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Audit quality improves as a result of oversight and regulation

Paul Hodgson | August 1, 2016

From June 2016, as a consequence of the U.K. implementation of the revised EU Statutory Audit Directive and Audit Regulation (ARD), the Financial Reporting Council’s (FRC) role has been formalised in legislation as the United Kingdom’s competent authority for audit. In this capacity, the FRC has six key governing principles:

  1. Audit and auditors are trustworthy, act with integrity, serve the public interest and consistently meet the objectives of audit and auditing standards
  2. Audit is subject to appropriate oversight within a clear regulatory regime
  3. Roles and responsibilities of auditors and audit committees are clear, and aligned with the interests and needs of investors
  4. Audit is a sustainable business with adequate capacity, and sufficient levels of competition and choice
  5. Audit innovates to meet changing business and economic circumstances to improve audit quality
  6. Global audits are effectively managed and overseen and quality is consistent across international work

According to the FRC’s latest report in this capacity, Developments in Audit, audit firms are seen as more independent due to developments in reporting; promoting the role of the audit committee, and more independent oversight, but concerns remain about the Big Four’s (PwC, Deloitte, KPMG, and EY) dominance of the FTSE350 market. The changes as a result of ARD, mandatory rotation and non-audit service caps among them have also helped, though again there are concerns that “over-regulation” may make some prospective auditors wish to work in another industry. The report also found that the effectiveness and efficiency of audit is being transformed through the use of technology.

The report recorded an increase in the number of audits assessed as “good or only requiring limited improvements,” up from 67 percent last yeart to 76 percent in its 2015/16 inspection. Only two audits were assessed as requiring significant improvements, the lowest category, compared to 10 in the previous assessment. There were also fewer findings of problems overall. The FRC wants to see the 76 percent figure at 90 percent. It has also asked audit firms to develop an action plan to address FRC findings of problems and to include details of this exercise in public reports on each firm.

In the future the FRC intends to cover inspections of the FTSE 100 every four years, FTSE 250 excluding investment trusts every five years, and FTSE 250 investment trusts every seven years.

From this year’s YouGov report, findings of which are included in the main report, it appears that stakeholders have a clearer understanding of what audit is and a higher level of confidence in it. What the YouGov report notes is that the relationship between auditor and client company is “central to many of the concerns expressed.” Auditors must “remain independent,” “have the skills,” are “guided by relevant principles and rules,” and “operate in a fair and open market.”

The market share of the big four firms has risen in the FTSE350 since the change to the U.K. Corporate Governance Code in 2012, and the FRC is concerned that the failure of one of the firms would have a “disproportionate impact on the functioning of the capital markets.” However, audit committee chairs reaffirmed their confidence in the quality of audit reporting, while investors affirmed the value of extended audit committee reporting. The FRC encourages audit committees to disclose the outcome of its quality review findings. The extended auditor reporting that was also introduced in 2012 has also led to higher quality reports that move away from generic language; but the FRC calls for further improvements in six areas:

  1. Greater transparency surrounding: auditor’s view of management estimates and assumptions and benchmarks used in auditor key judgements
  2. More information about sensitivity ranges in audit testing
  3. More information about auditor’s assessment of internal controls
  4. More commentary, especially on work done on risk of misstatement
  5. Explanation of any changes in approach
  6. More information on "performance materiality," which aims to reduce the likelihood of misstatements below a material level

The FRC has also recently published its Annual Report, which outlines its strategy for 2016-19. Generally, this means fostering investment and the importance of effective but proportionate regulation which will concentrate on promoting a step change in audit quality and on driving up standards of governance, stewardship, and reporting.

In the first year, this strategy will be to establish its role as Competent Authority for audit, ensure that the new framework established under ARD serves the interests of investors in the reliability of financial statements and that at least 90 per cent of FTSE 350 audits will require no more than limited improvements. Regarding corporate governance, it will continue to work on corporate culture and promoting effective engagement between boards and investors. The annual report also notes that: “We believe very strongly that risk management and internal control should be incorporated within the company’s normal management and governance processes, not treated as a separate compliance exercise.” For corporate reporting, it will focus on helping smaller listed and AIM companies with the quality of their reporting. On regulation, it intends to implement an audit standard to cover a broader range of actuarial work and refocus its specific Technical Actuarial Standards. Finally, next year, it will run a public consultation on the future of actuarial regulation.

Continue the conversation at Compliance Week Europe: 7-8 November at the Crowne Plaza Brussels. Join us as we look at changes in global anti-corruption regulations, slave labour risks in your supply chain, and how to detect fraud, to name just a few topics. Learn more