The Financial Reporting Council (FRC) has singled out KPMG’s audit work for increased scrutiny over the next year, after identifying an ‘unacceptable deterioration in quality’ in its latest annual quality inspection (AQI), with half of the firm’s FTSE 350 audits judged in need of improvements and strong criticism of the level of management challenge, lack of professional scepticism, and inconsistencies in audit practice
In total, the FRC inspected 24 audits at KPMG, which has recently been fined £4.5m by the regulator over failings in its 2013 audit of Quindell and is currently under investigation over its auditing of the collapsed outsourcer Carillion.
Overall, 61% of the firm’s audits were assessed as requiring no more than limited improvements, down from 65% in 2016/17. Of the FTSE 350 audits, 50% required improvements compared to 35% the previous year, with seven needing some improvement and one requiring significant improvement.
This compares with the FRC’s target that at least 90% of these audits should meet this standard by 2018/19, with the regulator noting that ‘there is substantially more for the firm to do to achieve this.’
The report states: ‘The overall quality of the audits inspected in the year, and indeed the decline in quality over the past five years, is unacceptable and reflects badly on the action taken by the
previous leadership, not just on the performance of front line teams.
‘Whilst we have seen improvements in certain areas where we have raised findings in previous years (for example, the audit of revenue), we are concerned that previous changes to the firm’s policies and procedures have not brought about the improvements required to the overall quality of audits we have reviewed.’
The FRC has decided to increase by 25% the number of KPMG audits it plans to inspect in 2018/19 and says it will also be monitoring closely the implementation of the firm’s audit quality plan.
The FRC identified issues in relation to audit challenge in judgemental areas on the majority of the KPMG audits reviewed, and said the firm needed to ensure greater consistency in this area. As in previous inspections, the key concerns were the audit of valuations, loan loss and other provisions, impairment reviews of goodwill and long-term contracts.
The concerns related primarily to the extent and rigour of audit teams’ challenge of management and whether they were sufficiently sceptical. On a significant proportion of the audits insufficient procedures were performed over one or more key assumptions or inputs, including challenging the reasonableness of the assumption/input.
The FRC also reported insufficient scepticism where historic trends appeared not to support the provision recorded or where there were differing opinions supporting a range of possible outcomes, together with insufficient procedures performed to support collateral values, a key assumption in the loan loss provision calculations.
Other concerns arose in relation to insufficient challenge of a management policy and, separately, forecasts. In one case, where management had assumed improved forecasts and cost savings, the audit team did not sufficiently challenge the plans and their likely success.
The FRC said KPMG needed to strengthen the involvement of the group audit team in component audits, saying its assessment had identified instances where oversight of areas of significant audit risk was inadequate. In particular, there were examples of insufficient evidence of the group team’s direction and supervision of the work of component teams and a failure to evaluate the sufficiency and appropriateness of audit evidence and reporting.
The FRC also had concerns over scoping, saying only limited procedures had been used in one audit where significant risks existed, while there was a lack of additional procedures in one case where a quality issue had been identified and in another where a non-network firm was involved.
Pension scheme assets
The FRC said KPMG had taken action on criticisms of the level of audit work required over pension asset values raised in its previous AQI report, and as a result there was a drop in the number of pension-related issues identified.
However, this year’s report stated: ‘We considered pensions as an area of focus in a large proportion of the audits we inspected and found inconsistent audit approaches leading to a number of concerns.’
These included insufficient testing of harder-to-value investments and assets across different investment managers; insufficient evidence over mortality assumptions; and insufficient evidence of challenge of the appropriateness of assumptions used, in particular where all were at the ‘optimistic’ end of KPMG’s acceptable range.
The FRC flagged up concerns about how KPMG handled the management review process in long-term contracts, an area where the firm faced criticism during the select committee inquiry into the events leading up to the collapse of Carillion at the beginning of this year.
The regulator said its findings arose on five audits and were largely related to the lack of audit evidence to demonstrate the operating effectiveness of management review. In particular, the FRC criticised the extent and/or effectiveness of KPMG’s challenge and the appropriateness of follow-up actions and the completeness and accuracy of contract data.
In a number of these cases, insufficient audit procedures were performed over the allocation of costs and in one case, the management review only considered key contracts and therefore did not cover the full population.
KPMG has issued supplementary, mandatory guidance to audit teams covering the review of management review controls, and the FRC says it expects the firm to monitor the successful
implementation of both the templates and audit guidance.
Other issues picked up by the FRC as driving lower audit quality assessments on individual audits included weaknesses in the firm’s quality control procedures (in particular, the audit engagement partner and engagement quality control review partner not identifying errors in the audit working papers) and insufficient procedures performed over revenue recognition for a significant component.
KPMG’s response, included in the AQI report, stated: ‘We recognise that the actions we have taken in previous years have not resulted in the necessary step change in improvement to audit quality which we had envisaged. We cannot, and will not, be satisfied with this and, as a firm, are committed to putting it right.’
The firm said that Bill Michael, who took over as chair in July 2017, ‘recognised that previous actions were not delivering change sufficiently quickly or consistently’, and has introduced a transformation programme to develop ‘a more structured and standardised approach and greater central command and control through increased oversight’.
This includes an expanded audit centre of excellence, greater support and challenge to engagement teams through an expansion of its 2nd Line of Defence (2LD) support team, more use of technology, and increased central monitoring of audits.
KPMG stated: ‘We are changing our core processes relating to recruitment and people development
alongside our client acceptance processes to ensure we only perform engagements where we have the right capacity to deliver them to the highest standards.’
Experienced auditors with three or more years’ experience will be required to attend an
additional mandatory three day training programme during 2018 on KPMG’s new approach to audit delivery, with regular updates subsequently, while candidates for senior promotions will need to have performed a role in an area ensuring audit quality, such as the audit centre of excellence, as part of their progression to partner.
Michelle Hinchliffe, head of audit at KPMG, said: ‘We are disappointed that our overall audit quality score has decreased by four per cent and that the steps taken in previous years have not resulted in the necessary improvements to audit quality. We are taking action to resolve this. We want all of our audits, regardless of size, to meet the highest standards set by the AQR.
‘It is important to note that the audit work appraised by the FRC for its 2018 AQR took place principally in respect of 2016 year ends, prior to commencement of this work. We cannot and will not be satisfied with these results and, as a firm, we are already working to put this right.’