The FRC has published its Annual Enforcement Review (the Review) analysing its investigations and enforcement actions for last year and setting its intentions for year ahead. The FRC also highlights the key themes arising from audit cases over the past six years, and its views on heightened risk areas as a result of COVID-19.
So, how is it all going?
- The FRC has had a busy year under the AEP, with 88 cases (the majority of which related to audit) opened by the Case Examination and Enquiries team (CEE) – almost double that of last year.
- Of the cases closed during the year, a lower proportion were referred to the Conduct Committee compared to last year, with a greater proportion resolved through constructive engagement or with no further action being taken.
- Key cases for the past year included Carillion (which is still in investigation phase) and Autonomy plc, the FRC's longest contested hearing to date (a final decision from the Tribunal is expected later this year).
- The FRC continues to be involved in a high-profile case involving Sports Direct International Plc involving important issues of privilege and the FRC's powers to require production of documents under SATCAR and the AEP.
- The number of financial sanctions imposed by the FRC was significantly lower than last year (down from £42.9 million to £16.5 million) but broadly similar to that of 2017/2018.
- Where audit firms are concerned, financial sanctions were imposed in five cases at a total of £15.9 million.
- Failures to obtain sufficient audit evidence and exercise professional scepticism continue to be among the key issues on audit cases.
- The number of non-financial sanctions imposed was also down on last year (from 38 to 27), though this remains a key area of focus for the FRC.
- The level of discounts offered by the FRC increased from 15% to 32% reflecting improved cooperation and earlier settlement by firms. That said, firms are still falling below the "exceptional" level of cooperation expected.
- COVID-19 will have a significant impact on the ability of firms to carry out audits in accordance with their usual methodologies, as well as on the FRC's ability to conduct its investigations. However, given the increased importance of the accuracy of financial statements during this time, firms should not expect any leniency.
- The FRC met its target of completing the investigation stage of a case under the AEP within 24 months in 44% of cases (up from 38% last year). However, it acknowledges that its timeliness must improve further, particularly on complex cases.
- The implementation of regulatory reforms signalled by the Kingman Review, Brydon Report, and CMA is likely to be delayed as a result of COVID-19, and further guidance is awaited from government.
- A review of the AEP – which has now been in place for three years – has been conducting over the past 12 months. A public consultation on proposed amendments is expected in autumn 2020.
We explore some of these key points in further detail below.
Key themes on audit cases
The FRC has conducted a review of audit cases over the past six years and identified the following underlying reasons for recurring audit failure:
- Audit partner too "hands off" – the FRC identified insufficient involvement of the audit partner and delegation of work streams to junior members of the team without proper supervision. Similarly, where issues were identified by junior staff members, these had not been properly escalated and dealt with.
- Too close to management – the FRC continues to come across instances in which the audit team is too close to the client in order to maintain objectivity and the required professional scepticism. For example, audit teams used language such as "we" and "our company", indicating that they considered themselves part of their client. Similarly, some partners (and regional offices, in particular) were found to be more concerned with maintaining the client relationship than with ensuring the quality and independence of their work.
- "Big Picture" issues – By carrying out work streams in silos, there is a failure by audit teams (especially audit partners) to step back and consider the audit as a whole.
- Disorganised audit work – a lack of organisation and clear communication between audit teams has resulted in things being missed. This is a particular issue for audits of large groups of companies.
- Role of EQCR partner – the FRC highlighted the issue of the ECQR not being conducted to a high enough standard. Problems included the ECQR partner not being engaged early enough to properly perform their function, and instances where issues were identified but then not properly dealt with.
- Use of experts – the FRC observed a lack of proper communication with experts or specialist teams carrying out work on the audit, and a tendency to accept their work without sufficient analysis by the audit team.
AEP cases and outcomes
There was an 80% increase in CEE cases coming from the FRC's "horizon scanning" activities – 13 from AQR inspections, and five from financial statement reviews.
The breakdown of case outcomes has changed from 2018/2019:
- 18 cases were referred to the Conduct Committee (21.6% compared to 28.3% in 2018/2019), 17 of which resulted in investigation or preliminary enquiry.
- 33 cases were dealt with through constructive engagement (an increase of 73.7% compared to 2018/19), 31 of which resulted in an allegation.
- The Conduct Committee opened 14 new investigations: 11 audit investigations under the AEP, two under the Accountancy Scheme, and one under the Actuarial Scheme.
The FRC provided the following examples of the cases it considered appropriate to resolve through constructive engagement:
- Cases involving errors in the financial statements appeared unlikely to have had a real impact on decisions taken by the users of financial statements, either because they were only marginally material quantitatively, or were in a highly technical area.
- Cases involving potential breaches of auditing standards identified through AQR inspection or as a result of events in the public domain having led to further enquiry, which have not impacted the financial reporting of the entities.
Overall, the timing of the FRC's investigations and enforcement actions continues to improve, with the current averages as follows:
- Issuance of a proposed formal complaint: 23 months (down from 24 months).
- Concluding a case at the Tribunal: 48 months (down from 82 months).
- Concluding a case by settlement: 23 months (down from 42 months).
- Concluding a case by constructive engagement: eight months.
The FRC intends to further expand its forensic accounting and legal teams, which it hopes will speed up outcomes generally. However, the FRC has notified readers of the likely delay to investigations and enforcement caused by COVID-19.
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).
To reflect the lower threshold for liability under the AEP as compared to the Accountancy Scheme, lower financial sanctions were imposed in cases against firms and individuals for conduct in breach of standards which would not necessarily amount to misconduct.
The FRC continues to focus on non-financial sanctions as a means of improving audit quality. In addition to reprimands and severe reprimands, examples of measures imposed include:
- requiring firms to undertake firm wide training
- to introduce and provide written reports to the FRC on quality performance reviews
- to implement an ethics board, and
- to increase the monitoring and support of regional offices.
In the Review, the FRC indicates that if firms carry out sufficient remedial work, non-financial sanctions may not be required.
All but one of the cases resulting in sanctions in the past year was a result of settlements. Where financial sanctions were imposed, reductions of between 30-35% were applied for early admissions.
An additional reduction in any financial sanction imposed is available where an "exceptional" level of cooperation is demonstrated (for example, by self-reporting).
Impact of COVID-19
The FRC has identified the following areas of heightened risk as a result of COVID-19:
- Financial reporting pressures – accountants should speak up if they witness pressure to report misleading financial information.
- Documentation – it may be more challenging to obtain audit evidence. Auditors are encouraged to think of alternative ways to get that information and document this process appropriately.
- Understanding the entity and its environment – the audit approach may need to change to respond to any changes in a business' operations and control environment.
- Access to audit evidence and use of technology – a greater use of technology is likely to be required, the appropriateness of which will need to be properly considered and documented.
- Going concern – auditors are encouraged to continue challenging management's judgments and ensure they have sufficient and appropriate evidence in light of the issues above, to support their own judgments.
- Professional scepticism – there may be greater pressure on the auditors to assist the company in presenting a misleading financial picture.
- Fraud – the pressure on financial reporting (see above) and changes in control environments may lead to an increase in fraud.
- Modifications to audit opinions and other disclosures in the audit report – may be required if certain audit procedures cannot be performed, or if management's key judgments are difficult to support in the current economic and political climate.
- Actuarial work (pensions and insurance) – there is a greater risk of underfunding of company pension schemes, the ability to rely on sponsor covenants, and the impact on pension asset valuations.
Notwithstanding the above risks, the FRC has stated that there will be no individual exceptions made to the standards against which it will hold accountants, auditors and actuaries to account.
There are many familiar themes in the review, but it's still a useful overview and reminder of the direction of travel. The move towards more cases going through constructive engagement seems positive to us, while the continued delay where running more complex investigations is concerned – something which, in our experience, cannot generally be fairly attributed to COVID-19 – is clearly less so.
On the face of it, there's little sympathy for the challenges of auditing in light of COVID-19. The FRC has not historically been supportive of alternative and inventive audit approaches, but it's still too early to see how such cases play out. Going concern will obviously be one key area in that respect.
More specifically, we'd highlight the following:
- For firms trying to encourage the FRC to pursue constructive engagement, the FRC refers to the benefit of timely intervention through constructive engagement as a means of enabling remedial action to be taken by the audit firm in time for the following year's audit.
- Where breaches in audit work are identified, remedial action should be taken as early as possible, to increase the chances of obtaining an early settlement and no non-financial sanctions.
- The FRC continues to look for "exceptional" cooperation from firms and individuals (including self-reporting) in return for early settlement and discounts.
- We are likely to see a greater increase in challenges by the FRC over modification of audit opinions, and it has therefore advised auditors to refer to its guidance on this area.
- It will be interesting to see what further amendments are proposed to the AEP later this year, with the consultation expected in the autumn.
Please contact a member of our Disputes and Investigations team if you'd like discuss this summary further.