With the continued focus on the audits of our largest companies and public interest entities, the work of the Financial Reporting Council’s (FRC) Audit Quality Review is firmly under the spotlight.
The Audit Quality Review Team (AQRT), successor to the Audit Inspection Unit, monitors the quality of listed and major public interest audits. But there is some discussion within the profession as to whether it is unduly focused on technical issues at the expense of big picture questions.
Paul George, executive director for conduct at the FRC, explains that audit inspections start with the team determining which firms are in scope and which audits to concentrate on. The Big Four, Grant Thornton and BDO meet the AQRT’s inspectors annually; Baker Tilly, Crowe Clark Whitehill and Mazars are on a three-year inspection cycle.
And the AQRT is under pressure to do more. “Where a firm carries out fewer than 10 major audits, we delegate. Going forward, if the audits meet the public interest entity definition, we will be taking back that inspection work,” says Paul George.
We provide opportunities for dialogue. We don't see it as a negotiation, although the firms do
The FRC’s Draft Plan, Budget and Levy Proposals for 2015/16 sets out a £1.2m increase in the cost of reviews, which largely results from the inclusion of recommendations from the Competition and Markets Authority (CMA) to increase the frequency of reviews as well as taking them back from professional bodies.
In fact, the AQRT inspection load is increasing steadily – from 100 a year two years ago to 130 last year and 150 next year – as the FRC seeks to meet recommendations from the CMA, and comply with the EU Audit Directive as well as new responsibilities heralded by the Local Audit & Accountability Act.
As well as an increase in levies charged to the firms, the FRC is carrying out an effectiveness review. “We are focusing on those areas that are important to stakeholders. We look not to do more and more of the same activity, but towards continuous improvement,” says George.
The inspection process identifies risk areas or queries and, having reviewed files and audit documentation and quizzed the firm concerned, the AQRT delivers its verdict – ranging from good to needing limited improvements and needing more or significant improvements.
A letter-style report on each audit inspected goes to the audit committee chairman concerned, and a report on each major firm goes to them during May or June. “We invite comments from firms and provide opportunities for dialogue. We don’t see it as a negotiation, although the firms do,” says George.
Report card time is never going to be enjoyable; each of the Big Four firms will, during the past few years, have read the words “significant improvement” from the AQRT or the Audit Inspection Unit.
However, without giving away any confidences about the contents of the AQRT’s 2015 reports to major firms, George says that, during the past few years, the FRC has seen improvements in audit quality. “But they are not happening as quickly and they are not as universally achieved as we would like,” he says.
Our profession has always been desperately over-regulated. Although they haven't always behaved well, we have locked auditors into a process driven approach
“The frustration for me is that we still find audits that require significant improvement,” says George. “An audit is a complex thing and anything you review independently will tend to show some area where it could be improved,” he says.
“What we would like to see would be significant improvement. It should be very different today.”
There is broad agreement that the inspection team does good work and has helped firms raise the bar in terms of their documentation and their internal processes.
Mark Cardiff, head of audit at Grant Thornton, believes the AQRT has undoubtedly helped to improve the quality of audit across the profession, but questions whether the approach it takes is capable of assessing the quality of audit opinions as rigorously as it assesses audit documentation.
“I’d say the quality of audit papers and the ability of the AQRT to follow through has improved substantially,” he says. “I would say there has been less pronounced development around the quality of opinions,” he adds.
From some quarters, the inspection as it is currently designed is poorly placed to do little but monitor how well the firms adhere to the standards and rules as they exist – and it is those standards and rules that are questionable and not the audits themselves.
Stella Fearnley, professor of accounting at Bournemouth University School of Business, feels that the AQRT, by necessity, monitors a strong but wrong-headed enforcement regime.
“Our profession has been desperately over-regulated,” she says. “Although they haven’t always behaved well, we have locked auditors into a process-driven approach.”
Corporate failures and reporting shortcomings going back to Enron have led to a more onerous regime, largely because each time regulators had to be seen to be taking action. “Enron led to firmer enforcement. Regulators took inspection away from the profession, because it had to be seen to be doing something,” says Fearnley.
There are also questions around the risk-based and report-led approach. Cardiff suggests that the eight to 10 audits looked at for a firm of Grant Thornton’s size compared with perhaps 15 for a Big Four firm presents less than a level playing field.
“In statistical circles, or within the profession, we are aware that the sample taken is not significant. But in reading a report, the natural thing to do is to focus on the stand out findings,” he says.
When it comes to the idea of taking a different approach, he suggests the inspection process might be better served by focusing more time on more significant aspects of audit.
At one Grant Thornton review, the team spent more time looking at audit planning documents than on the entirety of the audit, he says.
He also suggests that the approach to a review can vary from inspector to inspector and that the AQR needs to look at the big picture issues more consistently.
“The remit at the AQR is clearly to ensure that the quality of audits is at an appropriate level, so there is a clear line back from AQR work to investors. There is an opportunity to match the work that the AQR does in line with what matters to investors,” says Cardiff.
“Investors are interested in cash flow, profitability, the sustainability of revenues and perhaps less around the niceties of standards on intangibles, or on discounted value. A lot of that detail is irrelevant to investors yet it has made up a good part of the AQR’s focus.”
Colin Jones, deputy chairman of the Quoted Companies Alliance’s corporate governance committee and head of audit for London at UHY Hacker Young, says continuous improvement in the profession would be better served by a different approach.
“It could do more in terms of balance and suggesting improvements. The US system is slightly different. It tends to be more focused on helping people improve.”
“AQRT reports seem quite critical,” he says. “Yes, there is a risk-based approach and a focus on key areas, but my experience is that reports tend to be quite technical. Standing back I’m not sure we get that overview; that – ‘overall, what is the quality like?’.”
All debate aside, it is clearly in firms’ interests to get a high grade from the FRC.
“The challenge is to collectively make sure there are improvements,” says George. “What are the incentives for firms to perform work in such a way that reports stand head and shoulders above the rest. Is the system rewarding enough for high quality audits?”
“With a non-statistical risk-approach you will always have an assessment that flags up issues. In this context, is it important enough to firms to make sure they stand out? I think tendering is having an impact on that. Greater visibility [on performance] to Audit Committee will be a driver,” he adds.
One perennial issue for the FRC and the profession as a whole is the regulatory overload. “How do you get that balance between making continuous improvement and complying with the things you have to do?
“If something goes wrong, you – investors, audit committees, regulators – want to know why and in detail. Then we correct that detail for everybody, even if it’s not relevant,” says Jones.
Fearnley agrees: “The basic problem is we kept on adding to the rules.
“But nothing’s perfect. If you have a strong enforcement regime, you have to be careful that you’re not enforcing rules that aren’t effective ones. Like everyone, regulators are at the mercy of those rules.”