Recent Developments with the Financial Reporting CouncilJanuary 2023
2022 was a busy year for the Financial Reporting Council (the “FRC”), the body responsible for regulating auditors, accountants and actuaries and which sets the UK’s corporate governance and stewardship codes. Not daunted by its impending replacement by the Audit, Reporting and Governance Authority (“ARGA”) this year, it published a number of important documents relating to audit quality and restoring trust in audit and corporate governance which look to pave the way for ARGA in the coming months.
Audit Professional Judgement Guidance
In June 2022, the FRC published its “Professional Judgement Guidance”. Said to be “persuasive rather than prescriptive” the FRC nevertheless expects auditors to demonstrate compliance with relevant engagement standards should they choose not to adhere.
The FRC observed that “[t]he most significant quality issues identified by the FRC’s Audit Quality Review (AQR) team over a number of years involve the poor exercise of auditor judgement in some capacity”. This will come as no surprise following the close scrutiny of a number of high-profile audits in recent years.
As the FRC notes, professional judgement is relevant – and central – to all aspects of an audit.
This includes judgements about the issues faced during the audit, such as fair value, going concern, interpretations of standards and appropriateness of evidence. It also includes judgements about planning the audit, such as: designing procedures, resourcing, allocation of tasks, the need for specialist skills or knowledge, and the time needed to complete an audit; and internal processes within the audit firm around the design, implementation, and operation of a system of quality management.
Professional judgement framework
The guidance sets out a professional judgement framework, based around four areas: mindset, professional judgement trigger and process, consultation and environmental factors:
- The first area requires auditors to approach their work with an appropriate mindset, considering the purpose of the audit for both the business being audited and the wider public; applying appropriate professional scepticism; understanding the psychological biases and other factors that might influence auditor judgement, such as groupthink and overconfidence; sensitivity to uncertainty; and being committed to quality.
In our experience, this sort of mindset is essential for a satisfactory audit, and many of the claims that we see arise when it is not present. In particular, problems often occur when auditors are not sufficiently sceptical about the evidence and information before them, or gloss over uncertainty, or fail to seek assistance from others when needed. However, it is perhaps more difficult in practice for auditors to consistently appreciate the purpose of audit and its wider public purpose, not least because there seems to be little consensus in society at present about precisely what an audit is intended to achieve. Many of the claims that we see suggest that auditors are solely responsible for the proper functioning of the business being audited. That is not correct, and it is fair for the officers and directors to bear appropriate responsibility for their daily control of the business, often by way of contributory negligence for any losses that the business has suffered.
- Next, the FRC sets out a number of triggers and processes for exercising professional judgement. These include being alert to situations that require judgement and who should make that judgement; and marshalling information, properly analysing it and reflecting on it.
We would agree that these are helpful recommendations for any audit. In practice, we often see cases where insufficient information is gathered, or it is not properly analysed and considered before acting on it. We have also seen instances where someone without the necessary specialist experience has made erroneous judgements about an audit, especially in more unusual or niche situations.
- Thirdly, the FRC encourages auditors to consult widely, debating and challenging aspects of the audit as appropriate, within the engagement team and with an external expert or engagement quality reviewer if required. This can be an important element in carrying out a satisfactory audit, as well as identifying potential issues with an audit that might be relevant to improving other audit work.
- Finally, the FRC cautions auditors to be mindful of environmental factors, such as the resources available for an audit, those in charge of the business being audited, the relevant information available, and the culture of the firm carrying out the audit.
These environmental factors form important background to an audit, and proper consideration of them is essential to the audit being carried out properly. In the cases that we see, it is especially important that auditors properly consider the role played by those in charge of the business and challenge them appropriately about any issues that the auditors may find. In defending any resulting claim, it is equally important to ensure that those running the business take proper responsibility for any losses arising.
Also in June 2022, the FRC issued a consultation on firm-level audit quality indicators (“AQIs”). In doing so, the FRC is taking forward its proposals from its 2020 thematic review on publicly-reported AQIs. These are intended to be measured on a consistent and comparable basis so that more information about audit quality is available to users of audit services such as audit committees. The FRC sees this consultation as part of its work as a more assertive regulator, showing its sensitivity to the criticisms that have been made of it in the past and its upcoming replacement by the ARGA.
On 6 December 2022 the FRC published the consultation’s Feedback Statement, most notably suggesting most audit firms were against altering the current form of AQI reporting procedures, namely in firms’ Transparency Reports (where some AQI data is already published). Investors, by contrast, were generally optimistic that firm level AQI reporting would encourage more investors to engage in audit quality and considered that Audit Committee Chairs (“ACCs”) would be given greater, more transferable, data to compare and ultimately select an appropriate auditor. In conclusion the FRC expressed confidence that “reporting firm-level AQIs will lead to an improvement in the information available to stakeholders regarding factors that contribute to audit quality. Users of audit services will be provided with an additional source of information related to audit quality, which should facilitate detailed and robust conversations about audit quality with firms”.
Audit and Corporate Governance
In July 2022, the FRC published its position paper on “Restoring Trust in Audit and Corporate Governance”. It follows the government’s (somewhat disappointing) response in May 2022 to the consultation on strengthening the UK’s corporate governance, corporate reporting and audit systems (“the Response”), by setting out how the FRC will support these reforms as the FRC itself transitions into ARGA.
In particular, the FRC discusses revising and adding to the existing suite of Codes, Standards and Guidance to implement reforms (with many taking effect from around 2023-2024); developing new Standards in shadow form so that they can be voluntarily adopted ahead of legislation; setting expectations for the markets that the FRC regulates; developing guidance to address the issues set out in the Response; and setting high-level expectations around the future supervision and monitoring activities that will flow from the FRC’s work in this area.
It will be interesting to see how the detail of each of these areas is developed in the future, but even setting out its position in this way suggests again that the FRC is keen to be more proactive and assertive than it might have been in the past.
These recent publications by the FRC evidence a clear desire to change how it has historically been perceived and to address some of the criticisms leading to its replacement by ARGA, by acting in a more assertive way than it might have done in the past. It remains to be seen how the FRC’s approach, and its objectives behind these publications, will work out over time.
The FRC’s updated guidance may also be seen to have influenced the recent revisions to other key FRC documentation including but not limited to, the September 2022 “International Standards of Auditing (UK) 600 – Special considerations Audits of group financial statements (Including the work of component auditors)”, which comes into force in December 2023. The ISA (UK) 600 appears to place great emphasis on whether auditors have exercised sufficient professional scepticism, and/or if sufficient audit evidence has been obtained from the audit procedures performed. As outlined above, these are two core objectives of the Professional Judgment Guidance issued June 2022. It remains to be seen how audit professionals adapt to revisions of this nature. However, a pragmatic shakeup of the previous and potentially ‘outdated’ system appears to be welcome to investors, whereas audit firms appear to be conscious not to incur arduous/additional reporting requirements for AQI’s.
For now, the FRC’s guidance around audit judgement is a welcome and helpful starting point for auditors. Many firms will already be following the good practice that the FRC has put forward, but for them it is a useful consolidation and reminder of many of the key considerations behind good audits, which address a number of issues that we often see giving rise to claims. Insurers can be reassured by firms who adopt the FRC’s guidance wholeheartedly, which will also benefit the firms themselvesDownload PDF