The Financial Reporting Council (FRC) has issued a major revision of the ethical standard for auditors banning them from providing most non-audit services to listed company clients to reduce conflicts of interest
In future, auditors of public interest entities (PIEs) will only be able to provide additional services directly linked to the audit.
The previous list of prohibited non-audit services has been replaced with a much shorter list of permitted services, all of which are ‘closely related’ to an audit or required by law and/or regulation. No other services can be provided.
The move comes as part of measures to improvve auditor independence and prevent conflicts of interest and were the result of public and political outcry over the role of auditors in the collapse of companies such as Carillion and Patisserie Valerie.
The FRC says this will dramatically reduce the risk of a damaging conflict of interest, where the commercial interests of an auditor are perceived to be the most important factor in an audit relationship, rather than a focus on high quality audit.
Under the revised standard, auditors of the biggest listed companies will be banned from providing recruitment and remuneration services or playing any part in management decision making.
The standard states that ‘it is not possible to specify all types of decision that are the responsibility of management, but they typically involve leading and directing the entity, including making significant judgments and taking decisions regarding the acquisition, deployment and control of human, financial, physical and intangible resources.’
There is a cap on the total fees for non-audit services provided to the audited entity and its controlled undertakings, limited to no more than 70% of the average of the audit fees paid in the last three consecutive financial years.
The guidance sets out a prescribed list of those activities which can be listed as ‘audit related services’.
These are reporting required by law or regulation to be provided by an auditor; reviews of interim financial information; reporting on regulatory returns; reporting to a regulator on client assets, reporting on government grants; reporting on internal financial controls when required by law or regulation; and extended audit work that is authorised by those charged with governance performed on financial information, and/or financial controls where this work is integrated with the audit work and is performed on the same principal terms and conditions.
The ‘overarching principle’ in determining whether each engagement meets ethical standards is that ‘the firm and each covered person is free from conditions and relationships which would make it probable that an objective, reasonable and informed third party would conclude the independence of the firm or any covered person is compromised.’
Each firm should have an ethics partner, with a direct reporting line to the board. The standard details what kinds of controls and procedures a firm should have, and what action should be taken in the event of a breach of standards. It also considers how firms should communicate with clients about independence issues on long term or repeat engagements.
The guidance states: ‘Where it is expected that the total fees for services receivable from a non-listed entity, that is not a public interest entity, and its subsidiaries relevant to a recurring engagement will regularly exceed 10% of the annual fee income of the firm or the part of the firm by reference to which the engagement partner’s profit share is calculated, but will not regularly exceed 15%, the engagement partner shall disclose that expectation to the ethics partner/function and to those charged with governance of the entity and the firm shall arrange an external independent quality control review of the engagement to be undertaken, before the firm’s report is finalised.’
Audit firms are required to ensure that a primary criterion for evaluating the performance or promotion of members of the engagement team is how they have contributed to the quality of engagements undertaken, and do not include success in selling non-audit / additional services to the entity.
Sir Jon Thompson, the FRC’s chief executive, said: ‘High quality audit supports the effective functioning of capital markets and gives investors confidence.
‘Where audit fails, that confidence is undermined. The steps we have taken in revising our standards include measures which our stakeholders have identified as important to strengthen their confidence in audit, by ensuring greater independence and a focus on delivering high quality and consistent work.’
The regulator said the revised ethical standard has been simplified and made clearer to use, and the revised auditing standards include additional application guidance to make clear how an auditor should respond to requirements.
In its consultation, the FRC also considered whether further entities should be subject to the more stringent non-audit services requirements for public interest entities, which received widespread support.
However, a decision on expanding which entities will follow these requirements has been deferred until early in the New Year after Sir Donald Brydon has issued his report on his review of the audit market, to ensure a consistent approach.
The changes to the ethical standard and revised auditing standards were the subject of a consultation over the summer.
FRC Revised Ethical Standard 2019 issued 17 Dec 2019