Ethical standards for auditors: The FRC’s key proposed changes
James Barbour, Director, Technical Policy highlights the FRC's key proposed changes to its ethical standard for auditors.
FRC consultation on implementing the European Union (EU) Audit Legislation
This article highlights the Financial Reporting Council's (FRC) key proposals in relation to its revisions to its ethical standards for auditors to take account of the requirements of the EU Audit Regulation and Directive, both of which apply from 17 June 2016.
FRC Ethical Standard (FRC ES)
- The FRC is consolidating its existing five ethical standards for auditors into a single revised Ethical Standard (the 'FRC ES'). This standard will apply to all audit and other public interest assurance engagements. It will also replace the Ethical Standard for Reporting Accountants, and apply to Client Assets Sourcebook audits once the FRC finalises its new assurance standard for such engagements.
- This approach is intended to help avoid a situation where the current ESs 2-5 may be considered in isolation without regard to the overarching principles in ES 1.
- The FRC will continue to have a separate PASE standard which can be applied to the audit of smaller entities. This is the subject of some certain conforming changes.
General application of the Ethical Standard/Overarching Principles
- The revised standard has been drafted on the basis of seeking to make the overarching principles and supporting ethical provisions more prominent and more clearly outcome based, and to place them at the front of the standard. These outcomes must be met.
- Specific requirements and guidance that are designed to assist compliance with the principles and supporting provisions in particular circumstances are still included. However, compliance with the specific requirements may not necessarily mean that the overarching principles and supporting ethical provisions have thereby been complied with.
- FRC has clarified that, where applicable, safeguards have to reduce threats to "a level at which it is probable that an objective, reasonable and informed third party would not conclude that independence would be compromised" (rather than just saying reduce them to an "acceptable level").
Application to audits of PIEs and of listed entities
- For Public Interest Entity (PIE) audits, application of the FRC ES will ensure that auditors satisfy the applicable ethical requirements of the EU Audit Regulation. These requirements are not being extended to audits of any other entity.
- For audits of all listed entities, application of the FRC ES will ensure compliance with the existing more stringent ethical requirements for audits and investment circular reporting engagements for such entities that currently apply under the APB's ethical standards, subject to reliefs from some of those requirements (principally those relating to non-audit services) that the FRC is proposing for smaller listed entities that are not PIEs.
- FRC is also proposing to extend, to non-listed PIE audits, the more stringent requirements that are not subject to such relief (principally relating to reporting to those charged with governance and to circumstances when a firm's fee income from an entity is expected to exceed 5%, 10% or 15% of the firm's total fee income), on the grounds that this will enable consistency of focus on these matters by auditors and audit committees for such entities, without requiring any additional work by the auditor beyond reporting.
- Non-listed PIEs will also be subject to the FRC's more stringent requirements relating to the rotation of the audit engagement partner, the engagement quality control reviewer and other key audit partners.
- The EU Regulation requires a maximum tenure for an engagement partner of 7 years, but provides a Member State Option allowing that to be reduced. The FRC proposes to make use of the Option and to set the requirement at five years for all PIEs and for all listed entities (consistent with existing ethical standards).
- FRC proposes to maintain the existing flexibility that allows the engagement partner to be extended, in exceptional circumstances (for instance to maintain audit quality), to a maximum of no more than seven years where this is approved by the audit committee.
- The FRC ES will continue to define a listed entity consistent with the definition used in the international standards issued by the IAASB and the international ethical code issued by IESBA i.e.
"An entity whose shares, stock or debt are quoted or listed on a recognised stock exchange or are marketed under the regulations of a recognised stock exchange or other equivalent body"
- In the UK context, this means that the requirements in the FRC ES for listed entities will apply to the audits of any company in which the public can trade shares on the open market, such as those listed on the London Stock Exchange (including those admitted to trading on AIM), ISDX Markets and the Irish Stock Exchange (including those admitted to trade on the Irish Enterprise Securities Market), subject to the reliefs referred to above.
- However, FRC proposes to amend the definition to clarify that an entity whose securities are technically listed, but which are not in substance freely transferrable or tradeable are not listed entities for the purposes of the ES.
- FRC will also remove the previous language difference between the definition in the APB ethical standards and the International Standards on Auditing (ISAs) (UK and Ireland) of listed entities, to avoid any suggestion that the definition for the FRC ES is intended to apply only in relation to UK and Ireland exchanges.
- The FRC does not propose to make any additions to the EU blacklist of prohibited non-audit services for PIEs.
- The FRC also does not propose to adopt a 'permitted' of approved non-audit services for PIEs with all other unlisted services prohibited.
- The FRC does not propose to utilise the Member State option to apply a more stringent (lower) fee cap relating to the provision of non-audit services, as set out in Article 4 of the Regulation.
- However, the FRC is proposing amendments, in accordance with the Regulation to avoid resetting the three year calculation period where interruption arises from a gap year in providing NAS and to apply the cap to firms at the network level.
- Non-audit services which are required by law or by a rule issued by a regulator in accordance with powers granted by legislation are exempt for the purposes of the calculation of the cap. Therefore, fulfilling requirements set in rules made by, for example, the PRA or the FCA will be exempt, as will be work undertaken to comply with the UK Listing Rules but this exemption will not apply to a report under the Standards for Investment Reporting (SIRs) unless there is a requirement in law or regulation for such a report.
Proposed reliefs for smaller listed entities
- For the audit of non-PIEs, which are not subject to the requirements of the Regulation, the FRC proposes to offer relief from certain of the requirements set out in the FRC ES, where this will not be detrimental to the public interest. This will apply to listed entities which are not PIEs (a) by clarifying that the definition of listed entity does not include those entities whose securities are technically listed on a recognised market, but where those securities are not in substance open to trading by members of the public; and (b) in relation to restrictions on non-audit services, where the market capitalisation value of the entity is below £100 million (see below).
- The FRC's proposal to provide relief is subject to a rigorous and effective assessment of threats being undertaken, and appropriate safeguards being put in place.
- The FRC proposes that the £100 million threshold should be assessed using the average of the market capitalisation on the first and last days of the year six months prior to the accounting period under consideration. This is to prevent an entity from losing the proposed reliefs, in the event that market capitalisation is affected by a temporary spike. The selection of £100 million as the threshold will mean that around three quarters of the entities listed on the AIM market benefit from the proposed reliefs, while the largest 'other listed' entities which are likely to be of greater public interest will continue to be subject to all of the provisions of the Ethical Standard in respect of non-audit services. The proposed threshold is also aligned with the value used currently by the FRC's Audit Quality Review team, to determine those entities subject to its audit quality inspections.
- The FRC proposes once an entity exceeds the threshold for reliefs, it will be subject to the full requirements of the FRC ES in respect of non-audit services for a period of two financial years following the financial year in which the reliefs cease to apply, even if its market capitalisation falls below £100 million in a subsequent accounting period. The FRC considers this to be appropriate as investors may have an ongoing interest in the future performance of the entity which warrants the application of the more stringent requirements.
Requirements applicable to other group component auditors (extraterritoriality)
- FRC is not proposing to mandate that 'other auditors' of group components' statutory financial statements have to follow the FRC ES.
- FRC believes that a proportionate approach is to require the group auditor to carry out an evaluation of the independence of any network or third party firm whose work they propose to use in the group engagement and any other network firm. If the group auditor concludes that other group component auditors do not have the necessary level of independence, the lead group auditor cannot use their work and would have to obtain evidence by other means, such as doing the work themselves or requesting that another firm is used to do the work necessary for the purpose of the group audit.
- The relevant test for a network firm involved in the audit would be the FRC ES as applicable to the group auditor; and for other network firms and for third party firms involved in the audit, is the extant version of the IESBA Code.
Applicability of independence requirements
- Revisions made to the FRC ES to implement the Regulation and Directive include extending the applicability of the independence requirements for individuals to include "any other natural person whose services are placed at the disposal or under the control of the audit firm and who is directly involved in audit". In order to implement this requirement there is a series of related revisions to the overarching principles and supporting ethical provisions in the FRC ES.
- In addition, certain independence requirements for individuals in the current ethical standards are applied in relation to "immediate family members" but are now revised in line with the Directive to apply instead to "persons closely associated" which follows a broader EU definition, and which is set out in the definitions section of the FRC ES. Restrictions on gifts and hospitality now reduce the limits to those where "an objective, reasonable and informed third party would consider the value thereof as trivial or inconsequential" (as required by the Directive).
Extension of scope to other public interest assurance engagements
- FRC proposes that the FRC ES applies to all audit and other public interest assurance engagements (in effect for all such engagements in relation to which the FRC issues performance standards – this includes the SIRs, reporting in connection with investment circulars), engagements where the auditor reports on an interim review of the financial statements and the forthcoming Client Assets Standard.
- FRC proposes to withdraw the APB Ethical Standards for Auditors and the Ethical Standard for Reporting Accountants (ESRA) from issue. The FRC has retained certain specific requirements from the ESRA which are different from the equivalent requirements in the APB's Ethical Standards for Auditors, which can be identified from the wording of the requirements but has amended the definition of 'person in a position to influence the conduct or outcome of an engagement' insofar as it relates to investment circular reporting engagements, consistent with the changes made to the definition insofar as it relates to other engagements, to be clear that for an investment circular reporting engagement, the requirements only apply to those who have actual knowledge of the engagement.
Chain of Command
- The FRC proposes to eliminate the term 'chain of command'. Instead, it proposes a (revised) definition of a "person in a position to influence the conduct or outcome of the engagement".
- The term 'chain of command' is also referred to in the existing requirement in Ethical Standard 2.49 which specifies that if certain partners (including a partner in the chain of command) leave the firm and join an audit client in a senior position within two years, the firm resigns the audit and cannot accept reappointment until a two year period from that partner ceasing to have the ability to influence the audit has elapsed (or the former partner has left the audited entity).
- It is also relevant to other requirements that apply to persons in a position to influence an audit, FRC therefore, also proposes to amend paragraph 2.49 to replace "a partner in the chain of command" with "a partner in a position to influence the conduct or outcome of the engagement". This no longer specifies the need for a person in a position of influence to be able to exert "direct" influence, and now includes persons "at each successive level of firm management, supervision or oversight relating to the audit or other public interest engagement, up to and including individuals who have ultimate responsibility for the management or governance of the firm".
- The amendment to the definition of a person in a position to influence the conduct or outcome of the engagement is also relevant to a number of other requirements in the current ethical standards to which such persons are subject.
Acting as an advocate for an audited entity in relation to tax (non PIEs)
- The current requirement in Ethical Standard 5, paragraph 104, prohibits an auditor from acting as an advocate "before an appeals tribunal or court". This requirement is considered by some to be ambiguous in respect of whether an auditor can act as an advocate for an entity in its dealings with HMRC before it gets to a tribunal or court when the 'advocacy threat' (becoming wedded to a client's position in an adversarial context) is the same. The FRC proposes, therefore, to delete the words "before an appeals tribunal or court".
Not providing tax services on a contingent fee basis
- The FRC proposes to revise the current Ethical Standard 5 to prohibit the provision of tax services on a contingent fee basis. The FRC considers that the benefits resulting from a reduced risk of the auditor facing a conflict of interest outweigh any costs associated with obtaining those services on a fixed fee basis, or from an alternative provider.