In the Financial Reporting Council’s (FRC) latest set of audit quality inspection reports for 2016/17, covering 106 audit inspections, nearly a quarter (23%) of audits fell below standard, with eight audits flagged as requiring ‘significant improvements’ and 16 ‘improvements’. This is a significant improvement on 2014/15 when 42% of audits were sub-standard. The overall figures this year were pulled down by particularly poor audit inspections at companies outside the FTSE 350.

There has been a slight improvement in the overall quality of audit reporting over the last 12 months with four out of five audits achieving a grading of ‘good’ or ‘limited improvements’ required. One in four audits still require significant improvement and this number is up year on year from two to eight audits, with the only two firms avoiding being flagged in this category were PwC and EY. Only one firm, PwC, exceeded the FRC quality target of 90%, with 93% of inspected audits falling into the top two bands. The majority of audits which fell into the lower categories were for audits of companies outside the FTSE 350, the FRC said.

The FRC still resists publishing an actual breakdown of the results showing how many audits achieve the highest rating. This means it is difficult to conclusively review the improvement in overall performance.

Audits rated as good or requiring limited improvements 2016/17 (2015/16)

1. PwC 93% (84%)
2. EY 88% (85%)
3. Deloitte 78% (82%)
4. KPMG 65% (64%)
5. BDO 63% (50%)
6. Grant Thornton 50% (86%)

Note: % of audits ranked in band 1 or band 2A

Mike Suffield, director of audit quality at the Financial Reporting Council (FRC), who is in charge of the audit inspection cycle, told CCH Daily: ‘We publish across three different bands. It’s a balanced picture and it’s important to see that audit quality has improved significantly since 2014/15. Firms are making good progress towards the target of 90% which we have set them.

‘But it is important to note that outside the FTSE 350 the numbers are slightly less positive. It is a little difficult to draw a significant conclusion but outside the FTSE 350, these are often more challenging audits, there are not the levels of control in place or the resources which you would have at a FTSE company. This makes the audits much more difficult.’

The audit regulator does not provide a breakdown of how many audits are rated as ‘Good’ as opposed to ‘Limited improvements’ required, which makes it difficult to analyse the findings in depth.

It is always keen to stress that the annual audit reports provide a snapshot of audit quality as the company audits inspected change each year and are not wholly comparable. As the only benchmark for audit quality in the UK they are of significant importance.

On plans to publish a detailed breakdown, Suffield said: ‘I think it is something that we need to think more carefully about. Like all regulators, we’re always looking at how we can report continuous improvement.’

The FRC will be publishing more detailed information about the audit inspection results for companies outside the FTSE 350 next month [July].

Individual firms are each are given a complete breakdown of the firm’s individual results with specific bandings and details of the companies inspected.

Improvement required

Although the overall standard of audit quality has improved, Suffield said: ‘There are headline concerns about the continuing challenge of scepticism, asset impairment across the pitch and high risk areas of revenue recognition, which we continue to see across the firms.’

‘We are very keen that firms learn from good practice. It is really, really important that the firms invest time in learning what has gone wrong and what is going really well. My impression from talking to firms is that they do take our findings really seriously,’ Suffield added.

Ethics failures

There are concerns that failures around ethics reporting and transparency are inherently a cultural issue and need to be addressed. A revised Ethical Standard was introduced by the FRC in April 2016, but once again this year inspectors noted problems with conflict of interest and lack of adherence to the highest ethical standards at some firms.

The introduction of a revised Ethical Standard should not have been a factor for firms and was not seen as the reason that ethics standards were still flagged at a number of firms. ‘There is not a massive learning curve on the Ethical Standard, it is more the reporting practicalities,’ Suffield said.

‘It is worth noting that all the firms are looking at how they implement the new Ethical Standards.’

Revenue recognition

Once again this year, problems around revenue recognition reporting were flagged as a high risk area. ‘On revenue recognition there are challenges around substantive analytic reviews and assurance around audit data. It is not peculiar to this year and we are looking to the firms to review their audit processes. It makes it even more challenging with the introduction of IFRS 15 [Revenue from Contracts with Customers].

Audit committees

The annual AQI reports also highlight ongoing concerns with a lack of communication with audit committees, with all the firms being pulled up over their failures to engage with the key governance board at client firms, with instances of failures to submit written reports to a widespread lack of regular dialogue. The FRC called on firms to ‘challenge management in key areas involving judgment, such as impairment reviews, asset valuations and provisions’.

‘On audit committees, we’ve found some good things, and some not so good things. We are highlighting the key issues – there are instances where there is a lack of detail and audit committees are not given updates. As the AQR team we are engaging with more audit committee chairs and meeting with them to find out what they want; they have a great responsibility.’

Audit quality inspection reports 2016/17 year on year comparison by firm

FRC AQI rating system                                                                                                                                                  

Category - assessment                                                                                                                                                 

• 1              Good                                                                                                                                                    
• 2A           Limited improvements required                                                                                                                              
• 2B           Improvements required                                                                                                                                              
• 3              Significant improvements required

It is the first year Suffield has led the AQI team after he joined the FRC as director of audit quality  in July 2016. He leads the FRC’s Audit Quality Review (AQR) team in its work to monitor the quality of UK audits of public interest and large AIM entities. He is a qualified chartered accountant, who trained at Coopers & Lybrand (now PwC) and joined the regulator from the National Audit Office where he was lead director and joint head of the compliance and quality unit with responsibility for audit quality arrangements where he worked since 1995.

AQI reports by individual firm

Read analysis of AQI reports for Pwc, Deloitte, KPMG, EY, Grant Thornton and BDO

Report by Sara White