Can the FRC rescue its reputation?
It has become one of the most disparaged – and lampooned – regulatory institutions of this century.
The Financial Reporting Council’s (FRC) oversight of the audit profession has been dubbed everything from ramshackle to timid, to lacking in any real pace or direction.
The poor auditing practices of the ‘Big Four’ accountancy firms – which contributed to the collapse of prominent businesses such as Carillion, BHS and Thomas Cook – has put the regulator under an unprecedented spotlight over the past few years. Many industry voices are asking what to do about the FRC, which has repeatedly failed in its role to control the audit sector.
That answer came in December 2018, when an independent review of the FRC by Sir John Kingman concluded that the best option was to replace the embattled regulator with an independent statutory regulator, accountable to Parliament, called the Audit, Reporting and Governance Authority (ARGA).
Kingman’s report into the FRC, which included a whopping 83 recommendations, was damning, describing the regulator as “just serviceable, up to a point”, but adding that it “leaks and creaks, sometimes badly”.
So the FRC’s announcement at the end of 2019 that it was finally taking radical action to strengthen auditor independence and ban conflicts of interest within the industry might have come as a surprise – and may be a little too late considering the organisation is soon to be put out of its misery and disbanded.
In what may be its last chance to redeem itself, the FRC said it would introduce tougher rules as part of a major revision to its Ethical Standards and revised Auditing Standards.
The new standards will ban auditors from providing any recruitment, remuneration and due diligence services to public interest entities such as banks, listed companies, and insurers, as well as barring them from giving tax advice, advocacy and acting in any management role.
Admitting that its previous list of prohibited non-audit services was too open to interpretation, the regulator will now replace this with a shorter list of permitted services that are ‘closely related’ to an audit or required by law or regulation – with all other services provisions now strictly outlawed.
A cap will also be put on the total fees for non-audit services, limited to no more than 70% of the average of the audit fees paid in the last three consecutive financial years.
The FRC believes its revisions will significantly reduce conflicts of interest and put the focus back on providing high-quality audits.
“Where audit fails, that confidence is undermined,” FRC chief executive Sir Jon Thompson said. “The steps we have taken in revising our standards include measures that our stakeholders have identified as important to strengthen their confidence in audit, by ensuring greater independence and a focus on delivering high quality and consistent work.”
The rule changes will certainly see the revenues of the Big Four – KPMG, Deloitte, EY and PwC – take a hit, with these firms set to lose millions. According to the Financial Times, KPMG made £185m in fees from non-audit services provided to audit clients in 2019, making up 8% of its revenues; Deloitte made £195m, which was 6% of its income; PwC made £239m, 6% of its revenues; and EY made £118m, which was 5% of its income.
After decades of toing and froing and dragging its feet, these new standards, which become effective on 15 March 2020, appear to suggest the FRC is ready to show some teeth.
The FRC’s 2018/19 annual report revealed the regulator’s continuous struggle to get a handle over auditors’ poor quality work. It revealed only 75% of audits by FTSE 350 companies required no more than limited improvements – falling short of the FRC’s 90% target.
It also received 28 complaints from a range of parties including investors and fund managers about corporate reporting failings. Fifteen of these related to financial statements reporting issues, including impairment, measurement and valuation issues, and disclosures.
However, this hasn’t stopped the FRC from proudly boasting that previous attempts to clean up the sector in 2016 had seen an 8% fall in non-audit fee income among auditors.
According to the FRC, no audit firm has asked the regulator to waive the non-audit services fee cap in the last three years – describing this as a “positive change”.
The FRC may be proud of this achievement, but a lot of other things have happened in those three years which makes this one positive change seem rather insignificant.
Not least, the FRC has been the subject of three separate commissioned reviews by the government to investigate how the biggest consultancy firms are regulated and why auditing failures keep occurring.
The Brydon Review
In its review in April, the Competition and Markets Authority (CMA) called for the Big Four to be split from their non-audit arms and then recommended the introduction of joint audits to boost competition in the sector.
This was followed by Sir Donald Brydon’s year-long review published in December, which starkly warned that the UK’s audit industry required urgent reform.
Sir Donald, a former chair of the London Stock Exchange Group, argues that the industry can only be salvaged by introducing a standalone, transparent audit profession separate from the wider accounting trade.
“Auditing is too important to be left to an adjunct of another profession: it should be an independent profession in its own right, with its own governing principles, qualifications and standards,” the Brydon review states.
Urging that the sector be governed by a core set of principles established by ARGA, the review also calls for new requirements for auditors to publish the profits they make from audit work.
Senior auditors should also divulge their annual pay, Sir Donald’s review says, although he admits this proposal may not sit well with the industry. However, he points out many other corporate sectors have introduced this policy.
Under Brydon’s recommendations, shareholders would also be able to question auditors at annual company meetings and ask them what steps they have taken to help prevent fraud.
Deloitte’s statement about the Brydon review shows how the big accountancy firms have long sought more clarity from the FRC about what they can and cannot do as auditors.
Stephen Griggs, managing partner of audit and assurance and deputy UK CEO at Deloitte, says the Brydon report sets out a “bold vision of a future corporate reporting system and the very purpose of audit” – with much-needed clarity over the roles of auditors, directors, investors and regulators.
“A consensus around what an audit does and doesn’t do, and whose purpose it serves, has been long overdue,” Griggs says. “These recommendations would settle that debate and go a long way to repairing trust in business, strengthening the audit profession and improving the overall quality of UK financial and corporate reporting.”
The FRC’s response, on the other hand, was rather mixed. While it appeared to welcome the report and said it would “study it with interest”, it added that the recommendations, if accepted by the government, would have significant implications for the FRC in terms of its activities and resource requirements.
“We have already implemented a number of the recommendations of the independent review of the FRC and anticipate being involved in delivering the broader reforms to the UK audit market that the government has initiated,” an FRC spokesperson said.
No doubt, the need for reform is now essential, with the Big Four accountancy companies coming under increased criticism for prioritising profits over proper auditing of firms.
In one of the biggest auditing scandals of recent years, MPs accused the Big Four of “feasting” on the carcass of the now-defunct construction firm Carillion, after the auditors banked £72m for work in the years leading up to its demise.
A government inquiry into the Carillion collapse revealed KPMG had taken £29m in fees for what MPs called a “failing to exercise professional scepticism towards Carillion’s accounting judgements”.
Deloitte, which pocketed £10m for its Carillion auditing work, was exposed for failing in its risk management and financial controls, while EY made £10.8m despite its “failed turnaround advice”.
MPs said this opened the door for PwC to come on board as special managers following the company’s collapse, and effectively “set its price”.
A final report from the Carillion inquiry slammed the auditors, stating they should “be in the dock” for the company’s collapse.
Of course, this is just one failing in a long line of flops by the auditing giants.
For example, EY is currently under investigation over its audit of Thomas Cook – which folded last September leaving 9,000 staff out of work and 150,000 British holidaymakers stranded overseas.
In 2016, PwC was fined a record £10m by the FRC over its poor auditing of BHS, which entered administration in 2016 with debts of £1.3bn and a £571m pension fund deficit. For its part, PwC accepted there were “serious shortcomings with this audit work”.
Auditing practices don’t appear to be any better on the other side of the pond.
According to an inspection last year by America’s foremost auditing regulator, the Public Company Accounting Oversight Board (PCAOB), the Big Four were guilty of botching at least 20% of their audits.
Inspectors at the PCAOB found many of the sample audits performed by the US arms of the Big Four were so bad that the accounting firms had no business issuing opinions based on those audits.
The regulatory body found Deloitte botched 20% of audits examined, PwC botched 23.6%, EY 27.3%, and KPMG a huge 50% of audits.
As Brydon noted himself, it’s clear the current audit framework – which is built on an unstable foundation of formal and informal guidelines developed over a century – is no longer fit for purpose.
The industry and its players must embrace a complete overhaul of the standards to boost confidence in the sector and help prevent needless corporate failings from occurring again.Last Updated: 15 January 2020