In addition to the long awaited and much vaunted draft audit reform legislation appearing in the Queen’s Speech, supporters of reform can also rest well knowing that the proposed migration of licencing powers away from the accounting professional bodies to the FRC should be unaffected. It remains to be seen how long it will be before the Government’s audit reform proposals find their way into the Statute book (2024 at the earliest is the general guesstimate), however, both the FRC and the Government report that the power to repatriate licensing powers to the FRC already exists within the current legislative framework.
According to its recently published proposal, currently open to public consultation, the Financial Reporting Council’s (FRC’s) authority over audit firms that audit public interest entities (PIEs) will be significantly enhanced: a move that appears to be widely supported. Once the proposal is approved, the FRC will have the power to penalise both audit firms and individual auditors, with the worst offenders having their licences restricted and, in serious cases, revoked.
Commentators suggest that the thinking behind the proposal is to increase the FRC’s power by giving it the regulatory teeth over the audit sector that had previously been lacking. Hitherto, the FRC found itself in the slightly anomalous situation whereby it carried out inspections but had significant impediments to its powers to sanction the wrongdoing it discovered. Correcting the ‘disconnect’ between the FRC’s inspections and its ability to ban or restrict individual auditors and firms is at the heart of the proposed reforms.
According to an FRC statement: “The proposal will bolster the Financial Reporting Council’s supervisory toolkit and enable it to become increasingly assertive in holding audit firms to account for the delivery of high-quality audit.”
Among the powers currently delegated to it by the Government, the FRC defines its primary responsibility as “the recognition, supervision and de-recognition of those bodies which are themselves responsible for supervising the work of auditors and/or offering an audit qualification”.
Although the FRC oversees the regulation of auditors, hitherto, the licencing of individuals and firms to conduct audits of Public Interest Companies (PIEs) date been delegated to the professional accountancy bodies themselves, the most prominent of which is the Institute of Chartered Accountants in England and Wales (ICAEW) and amounted effectively to a system of self-regulation.
The new powers will change all this and replace this system of effective self-regulation and pass responsibility for PIE audit licencing to the FRC.
Contingent on the extent of incompetence unearthed, the new system will allow a range of sanctions to be implemented. This will enable the FRC to impose conditions, suspensions and in the most egregious cases, remove registration. If audit firms or individual auditors are found to have conducted poor audit work, the FRC could temporarily restrict them from working for clients in a specific economic sector (e.g. construction, pharmaceuticals) where “Registration Requirements” are not met.
Should the regulator judge a firm or an individual to lack the required competence or resources to safely audit PIEs, the suspension of a licence will really bite. As punishment for manifestly poor performance, the FRC’s new powers would allow the removal of a licence to practise – in the most severe cases, it could be removed on 20 days’ notice.
Although more than 30 different firms currently audit at least one PIE, the vast majority of such audits are undertaken by the Big 4 – all of which have been the target of widespread critical comment for their audit failures. That criticism has also extended to the FRC, particularly for its inadequate supervision and oversight failures in the much-publicised collapses of Carillion and Patisserie Valerie. Objectively, these criticisms were a little unfair given licencing of PIE audit firms was outside their remit and remained in the hands of the Recognised Supervisory Bodies.
The underlying thinking
The FRC’s 2021 Audit Quality Review proved to be the key catalyst for change. It found that an extraordinary 29% of audits reviewed were either in need of improvement or significant improvement.
Under the proposed change to the audit licensing regime, the new powers to control who gets licences to undertake audits of PIEs will, according to the FRC’s statement, “enable it [the FRC] to become increasingly assertive in holding audit firms to account for the delivery of high-quality audit”.
Enhancing the FRC’s role is a practical step that forms part of the government’s strategy to reform and improve the audit sector. The move may come as no surprise, but it does create some concerns.
The law of unintended consequences?
The market has a finite capacity to take on large audits. This is compounded by an increasing trend of firms cherry-picking which audits to undertake and which to reject because they are less profitable or risky.
Regrettably, the introduction of tougher audit licence conditions and restrictions might serve to be an additional deterrent for challenger firms to take on such audits. As an unintended consequence, this would undermine the Government’s stated aim of diluting the monopoly that the Big 4 enjoy at the top end of the audit market.
Another factor is digital data, which PIEs generate in huge volumes. For challengers to be able to audit them effectively, significant levels of investment are required. Given the inevitable costs involved, together with resource diversion and big data challenges, the question arises: if they were to find themselves at the wrong end of a licence revocation, would audit firms have the appetite to absorb those costs in order to re-enter the market?
According to the FRC’s 2021 review, “the primary responsibility for the prevention and detection of fraud rests with the directors”. The audit reform white paper does to some extent address this in a manner beyond mere PIE audit licencing. Beyond the existential debate concerning why audits exist, these reforms and the associated upheaval are unlikely to deter a sophisticated corporate fraudster. The full package of reforms is still very much the key to restoring public confidence in the audit sector.
By Paul Brehony, partner at Signature Litigation