With recent accounting scandals such as Wirecard, we’re seeing a continuing focus on the role of auditors in detecting fraud and, the importance of confidence in the audit process for corporate reporting.
The Financial Reporting Council (FRC), principal regulator of the profession (and accountants in business), recently published its Annual Enforcement Review 2020. It analyses its enforcement actions and outcomes across the past 12 months, identifying key themes and issues, and sets itself performance objectives for the year ahead.
One of the notable themes coming out of the Review is the FRC’s greater focus on the use of remedial action and non-financial sanctions as a means of driving audit quality within audit firms. It seems to us a sensible development.
Despite being criticised for not being tough enough on audit firms (total fines have come down this year, although the trend of fines in individual cases is on the rise), the FRC has focused on measures aimed at achieving lasting improvements in audit quality. Heavy fines, while inevitable in the more serious cases, mark public censure but do not in themselves change practices, and ultimately can reduce a firm’s resources to invest in audit quality. Audit cases dealt with by the FRC are rarely about intentional conduct by auditors. Far more often, they relate to errors of judgement, points missed in audit work, or inadequate processes. Non-financial sanctions can be a much more direct mechanism to promote investment of time and resource into audit improvement across a firm.
FRC’s enforcement powers
The FRC became the “competent authority” for audit in the UK under the Statutory Auditors and Third Country Auditors Regulations 2016 (SATCAR), which came into force following the EU Audit Regulation and Directive. SATCAR requires that the UK has effective systems of investigations and sanctions to “detect, correct and prevent inadequate execution of statutory audit” – which led to the implementation of the Audit Enforcement Procedure (AEP).
Under the AEP, a statutory auditor and/or statutory audit firm may be liable to enforcement action where there has been a breach of the Relevant Requirements of SATCAR 2016, the EU Audit Regulation or the Companies Act 2006. This creates a very low hurdle for regulatory sanction. Any breach of any auditing standard can be sanctioned, however trivial, although the FRC has increasingly been willing to handle the more minor cases through constructive engagement.
The FRC has a wide remit of sanctions at its disposal, which can be imposed singly or in combination. Possible sanctions include permanent or temporary prohibitions on the auditor performing statutory audits or signing audit opinions; exclusion of the auditor as a member of a recognised supervisory body; financial sanctions; declarations that the statutory audit report did not satisfy the relevant requirements; requiring the auditor or firm to cease or abstain from certain conduct and ordering a waiver or repayment of client fees.
While the FRC may have a greater remit for enforcement action under the AEP than the former Accountancy Scheme, its purpose in imposing sanctions is not to punish, but to protect the public and the whole public interest. The public is after all better served by higher quality audits which lead to higher investor confidence in the company’s financial statements.
Financial sanctions will continue to have an important role in the FRC’s enforcement strategy, particularly with regard the deterrence of future breaches; however, the use of non-financial sanctions continues to increase significantly. Non-financial sanctions are used at all stages of the enforcement process, whether that is as part of its early resolution of cases via the Constructive Engagement process, settlement, or following conclusion of a Tribunal hearing.
Constructive Engagement and remedial action
Constructive Engagement is a process introduced by the AEP for resolving cases where the audit quality concerns can be addressed without full enforcement action. The FRC’s guidance provides that it will be suitable for cases where there has been a minor, technical breach, and there is no real concern about harm to the public or a loss of confidence in the audit process.
Constructive Engagement is a more flexible process, aimed at ensuring that the breach is rectified quickly, and not repeated. It may take any form including written advice, warning letters, discussions or correspondence with the auditor and/or audit firm. Unless the FRC is satisfied that the conduct leading to the breach has already been sufficiently addressed to prevent the risk of recurrence, the outcome of constructive engagement will usually be for the firm to carry out remedial actions (if a breach is identified).
The remedial actions imposed in each case are bespoke to the particular circumstances of the breach, and will often involve amendments to a firm’s audit procedures and/or training and guidance across the firm. Remedial actions are often firm wide rather than limited to the particular audit process, or team, in order to reduce the risk of reoccurrence of the conduct that lead to the breach.
The FRC dealt with 33 cases in Constructive Engagement over the past year, an increase of 73% compared to 2019.
Remedial actions were imposed in 27 of those cases, and were predominantly focused on ways audit firms could improve audit procedure and technical knowledge in problematic areas. For example, firms were required to implement measures requiring audit teams to consult with a firm’s technical team on particular issues such as:
- require enhanced work to be carried out by specialists such as tax and actuarial specialists;
- implement better procedures for communication between audit teams and specialists;
- implement additional audit procedures and training on complex areas;
- implement guidance for improving the level of documentation on the rationale for conclusions reached.
A recurring problem with FRC investigations is that they take too long. Constructive Engagement provides the FRC with the flexibility to resolve cases more quickly: the average time taken to conclude a matter through Constructive Engagements is eight months, compared to an average of 48 months for the FRC to conclude a case through to a hearing before the Tribunal. The firm can then implement the remedial actions imposed more swiftly, while the FRC can direct its resources to cases involving more serious breaches which warrant full investigation. We expect the trend towards Constructive Engagement to continue in the coming year.
Investigations resulting in sanctions
Over the past year, the FRC imposed sanctions in nine cases in relation to audit matters, 11 of which were financial, as compared to 27 non-financial sanctions. All but one of the cases resulting in sanctions in the past year was a result of settlements.
The total amount of financial sanctions on audit firms alone (pre-discount) was £15.9 million. Financial sanctions were also imposed against six audit partners, totalling £0.7 million (pre-discount). Where financial sanctions were imposed, 30-35% reductions were applied for early admissions and settlement.
The use of non-financial sanctions is clearly a key part of the FRC’s enforcement strategy. Measures imposed over the last year included increased use of reprimands and severe reprimands, requirements for firms to undertake firm wide training, requirements for firms to produce written reports to the FRC on quality performance reviews, requiring firms to implement an ethics board, and increasing the monitoring and support of regional offices.
If firms carry out enough remedial work prior to the conclusion of the matter, further non-financial sanctions may not be required.
The FRC reminds firms in this Review that a further way that they reduce any financial sanction imposed is by providing an “exceptional” level of cooperation with the FRC’s investigation, for example, by self-reporting.
The year ahead
The FRC remains in a state of flux. Following Sir John Kingman’s review in December 2018 and the Brydon and CMA Reviews in 2019, a number of recommendations have been made to the government for the overhaul of audit profession which, if adopted, will have a significant impact on the regulation of audit in the UK. The FRC itself is due to be renamed as the Audit, Reporting and Governance Authority (ARGA). There has been little progress on the legislative front however, with no shortage of recent other distractions on parliamentary time.
The FRC has been recruiting heavily, notably to increase its ability to monitor audit work, which will then feed into more cases for Enforcement. It has also conducted a review of the AEP, and a consultation on proposed amendments to the procedure is expected later this year. It will be interesting to see what changes are proposed to its enforcement strategy. Beyond that, we may see significant upheaval in audit regulation once we return to normal business.