FRC plans £1m additional funds to monitor audit firms, says McLaren

Harsher penalties for poor audit work and tougher monitoring by the Financial Reporting Council (FRC) is necessary given the current lack of confidence in the audit profession. Philip Smith talks to Melanie McLaren, FRC executive director of audit, about the tougher approach

The Financial Reporting Council (FRC) plans to beef up monitoring activity of the six largest accounting firms in the UK and introduce a harsher penalty regime for audit failure with the risk of £10m fines for worst examples of audit failure, from June 2018.

The move will see the accounting watchdog adopt a far more rigorous approach to the way it reviews work carried out by the firms – BDO, Deloitte, Grant Thornton, EY, KPMG and PwC – while increasing fines to £10m or more for ‘seriously poor’ audit work.

But the regulator’s powers will be limited as although it is the competent authority overseeing the audit firms, it will have to rely on the firms’ cooperation in addressing any concerns as a result of the reviews.

In the first year of operation, the FRC expects to increase the budget for its monitoring by £500,0000, and this will double to £1m from June 2019. The regulator’s plan is to hire four staff members to work on the new monitoring activity plus administrative support.

‘It is a step change, but a necessary step change given the concentration and systemic importance of these firms,’ said Melanie McLaren, FRC executive director of audit. ‘On careful review of the responsibilities of the competent authority for audit we feel we are under an obligation to make this step change.’

McLaren added that for over a decade the FRC had been inspecting individual audit engagements and the procedures that the firms have in place to support audit quality as required under audit standards, such as independence and ethics checks. ‘What is new is that we will now look at wider procedures within the firms, with a focus on their business models, their profitability, their governance, leadership and risk management,’ McLaren said. ‘There may be supervisory actions that we may want to take or oblige the firms to take, but the first steps will be to gather evidence and make assessments.’

Senior appointments

The reviews will include monitoring senior appointments at the firms, though the FRC would not have the power to veto appointments and will have to rely on a ‘gentleman’s agreement’ that firms will listen to its concerns.

‘We have been engaging with the firms as we have been designing this approach, and there has not been any resistance or defensiveness,’ McLaren said. ‘All of the firms, like us, are very conscious of the current environment that the audit profession is facing.’

However, McLaren pointed to the powers that are available to the regulator if firms are not cooperative, such as audit firm registration, which is delegated to the professional bodies such as ICAEW. ‘We could put a condition on registration, or refer matters to a formal investigation,’ she said.

McLaren argued the moves to monitor the nature and level of risks in the audit firms recognised the systemic importance of these firms. ‘From our point of view, the driver for these changes is that, in law, we have the responsibility to look at the risks for the public interest entity audit market, including the risks that could arise from the demise of an audit firm. It is not a “too big to fail” regime but we have to be clear that the capital markets are depending on these firms for their assurance, and if one were to suffer a demise through a hit to reputation or quality, then confidence in the capital markets might dissipate.’

Sanctions

The announcements came against a background of corporate collapses such as outsourcer Carillion, increasing fines for audit failure and calls from the regulator itself for the Competition and Markets Authority (CMA) to re-open its investigation of the larger company audit market. The FRC launched an investigation into KPMG over its role at Carillion in January this year, adding to the investigation of the firm’s role in the preparation of financial statements made by Rolls-Royce launched last year.

Deloitte is currently under investigation over its work at MITIE, while PwC is also facing a probe in the wake of the accounting scandal in BT’s Italian subsidiary and misstated accounts at Redcentric. Grant Thornton is facing an investigation over its work at Sports Direct relating to a deal struck between the sportswear retailer and a delivery company owned by Sports Direct founder Mike Ashley’s brother.

PwC landed a record £5.1m fine for the RSM Tenon audit, and another £5m for failures over Connaught, while Deloitte was given a £4m fine for Aero Inventory audit failures and Grant Thornton a £2.2m fine for AssetCo.

The FRC’s new sanctions regime, which begins on 1 June 2018, will allow tribunals to hand out fines of £10m or more for seriously poor audit work.

Last year, an independent Clarke review of sanctions, led by Court of Appeal judge Sir Christopher Clarke, recommended the £10m penalty following criticism that fines were not punitive enough for the Big Four.

About the author

Philip Smith is contributing editor of Accountancy and a specialist audit, business and accounting writer and author

Further reading

Sanctions and ethics: is the audit regulator fit for purpose? 

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