AQI 2019: KPMG auditors fail to challenge management

KPMG has started to turn around its audit business with an improvement in the quality of audits reviewed in the 2018/19 audit quality inspection (AQI) reports, although inspectors criticised a lack of management challenge and quality control, reports Sara White

In a substantial improvement on last year’s audit quality inspection (AQI) reports by the Financial Reporting Council (FRC), the latest sample of 29 FTSE 350 audits found that 76% (22 total) of the firm’s audits required no more than limited improvements, compared with 61% in 2017/18. Of the FTSE 350 audits reviewed this year, 80% achieved this standard compared with 50% in 2017/18.

For the first time in five years, no KPMG audits were marked down with a ‘3’, the rating where significant improvement is required, a sign that KPMG is beginning to show signs of restoring its audit credentials. However, the firm’s overall audit review rating is still well below the regulator’s expectations of a 90% pass rate. It is also facing a number of FRC enforcement investigations, including for outsourcer Carillion, which went into liquidation in January 2018.

However, although the results have improved since last year, the FRC warned that ‘this was from a low base and below our target for FTSE 350 audits. The firm still has more to do to reach a consistently acceptable standard and ensure that the improvement is sustainable’.

The FRC said it was watching developments closely at the firm as there were still some fundamental problems although ‘it had seen an improvement in relation to most of the key findings highlighted in last year’s report’. It added that it would take time for the Big Four firm to overhaul its audit practice, as ‘the firm’s quality control procedures have not been sufficiently effective to achieve the necessary improvement in audit quality’.

The Big Four firm has made improvements to its audit quality but along with other firms was failing to challenge manage robustly, often relying too much on company estimates and assumptions, rather than probing the numbers with an independent, sceptical eye. FRC said that KPMG needed to ‘improve the consideration and challenge of management’s estimation of provisions’.

On one audit, for example, there was insufficient verification and challenge of management adjustments when the company had increased the estimated cash flow forecasts, partly due to an expectation that recently declining profitability would return to historical levels and growth rates. The firm failed to question this for example.

One of the main concerns related to financial services institutions, where the FRC was critical of the quality of audit of the valuation of financial instruments and loan loss provisions. It also flagged the need for improvements in the consideration and challenge of cashflow forecast assumptions in relation to the impairment of goodwill, and a lack of challenge of management’s estimation of provisions.

The audit of fair value instruments at financial entities was also problematic, FRC said, with aspects of the audit procedures performed to test fair values (or the evidence thereof) raising concerns with an insufficient focus on the fundamental issues, including testing of management methodologies and assumptions relating to certain valuation models, poor risk assessment of portfolios, and too much reliance on management statements when auditing valuations of certain private equity and other investments.

Loan loss provisions

Another area of concern was the audit of loan loss provisions for those financial services entities where the provisions were identified as a significant risk. The FRC identified issues in the testing and challenge of models and assumptions for collective provisions and the assessment of specific loans, with weaknesses in the quality control procedures and a lack of management challenge.

Loan loss provisioning involves significant management judgement and estimation uncertainty. Provisions for loans are calculated either on a specific basis, when individually impaired, or on a collective basis, usually based on management models. Auditors should perform sufficient procedures to corroborate and challenge the models’ key inputs and assumptions, in order to support their conclusions.

Cash flow forecasting

While the audit work in this area was often performed to an acceptable standard, on two audits there was insufficient consideration and challenge of management’s short-term cash flow forecasts used in the impairment models. This was a particular issue when auditors had to assess the achievability of estimated cost savings.

Due to the complexity of this type of audit, the firm has started to include restructuring specialists on teams where goodwill impairment considerations relied heavily on cost saving initiatives.

KPMG implemented an internal audit quality plan in 2017 to improve the quality of audit at the firm, which was spearheaded by the incoming chair Bill Michael.

So far, this has shown some results but the FRC said that ‘while actions have been taken in relation to our key findings during 2018, we require the plan to focus more on improving the quality of financial services audits and the robust challenge of management going forward. We will monitor whether the plan remains sufficient to achieve the necessary improvements to audit quality’.

In terms of overall quality the FRC noted improvements to KPMG’s group audits and assessment of going concern met the standards expected. The extent and quality of evidencing of the group audit team’s involvement and review of work performed by component audit teams was good, while there were well-evidenced risk assessment and scoping of procedures at a component level.

Firm’s response

In May this year, KPMG UK managing partner Bill Michael announced significant changes to the firm’s executive governance structure, including setting up a new audit executive committee and reshaping its executive leadership team.

A priority for the firm is to standardise the audit approach, expand the review team, and support and coach audit teams, to improve the overall quality of audits. Over the next year, the firm also plans to expand the financial services team, following issues raised by the FRC inspectors.

Jon Holt, head of audit at KPMG UK told Accountancy Daily: ‘Audit quality is our number one priority, and we are pleased to see we’re making good progress, achieving a 30 percentage point rise in our audit quality scores for FTSE 350 audits, as assessed by the FRC. Through our Audit Quality Transformation Plan, we are continuing to invest heavily in our audit teams and the processes and technology which support their work.

‘In the last 12 months, we have hired an additional 750 experienced auditors and more than 1,000 graduates and apprentices into our audit practice alone, our largest-ever recruitment drive. We have conducted almost 300,000 hours of training through our Audit University, introduced new technology which has enhanced the way we check data, and strengthened the processes our auditors follow.

‘As a firm we have introduced far-reaching reforms, which demonstrate how serious we are about rebuilding trust in our profession and the excellence and independence of our audit practice. We were the first to change our structure to create a separate audit governance committee, which is solely focused on the performance management of our audit business. We have also voluntarily implemented a ban on the provision of non-audit services to the FTSE 350 companies we audit.

‘It is clear there is a public desire to see fundamental change in our sector and we are absolutely committed to driving continuous improvement in our audit business. We welcome the new targets set by the FRC, including the addition of a zero-tolerance approach to audits rated 3. It is vital that we, together with our competitors, strive to meet the high standards rightly expected of us.’

KPMG has 549 audits within the scope of FRC's AQR inspection, including 26 FTSE 100 and 51 FTSE 250 audits.

Report by Sara White

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