The Financial Reporting Council (FRC) has published a report Our Approach to Audit Supervision, which sets out what firms can expect from the FRC in the course of supervision with a focus on audit quality and firm resilience
The regulator focuses its risk-based supervision on those firms that have the largest share of the UK public interest entities (PIE) audit market and specifically on weaknesses in the firm which would have the greatest impact on overall audit quality.
The FRC reviews the largest seven firms annually, which together audit approximately 2,000 PIEs, including all UK-incorporated FTSE 350 entities. Around 30 firms audit the remaining (circa 200) PIE audits, based on the current definition of a PIE. Of these firms, only a few audit a significant number of PIEs and these are inspected at least every three years. The remainder audit fewer than five PIEs and those firms are inspected at least once every six years.
Individual audits are selected for inspection from a firm’s audit portfolio balancing several factors including: the size of the entity, the risk associated with the audit, how recently audits of that entity were inspected and the grading of those inspections, and random selections.
Audits of all FTSE 350 companies are usually inspected at least every five years. In recent years, the FRC’s audit inspection activity has become more focused on the audits where there is a higher likelihood of finding significant issues with audit quality and where the lack of high quality corporate reporting will have the most adverse impact.
Factors that may indicate high audit risk include where the group or entity:
- is in a high-risk sector or geography;
- is experiencing financial difficulties and/or has a volatile share price and high short-selling interest;
- has balances with high estimation uncertainty; or
- where the auditor has identified governance or internal control weaknesses in previous years.
The risk to audit quality also increases where audit teams are required to assess and conclude on complex issues of judgement, for example where materiality becomes a key factor in determining the significance of audit judgments for entities that have low profitability; headroom on impairment assessments may be lower and the entity’s balance sheet may be more sensitive to changes in key assumptions; and going concern assessments are less clear cut.
Jon Thompson, CEO of the FRC said: ‘The FRC has revamped our approach to the way we supervise the largest audit firms through the creation of three teams – Audit Firm Supervision, Audit Market Supervision and Audit Quality Review (within the supervision division). Each of these teams have clear mandates to focus upon audit quality and firm resilience through their supervisory activity. Another key feature of our work is an emphasis on creating a culture of challenge in the firms.’
The latest audit quality reviews will be published in July with details on the latest shortfalls on audit performance and highlights of areas of weakness. Audits are ranked by four measures from 1 – Good; 2 – Limited improvements required; 3 – Improvements required; and 4 – Significant improvements required. Historically the FRC has combined the results of 1 and 2 into a single ranking, making it difficult to assess the actual number of ‘Good’ audits.
Meantime, the audit profession is facing a major overhaul with the publication of a consultation on the future of audit currently out for comment.
At the same time, the four largest audit firms (Deloitte, EY, KPMG and PwC) are transitioning to operational separation of their audit practices, with a final deadline in summer 2024. The FRC published Principles for Operational Separation of Audit Practices in July 2020 (updated in February 2021), which these firms have agreed to meet.
The objectives of operational separation are to improve audit quality by ensuring that people in the audit practice are focused above all on delivery of high-quality audits in the public interest and to improve audit market resilience by ensuring that no material, structural cross-subsidy persists between the audit practice and the rest of the firm. Each firm has developed a transition plan and many elements of operational separation will be in place well in advance of this deadline.
From 2024 the FRC plans to publish an assessment of the effectiveness of the four largest firms’ arrangements for operational separation.
In addition, the FRC will hold pre-appointment meetings with senior management for key roles in the restructured firms.
The FRC said: ‘We expect the individuals stepping into certain key roles at the Tier 1 and Tier 2 firms to attend an interview with the FRC before appointment is confirmed, to ensure that they have the right characteristics and experience for the role and to communicate our regulatory expectations.’