Although 65% of inspected audits at KPMG were given a band 1 or band 2A rating, this is the second year running that KPMG has faced criticism from Financial Reporting Council (FRC) inspectors with 35% of inspected audits falling below standard. Two audits were singled out as needing ‘significant improvements’, while six were flagged as ‘improvements required’.

On one audit, flagged for significant improvement, the AQI inspectors identified weaknesses in the audit approach adopted for goodwill impairment, including insufficient professional scepticism and challenge of management’s assessment; and insufficient evidence of involvement by the group team in the auditor’s work relating to a material acquisition. On the second audit, there was insufficient evidence of an appropriate risk assessment and response in respect of material supplier income.

Quality improvement plan at KPMG

After two years of tough audit inspections, KPMG is mid-way through a major investment into its audit practice, with guidance and training, an audit quality programme and better integration of the firm’s values and culture into its appraisals process feedback. With new leadership at the top of the firm under Bill Michael with a strong financial services audit background, from October, it is expected that the firm will refocus more on its core strengths, including audit.

In the AQI report KPMG outlined more detail on this, stating that 'following the AQR report issued in May 2016 we undertook a comprehensive review of our methods and processes to identify additional improvement actions. This was distilled into a multi-faceted and holistic quality improvement plan (QIP) that was launched in October 2016'.

The QIP plan ‘focuses on the mind-set of our teams as well as their technical capabilities’, adding, ‘we are driving greater consistency between our teams in the way that we approach specific aspects of audits and the way findings are evidenced. This represents a change from our previous philosophy that encouraged all teams to exercise their professional judgment in all aspects of their audit approach’.

The latest inspection does not reflect the full impact of these changes, KPMG said, since ‘the “lag” effect means that this plan did not impact any of the engagements covered by this review cycle’. The current AQI cycle is reviewing annual audits for year end 2015.

Challenging management and auditor independence

The inspectors cited a number of areas which require immediate action, including improvements to the scope of challenge to management in relation to areas of judgment, in particular concerning impairment reviews, loan loss provisions and other valuations. As with other Big Four firms, revenue recognition was highlighted as a serious concern and the FRC said KPMG needs to reassess its approach to the audit of revenue and the related training provided.

On a more fundamental level, it also needed to improve the accuracy or precision of the description of audit procedures performed in auditors’ reports. It cited instances where testing of inventory was described as ‘data analytics’ without substantiation, which FRC claimed ‘may have over-stated the work performed’.

A lack of robust challenge of management was cited as an ongoing concern with a failure to question the management of client companies more forensically about internal assumptions.

The inspectors found that audit teams did not adequately demonstrate their critical assessment of valuation assumptions or methodology relating to investments and inventory; insufficient challenge of management’s assumptions in relation to the impairment of goodwill and other intangibles, with undue reliance placed on evidence which supported management’s assumptions/ position, as well as failing to put in place adequate procedures to corroborate certain of the loss provision inputs used.

Lack of scepticism

In line with wider FRC concerns about a lack of scepticism, AQI inspectors said: ‘The work performed did not demonstrate sufficient scepticism and challenge of management regarding the appropriateness of the [loan loss] provisions’. There were similar concerns about reporting and identification of intangibles, which are more judgmental decisions and are open to interpretation.

On the plus side, FRC commended KPMG’s high quality of work around the design and direction of the component auditors’ work around significant risk issues, and the use of detailed testing and IT controls work related to the valuation of financial instruments in two financial services audits.

In its defence, KPMG said: ‘The primary root cause identified… is the failure to adequately evidence all elements of the thought process and the basis for the decisions made. Going forward, we will drive more consistent approaches from our teams and ensure their findings are evidenced using mandatory templates. Where practical, consistency will be achieved using data analysis tools which we have already developed.’

Revenue recognition

On revenue recognition, a major area of concern for the FRC inspectors particularly with the imminent release of IFRS 15 Revenue from Contract with Customers, KPMG was pulled up over insufficient revenue testing on certain audits, and problems with testing of system-generated interest income.

Following ongoing criticisms of the firm’s approach to treatment of revenue recognition, KPMG has reviewed the use of Substantive Analytical Procedures (SAPs) in the audit of revenue and is ‘now significantly restricting their use except where revenue flows are highly predictable’.

Over the last year, the firm has addressed a number of fundamental issues identified in earlier annual inspections and has allocated more resources to audit, with training being a cornerstone of the firm’s approach.

It is also worth noting that unlike the other firms inspected in this cycle, KPMG has not been singled out for criticism over compliance with the new FRC Ethics Standard, introduced last year, which has tripped up a number of audit firms who have failed to get to grips with the new reporting rules.

Despite fairly robust criticism of its failure to challenge management, on the whole its communications with audit committees met FRC expectations, although KPMG was told to ‘improve the accuracy or precision of the description of audit procedures in auditors’ reports’, with calls for more transparency about the presentation of risks and explanations to help the users of financial statements interpret the information.

KPMG head of audit Adrian Stone told Accountancy: ‘We are fully committed to the delivery of high quality audits and value the importance of the regulator to the profession, business and society.

‘Our people are passionate about audit. We all recognise the effort the FRC has made to raise the bar in audit quality and we will continue to strive to exceed their expectations. That is why we are disappointed to have two engagements assessed by the AQR as needing significant improvement.

‘We are pleased that the AQR has identified areas of good practice in our work however given our aspiration to consistently deliver high quality audits, our focus is on areas where the FRC believes we can improve further. These learnings, combined with our ongoing investment in our people and technology, will see us continue to drive towards the consistently high levels of audit quality both we and the FRC aspire to achieve.’

KPMG audited 466 UK entities within the scope of independent inspection as at 31 December 2015. Of these entities, our records show that 280 had securities listed on the main market of the London Stock Exchange, including 26 FTSE 100 and 54 FTSE 250 companies.

Full AQI 2016/17 reports

Read the full KPMG AQI report:  kpmg_llp_-_audit_quality_inspection.pdf.

Report by Sara White