The FRC publishes its latest Developments in Audit paper
The FRC publishes its latest edition of Developments in Audit.
On 18 November 2021, the Financial Reporting Council (FRC) published its latest edition of Developments in Audit. This report sets out the FRC’s work in the past year to support its objectives of improving audit quality and maintaining resilience in the UK audit services market. It not only provides an assessment of the UK audit market as a whole but also sets out the FRC’s expectations of how audit firms should deliver audit quality improvements. It focuses on the following:
(i) Key issues for audit
The results of the FRC’s Audit Quality Reviews and recent enforcement cases have highlighted deficiencies relating to a lack of professional scepticism by auditors, including failures to sufficiently challenge management’s assumptions, as well as evidence of the poor application of professional judgement. The FRC’s regulation of the audit market includes measures designed to drive improvement in the auditor’s mindset. Its principles for operational separation of the audit practices of the Big Four audit firms in the UK include the objective to strengthen professional scepticism and judgement through a greater focus on audit and audit quality. The FRC is also launching a project to design a new framework for the exercise of professional judgement, partly in response to a specific recommendation in the Brydon review.
(ii) The work of the FRC
The FRC highlights that it has revamped its approach to the way it supervises the largest audit firms through the creation of three teams – Audit Firm Supervision, Audit Market Supervision and Audit Quality Review (within the Supervision Division). Public Interest Entity (PIE) audit firms have been divided into three tiers by the FRC with the aim to ensure proportionality and fairness. In 2021/22 the FRC plans to continue increasing its engagement with the smaller firms that have growth plans in the PIE market. The FRC’s approach to audit supervision will continue to evolve and respond to developments, such as any additional powers gained as it transitions to the new regulator, the Audit, Reporting and Governance Authority.
(iii) Audit quality results
The 2020/21 FRC audit quality results show that challenges remain within the wider audit market in achieving and improving quality in audits undertaken. This observation holds true for both larger and smaller audits and audit firms, as well as for the sample of National Audit Office audits reviewed. The most significant thematic weaknesses identified in the 2020/21 inspection cycle by the FRC included:
- Inconsistency in audit quality across different firms, across different audits within the same firm and within different parts of the same audit.
- The lack of professional scepticism, including the failure to adopt an attitude to sufficiently challenge management’s assumptions.
- The poor assessment of internal controls – including their effectiveness in mitigating fraud risk.
However, on the positive side the FRC identified various examples of good practice in the audits inspected during the 2020/21 cycle, such as:
- The effective use of internal and external specialists to review and challenge management’s methodology and assumptions.
- The delaying of audit opinion sign-offs to ensure that sufficient time is available to deliver quality output.
- The rigorous assessment of the risks related to the carrying value of assets which could be impaired.
To provide enhanced transparency for the 2020/21 cycle, the FRC intends to publish a summary of the key findings and good practice of all corporate inspections, with the audited entities and the audit firm kept anonymous. It plans to inspect around 150 audits in 2021/22 and will continue to focus on more complex and higher-risk audits.
(iv) Audit market developments
An audit market overview highlights that while the Big Four continue to audit all FTSE 100 companies, the non-Big Four audit firms increased their market share of FTSE 250 audits. In 2019, two non-Big Four firms audited ten of the FTSE 250 companies; in 2020 four non-Big Four firms audited 22 of these entities. In the wider PIE audit market between 37 and 39 firms have provided audit services to PIEs over the last 4 years. The proportion of FTSE 350 companies switching auditors averaged 8.7% per year between 2016 and 2020. Switching from Big Four to non-Big Four has remained the largest of the four switching categories. In the last 2 years, however, the proportion of such switches has been falling, from 77.4% in 2019 to 69.2% in 2020.
(v) Restoring trust in the audit market
The government’s white paper ‘Restoring Trust in Audit and Corporate Governance’ has the potential to significantly alter and enhance the FRC’s supervisory and enforcement powers. The government is expected to publish its consultation response in the near future, which will include the proposed next steps in the process. Covid-19 and the UK’s exit from the EU have heavily affected the available parliamentary time, and the government’s update on the timetable for tabling legislation is awaited. In the meantime, the FRC highlights that it has progressed recommendations that are not fully reliant on legislation to implement, including:
- Ongoing enhancements to auditing standards.
- Operationally separating the Big Four firms’ audit practices.
- Revising the Audit Firm Governance Code (consultation closed on 18 November).
- Building a proportionate supervisory approach.
- Changes to the PIE auditor registration process.