FRC fines fall in favour of ‘constructive engagement’

There has been a steep fall in the financial penalties levied on accounting firms and auditors over the past year, down from £32m to £11.3m, with the Financial Reporting Council (FRC) making greater use of constructive engagement to address issues regarding poor work or breaches of standards

The watchdog’s second annual enforcement review (AER) shows it levied financial sanctions of £16.5m during 2019/20, discounted for early settlement and cooperation to £11.3m.  This compares with a record £42.9m of fines the previous year, which was discounted to £32m. 

The report highlights the FRC’s use of constructive engagement and the wider deployment of tailored non-financial sanctions, with the regulator saying this approach is intended to secure cultural changes at firms, as part of its bid to drive up audit quality.

During the last year, the case examination team opened 88 cases, a 91% increase on the previous year’s 46 cases. 

Recurring themes in concluded cases were a failure to obtain sufficient appropriate audit evidence and failure to exercise professional scepticism. In order to understand the underlying reasons for these common failures, the FRC analysed its enforcement investigations in audit cases over the past six years and identified six key themes.

These are insufficient involvement of the audit partner and over-delegation to junior members of the team; disorganised audit work; failure to step back and take an overall look at the financial picture; the auditor being too close to management; failure to involve the audit quality assurance partner; and the use of auditors’ experts and specialists.

In the report’s forward, Elizabeth Barrett, FRC executive counsel and executive director of enforcement, said: ‘Failure to exercise professional scepticism is an ongoing issue. Reasons for this include auditors being too close to management and creating risks to objectivity and insufficient escalation to and involvement of the audit partner leading to a failure to appreciate the significance of issues in the context of the audit as a whole.

‘Given the detrimental impact those failings can have on investors and wider society it is in everyone’s interest that where standards are not met or ethical failures occur, they are addressed and rectified.

‘Our message to firms last year was to identify, remediate and report.

‘Whilst we have seen examples of good behaviours, it is disappointing that, overall, the response has been mixed. We look forward next year to highlighting firms that have demonstrated their commitment to this approach.’

Constructive engagement

The case examination team received almost double the number of complaints and whistleblowing disclosures compared to the previous year, while the number arising from professional bodies and from audit firms remained steady. Similar to last year, the majority of cases opened were audit-related matters (89.8% compared to 87%).

It successfully resolved 31 cases through constructive engagement. 

Over three quarters of these involved errors in financial statements which led to subsequent restatements. These cases were predominately those where the errors appeared unlikely to have had a real impact on decisions taken by users of the financial statements.

For example, the errors may have been only marginally material in a quantitative sense and they may have been in highly technical areas of the financial statements or in areas that were not of fundamental importance to the measurement of the underlying financial performance of the entity.

The most common root cause of the allegations was insufficient audit testing. In 22 cases there was a failure to identify a material error in the primary financial statements, often in an area not regarded as a significant risk or area of audit focus, for example accounting for reserves, or deferred tax.

Other issues identified were a failure to challenge or document the challenge to management’s accounting treatment (seven cases); and insufficient technical knowledge within the audit team (two cases).

In 27 of these 31 cases, bespoke remedial actions were agreed with the firms, usually on a firm-wide basis but in some cases specific to a particular audit.

The FRC says it has deployed a wide range of significant non-financial sanctions, including the creation of an ethics board at a Big Six firm, mandated improvements to policies and procedures, the requirement for firm-wide training, the monitoring of regional offices, two undertakings to suspend accountancy membership and a lifetime prohibition on signing audit reports.

Timeliness

The FRC review shows 83 cases were closed in the year, an increase of 30, or 56.6%, on the previous year and relatively in line with the increase in number of cases opened.

The average time taken to conclude the constructive engagement cases was under eight months.

Overall the FRC reported the centage of investigations completed within its target of two years has increased from 35% to 44%, and said timeliness remains a key priority and that increased resourcing in the enforcement division, which grew by 14% over the course of the year, is beginning to have a real impact.

 Barrett said: ‘Given the detrimental impact audit failure can have on investor and wider stakeholder confidence it is critical that when audit standards are not met or ethical failures occur, they are identified and rectified.

‘This year’s AER shows an increased use of constructive engagement, to provide a timely and proportionate way of addressing deficiencies and the wider deployment of non-financial sanctions to drive audit quality.

‘The overall results for the year also reflect the impact of a larger and more effective enforcement division.’

FRC’s Annual Enforcement Review 2020

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