AQI 2020: FRC finds a third of audits need improvement

The Financial Reporting Council (FRC) has branded the level of audit quality in the UK’s top seven firms as ‘unacceptable’, after its annual inspection cycle found a third of the audits reviewed needed improvements.

This year’s audit quality inspection (AQI) reports on the seven firms reviewed annually (Deloitte, EY, KPMG, PwC, BDO, Grant Thornton and Mazars) are based on fewer assessments than in previous years because of resource constraints. Across all firms, the FRC completed 130 audit inspections compared to 160 in 2018/19.

The 88 audits reviewed at the seven largest firms represented the lowest number for five years, and around 20 fewer than usual.

Of these overall, 59 (67%) required no more than limited improvements, but the FRC reported: ‘The number of audits requiring more than limited improvements, 29 (33%), remains unacceptable.’

 ‘We acknowledge the steps taken by firms seeking to address the key findings in our 2019 public reports. However, firms are still not consistently achieving the necessary level of audit quality.’

Big Four

Of the Big Four, KPMG is highlighted as having made ‘unsatisfactory’ progress, having been placed under increased scrutiny in the previous inspection cycle.

The FRC reviewed 18 individual audits this year and assessed only 11 (61%) of them as requiring no more than limited improvements. Of the twelve FTSE 350 audits reviewed, only seven (58%) achieved this standard.

The FRC stated: ‘We have seen considerable focus on audit quality at the top of the firm and there have been a number of improvements to the audit practice as a result.

‘However, our inspection results show that high audit quality is not being achieved consistently and this report identifies key areas where the firm must make improvements more quickly.

‘The overall inspection results therefore remain unsatisfactory and we expect the firm to take specific action to address this.’

The FRC said inspection results also remained unsatisfactory at PwC, where it reviewed 17 individual audits and assessed only 11 (65%) as requiring no more than limited improvements. Of the 12 FTSE 350 audits reviewed this year, only eight (67%) achieved this standard.

The regulator said it expects the firm to take specific action to address this, and to inspect a higher number of its audits proportionately in its 2020/21 cycle than at some other firms.

EY’s performance dipped slightly, with the FRC reviewing 14 audits and assessing ten (71%) as requiring no more than limited improvements. Of the nine FTSE 350 audits reviewed this year, seven (78%) achieved this standard.

Deloitte headed the list of audits requiring fewest improvements. Of the 17 individual audits the FRC assessed, 13 (76%) required no more than limited improvements, while of the ten FTSE 350 audits reviewed, nine (90%) achieved this standard, the only one of the Big Four to match the FRC target in this respect.

Mid tier

The FRC’s assessment of the three mid-tier firms in the AQI review suggested some of the Big Four’s closest competitors are having difficulties with audit quality, casting doubt on proposals to open up the audit market by encouraging more of the smaller firms to take on FTSE 350 audits.

The regulator was scathing in its assessment of Grant Thornton’s plans to improve audit quality. Of the nine individual audits reviewed year, only five (55%) required no more than limited improvements.

The FRC said: ‘In response to the very poor audit quality identified in our 2019 report on the firm, GT initiated an audit quality plan which GT refer to as its Audit Investment Plan (AIP) in Spring 2019.

‘We therefore increased our scrutiny of the firm. Due to the timing of the plan, it had not yet had any significant impact on the quality of the audits we reviewed in this inspection cycle.’

However, the FRC went on to state: ‘The overall inspection results remain unacceptable following poor inspection results last year.

‘We continue to have recurring findings that contributed to this year’s inspection results. These include the effectiveness of the audit of revenue and appropriate levels of challenge and scepticism in areas of judgement.’

At BDO, the FRC reviewed eight individual audits this year, including a FTSE 350 audit, and assessed only 62% of them as requiring no more than limited improvements.

Its report stated: ‘The findings that most contributed to the results of those reviews classified as requiring improvements were issues surrounding the audit of revenue, particularly the testing of the accuracy and occurrence of revenue and the quality of substantive analytical procedures.

‘We note that a number of key findings identified in our reviews related to shortcomings in core auditing processes.

‘The firm should take robust action to address our concerns. We will closely monitor and assess the promptness and effectiveness of the firm’s actions to address the findings raised. Should the firm’s response not address our concerns adequately, we will take further action.’

However, the third mid-tier firm included in this year’s cycle, Mazars, scored more highly in the FRC’s assessments.

The FRC reviewed five individual audits this year and assessed four (80%) of them as requiring no more than limited improvements. The regulator said Mazars has made progress in relation to the key findings highlighted in last year’s report with no recurring issues identified.

Its report stated: ‘We also identified good practice in a number of areas of the audits we reviewed (including testing the valuation of insurance technical provisions) and in the firm-wide procedures (including the firm’s audit quality initiatives’ focus on culture and audit team behaviours).’

How the firms stack up 2014/15 - 2019/20 AQI inspections

 

Total audits inspected

Good or limited improvements

Improvements required 

Significant improvement required 

Firm

2019/20

2018/19

2017/18

2016/17

 2015/16

2019/20

2018/19

2017/18

2016/17

2015/16

2019/20

2018/19

2017/18

2016/17

2015/16

2019/20

2018/19

2017/18

2016/17

2015/16

PwC

17

26

28

27

25

11

20

23

25

21

5

4

5

2

4

1

2

0

0

0

Deloitte

17

25

25

23

22

13

21

19

18

18

3

3

6

3

4

1

1

0

2

0

KPMG

18

29

23

23

22

11

22

14

15

14

7

7

8

6

6

0

0

1

2

2

EY

14

18

18

17

20

10

14

12

15

17

3

3

5

2

3

1

1

1

0

0

Grant Thornton

9

8

8

8

7

5

4

6

4

6

2

2

0

1

1

2

2

2

3

0

BDO

8

8

8

8

8

5

7

7

5

4

1

1

1

2

4

2

0

0

1

0

Mazars

5

5

5

5

-

4

3

4

3

-

1

1

1

1

-

0

1

0

1

-

Totals

88

119

115

111

104

59

91

85

85

80

22

21

26

17

22

7

7

4

9

2

Issues overall

In its commentary about all seven firms, the FRC said it continued to find improvements needed in the same three audit areas: impairment of goodwill and intangibles; revenue and contracts; and provisions, including loan loss provisions.

Over the past three years, 76 of the 166 (46%) of the findings driving reviews requiring more than limited improvements have been in these areas. These findings often relate to insufficient challenge of, and standing up to, management in areas of complexity and forward looking judgement.

Other audit areas in which the FRC had findings for more than one firm this year included audit of inventory, group oversight, going concern and investment property valuations.

The FRC said: ‘Firms’ senior management need to be clear that taking difficult decisions is an appropriate response to improving audit quality, even if it might sometimes mean delaying or modifying opinions, and ultimately losing some audit engagements.

‘The tone from the top needs to support a culture of challenge and back auditors making tough decisions.’

In response to its findings, the FRC said it is initiating a number of significant changes to improve audit quality, which include increasing the focus on proactive supervision of the large audit firms. This will involve identifying priority areas to improve audit quality, requesting the firms to implement suitable actions to achieve them and hold the firms accountable for delivery.

From next year, the FRC intends to publish the scope and key findings of each of its individual audit inspections, where it has the consent of the audit firm and the audited entity, alongside the annual reports on each of the largest audit firms.

The regulator also plans to increase its AQR team in order to carry out more inspections, aiming for overall target of 145-165 inspections for 2020/21.

In addition, the FRC says it will continue to focus on higher risk audits, saying that this year 42 of the 108 inspections (39%), excluding public sector reviews, were higher risk compared to 32% in the previous year. These are defined as those where the group or entity is in a high-risk sector or geography; is experiencing financial difficulties; has balances with high estimation uncertainty; or where the auditor has identified governance or internal control weaknesses.

Of the audits that required more than limited improvement this year, the FRC had identified almost half as higher risk. This year 40% (47% last year) of the audits identified as higher risk were assessed as requiring improvement, compared with 27% (13% last year) of audits not identified as higher risk.

This year’s sector focus was on financial services, general retailers, business support services, construction and materials, and retail property

Areas of focus were going concern and the viability statement, the other information in the annual report, long-term contracts, the impairment of assets and fraud risk assessment.

Vernon Soare, ICAEW chief operating officer, said: 'We are disappointed by the overall results, and support efforts to drive up standards across the largest firms

'We agree that robust professional scepticism is vital to delivering high quality audits, however recent events have reinforced the need  for a broad focus on internal controls, fraud and viability, which are critical  to assessing whether a business is honestly run and has a future.

'Audit committees also have an important role to play in challenging management, in addition to selecting auditors who will do the same, as the BEIS select committee has highlighted.

'It is absolutely right to inspect the work of audit firms and hold them to account. Robust regulation is key to restoring trust in audit, and we urge the government to establish ARGA, the new regulator, at the earliest opportunity.'

The FRC’s audit firm specific reports

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