its criticisms and saying it was ramping up the number of audits by the firm it was scrutinising.

Room for improvement Repeating findings it announced over the summer, the FRC said: “The results of our reviews of KPMG’s audits over the past five years have been disappointing. The firm’s 2017/18 inspection results show further deterioration, with only 50 per cent of the FTSE 350 audits inspection being assessed as good or requiring no more than limited improvements.”

Trouble spots KPMG made the most appearances of any firm in the FRC’s list of completed cases for the year, having faced investigations over its work from HBOS, Quindell and Ted Baker. It was fined over £5m in total.

Read more: EY boss hits back at calls to break up Big Four

4. Mixed results for mandatory rotation

Pass-the-parcel Mandatory rotation of auditors was introduced in 2016, the combination of new EU regulations and recommendations by a previous review into the sector by the Competition Commission. Listed firms now have to put their audit contracts out to tender every ten years, and can be audited by the same firm for an maximum of twenty years if an audit in renewed.

Plus ça change Has the change worked? Yes and no, the FRC says. There’s been an unprecedented shake-up in auditors for the top firms – bear in mind that until 2014, PwC had been Barclays’ auditor for 120 years – but all that has meant in practice is that contracts have swapped hands between the Big Four. Put bluntly by the FRC: “There has been no diversification of the UK audit market”.

From footholds to toeholds Looking at data from August last year, the FRC concluded that all of the Big Four has seen their number of FTSE 350 clients stay roughly the same since 2011. Meanwhile, the only two challenger firms that had a look-in at the top-listed clients – Grant Thornton and BDO – have seen their numbers drop.

Read more: High-profile failures have eroded trust in audit sector, says watchdog

5. A crackdown on bad audits

Harder, better, faster, stronger The FRC has posted penalties on auditors in access of £23m since April 2017, and has set a series of record fines in recent months. That “toothlessness” criticism from the government stings though, and the watchdog is continuing to look at its enforcement approaches.

Lessons learned The shadow of the FRC’s investigation into HBOS, which went bust in 2008, eight months after posting a £5.5bn pre-tax profit, hangs over the report. In its assessment of KPMG’s audit of the bank, which gave it a clean bill of health, the FRC concluded: “We were not sufficiently proactive in making enquiries in relation to the HBOS audit”. Its decision to close an investigation into the bank last autumn was heavily criticised. Today’s report contains a commitment to learning lessons and maintaining transparency.

Quick moves The watchdog has pledged “faster case resolution”, with a particular emphasis on speeding up investigations by working more closely with auditors to reach settlements and setting clearer parameters. It also said it has increased the level of resources it can assign to each investigation, which will particularly speed up smaller investigations.