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Audit Quality Inspection Report 2016/17 - EY LLP

The Financial Reporting Council (FRC) is the UK's independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. The FRC sets the UK Corporate Governance and Stewardship Codes and UK standards for accounting and actuarial work; monitors and takes action to promote the quality of corporate reporting; and operates independent enforcement arrangements for accountants and actuaries. As the Competent Authority for audit in the UK the FRC sets auditing and ethical standards and monitors and enforces audit quality.

The FRC does not accept any liability to any party for any loss, damage or costs howsoever arising, whether directly or indirectly, whether in contract, tort or otherwise from any action or decision taken (or not taken) as a result of any person relying on or otherwise using this document or arising from any omission from it.

The Financial Reporting Council Limited 2017 The Financial Reporting Council Limited is a company limited by guarantee. Registered in England number 2486368. Registered Office: 8th Floor, 125 London Wall, London EC2Y 5AS

About the FRC and its Audit Quality Review team

Our objective

The FRC's mission is to promote high quality corporate governance and reporting to foster investment. The Audit Quality Review (AQR) team contributes to this objective by monitoring and promoting improvements in the quality of auditing.

What we do

The FRC is the designated competent authority for statutory audit in the UK. It is responsible for the public oversight of statutory auditors and for ensuring that the various regulatory tasks set out in legislation are carried out by the FRC or the Recognised Supervisory Bodies to whom the FRC may delegate many of those tasks. These tasks include the monitoring of audit work. The FRC is responsible for monitoring the audit work of UK firms that audit Public Interest Entities (PIEs), and certain other UK entities, and the policies and procedures supporting audit quality at those firms. The monitoring work is undertaken by the AQR team.

The AQR team also reviews audits of entities incorporated in Jersey, Guernsey or the Isle of Man whose securities are traded on a regulated market in the European Economic Area.

The AQR team

The AQR team consists of approximately 35 professional and support staff. Collectively, our professional staff have extensive audit expertise (including appropriate professional education, relevant experience in statutory audit and financial reporting, specific training on quality assurance reviews and specialist expertise). Our audit quality review work is subject to rigorous internal quality control reviews. Independent non-executives advise on and oversee our work. Independence requirements for staff and non-executives are set out in Appendix B.

Working with Audit Committees (or equivalent bodies)

Audit Committees play an essential role in reviewing and monitoring the effectiveness of the audit process. We are committed to engaging with Audit Committees to improve the overall effectiveness of our reviews and to support our common objective of promoting audit quality. From 2017/18 we are increasing the level of our pre-review discussions with Audit Committee Chairs. We send our reports on each individual audit reviewed to the Chair of the relevant Audit Committee (or equivalent body) and offer them an opportunity to meet with us at that time. We also request feedback from Audit Committee Chairs on our report and discussions held with them.

Priority sectors and areas of focus

We adopt a risk-based approach to our work, as set out in Appendix B.

Our priority sectors for inspection in 2016/17 were natural resources/extractive industries; companies servicing the extractive industries; business/support services including the public sector; and media. We reviewed a number of audits from these sectors at the firms, together with a number of first year audits (this was identified as an area of focus given the extent of changes in auditors following increased audit tendering). We also paid particular attention to the audit of revenue recognition, IT controls and tax provisioning.

Thematic reviews

In addition to our annual programme of audit reviews, we undertake thematic reviews each year. We review firms' policies and procedures in respect of a specific area, and their application in practice, enabling us to make comparisons between firms with a view to identifying both good practice and areas for improvement.

This year we have published reports on Root Cause Analysis (September 2016). The Use of Data Analytics (January 2017) and Quality Control Review Processes (March 2017).

Developments in Audit 2016/17

In addition to reports on our audit quality reviews of the major firms, the FRC intends to publish later in 2017 an overall report on the quality of audit in the UK, covering work across the FRC in relation to audit quality and other relevant developments. The first such report was published in July 2016 and an update was issued in February 2017.

We expect all the firms we inspect to make continuous improvements such that, by 2019, at least 90% of FTSE 350 audits reviewed will be assessed as requiring no more than limited improvements.¹ The next Developments in Audit report will include aggregate information on firms' performance against this target.

Contents

The AQR assesses the quality of audit work and policies and procedures supporting audit quality at firms which audit Public Interest Entities

1. Overview

This report sets out the principal findings arising from the 2016/17 inspection of Ernst & Young LLP (“EY” or “the firm”) carried out by the Audit Quality Review team of the Financial Reporting Council ("the FRC"). We conducted this inspection in the period from February 2016 to January 2017 (“the time of our inspection"). We inspect EY, and report publicly on our findings, annually.

Our report focuses on the key areas requiring action by the firm to safeguard and enhance audit quality. It does not seek to provide a balanced scorecard of the quality of the firm's audit work. Our findings cover matters arising from our reviews of both individual audits and the firm's policies and procedures which support and promote audit quality.

We are grateful for the co-operation and assistance received from the partners and staff of the firm in the conduct of our 2016/17 inspection.

Structure of report

Section 2 sets out our key findings requiring action and the firm's responses to these findings.

Appendix A provides details of the types of audits inspected in 2016/17.

Appendix B sets out our objectives, scope and basis of reporting.

Appendix C explains how we assess audit quality.

Scope of our 2016/17 inspection

We estimate that the firm audited 272 UK entities within the scope of independent inspection as at 31 December 2015. Of these entities, our records show that 179 had securities listed on the main market of the London Stock Exchange, including 11 FTSE 100 and 33 FTSE 250 companies.

We reviewed selected aspects of 17 individual audits in 2016/17. In selecting which aspects of an audit to inspect, we took account of those areas identified to be of higher risk by the auditors and Audit Committees, our knowledge and experience of audits of similar entities and the significance of an area in the context of the audited financial statements. The communications with the Audit Committee (or equivalent) were reviewed on all of these audits, and the audit of revenue was reviewed on nearly all of these audits. We also reviewed either the audit of investment valuations or impairment assessments, which were usually identified as a significant risk, on all of these audits.

We now publish periodically on our website the names of entities whose audits we reviewed.² The names are published after the entity's next Annual Report has been issued. The final list for our 2016/17 reviews will be published around the end of June 2017.

We also reviewed selected aspects of the firm's policies and procedures supporting audit quality.

The FRC issued a single revised Ethical Standard in 2016, effective at a firm-wide level from 17 June 2016 and applicable to individual audits for financial periods starting on or after this date. We discussed the firm's approach to implementing the revised Ethical Standard during our 2016/17 inspection. We will review this area in detail as part of our 2017/18 inspection, along with the firm's implementation of the revised UK Auditing Standards effective for financial periods starting on or after 17 June 2016.³

In response to the findings from our last inspection, the firm undertook to implement certain actions. We reviewed the actions taken by the firm and the extent to which they have contributed to improvements in audit quality.

Progress made in the year

We have seen an improvement in certain areas this year, in particular IT and other controls testing and the firm's independence procedures. However, we continue to identify findings relating to the challenge of management, communications with Audit Committees and the audit of revenue. For these recurring findings, while certain aspects have improved, the firm is in the process of implementing a number of actions on audits to be considered in our 2017/18 inspection and beyond.

The firm has enhanced its policies and procedures in the following areas and we believe these initiatives have contributed to the overall quality of the audits we have reviewed:

  • Continued development and enhancement of the firm's Audit Quality Programme which re-enforce the firm's 'tone from the top' in its commitment to audit quality: in the past year the firm has emphasised the importance of coaching, its Audit Quality Support Team hot reviews, sharing examples of best practice and giving timely recognition for good audit quality. The firm also engaged with a third party to analyse the behaviours and characteristics of high performing audit teams.
  • Introduction of a new global audit software tool, Canvas: this was rolled out during 2015 and was used for the first time on most of the audits we reviewed in 2016/17. Improvements have been made to the structure of the audit and the related software supporting project management. It also facilitates more effective communications between the group auditor and component auditors.
  • Simplification and rationalisation of the firm's audit methodology: the firm's audit methodology has been restructured to reflect the different phases of the audit, with more easily accessible supporting guidance.

Good practice identified

Examples of good practice we identified across a number of audits in the course of our work include:

  • The interaction of the audit team with both the firm's and management's specialists, including robust reporting by the firm's specialists to audit teams in areas of judgment.
  • The extent of the group auditor's involvement in, and evaluation of, the component auditors' work, including improved communications and exchange of audit information (partly due to the introduction of the Canvas software).
  • The testing of IT and other controls to conclude on whether they were operating effectively.

We also note the effort taken on the two first year audits we reviewed to understand the business and plan the audit.

Key findings in the current year requiring action

Our key findings in the current year requiring action by the firm, which are elaborated further in section 2 together with the firm's actions to address them, are that the firm should:

Individual audit reviews

  • Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments.
  • Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness.
  • Continue to improve the quality of written communications with Audit Committees on significant findings.

Review of firm-wide procedures

  • Make enhancements to staff appraisal processes.

Assessment of the quality of audits reviewed

Bar chart showing the results of our assessment of the quality of audits reviewed in 2016/17, with comparatives for the previous four years. The number of audits within each category in each year is shown at the top of each bar.

The chart displays five categories of audits (2016/17, 2015/16, 2014/15, 2013/14, 2012/13) against three assessment levels: "Good or limited improvements required", "Improvements required", and "Significant improvements required". Each bar shows the percentage breakdown for a given year and category, with the total number of audits in that category displayed at the top of the bar.

Good or limited improvements required: * 2016/17: 15 audits, 90% * 2015/16: 17 audits, approximately 70% * 2014/15: 10 audits, approximately 55% * 2013/14: 8 audits, approximately 45% * 2012/13: 6 audits, approximately 30%

Improvements required: * 2016/17: 2 audits, approximately 10% * 2015/16: 3 audits, approximately 20% * 2014/15: 6 audits, approximately 35% * 2013/14: 6 audits, approximately 35% * 2012/13: 4 audits, approximately 25%

Significant improvements required: * 2016/17: 0 audits, 0% * 2015/16: 1 audit, approximately 10% * 2014/15: 1 audit, approximately 10% * 2013/14: 2 audits, approximately 15% * 2012/13: 1 audit, approximately 5%

Issues driving lower audit quality assessments

The principal issues resulting in two audits being assessed as requiring improvements in 2016/17 included the following:

  • Insufficient attention to the audit completion procedures on one audit. Certain audit working papers had been amended after the date on which the audit file should have been completed or after we had notified the firm that the audit would be reviewed. There was, however, evidence that key audit working papers had been completed and reviewed by the date of the auditor's report. The firm also reported back to us, at our request, on the actions it had taken to improve its monitoring of compliance with completion deadlines.
  • On another audit there was insufficient evidence that internal development costs should be capitalised and a lack of rigour when challenging management's assumptions in goodwill impairment testing (further details are set out in section 2).

Root cause analysis

Thorough and robust root cause analysis (RCA) is necessary to enable firms to develop effective action plans which are likely to result in improvements in audit quality being achieved. The firm has performed RCA in respect of our key findings in this report.

The firm has continued to develop its process for identifying the causes for inspection findings and has implemented a number of the recommendations from our thematic report on the subject, including increasing the scope and depth of the RCA and improving its timeliness.

Firm's overall response and actions:

We share with the FRC a common objective of promoting confidence in the capital markets by a continuous focus on audit quality. We take our role in helping to sustain stable capital markets seriously and therefore maintaining and continuing to improve audit quality is a priority for us. We welcome the insights and challenges provided by the FRC's inspection.

We continue to invest in developing and supporting our audit teams. In 2014 we initiated a long-term Audit Quality Programme to help us deliver outstanding audit quality on a sustainable basis. We also established our Audit Quality Board which has executive oversight over all matters impacting audit quality. In each of the last three years we have increased our investment in the programme. We are pleased with the results of this investment, which are reflected in the table above, and in particular that more than 90% of our FTSE 350 audits inspected this year were assessed as requiring no more than limited improvements, meeting the target set by the FRC. We were also pleased to receive positive feedback on the audits inspected that were new appointments for us.

Our root causes analysis continues to be a key input into our Audit Quality Programme. We have refined our approach in light of feedback from the FRC's thematic review of root cause analysis. In Section 2, we have explained the causes we have identified for the FRC's key findings and the actions that we took during the period of the FRC's inspection, together with the further actions we plan to take in light of our root cause analysis. Our root cause analysis tells us that key to our good quality results were a consistent message from the firm's leadership and early, detailed partner involvement in audit planning, as well as the focus of our Audit Quality Programme.

We have detailed below some of our key ongoing priorities.

  • In 2016, we commissioned a project led by external cognitive psychologists to analyse the behaviours of audit teams which performed at an exceptional level so we can help coach all our teams to replicate these behaviours. The work to roll out the findings has commenced and is a major focus during 2017 helping to drive further improvements.
  • Our Audit Quality Support Team (AQST) perform hot reviews of a sample of FTSE 350 and other major audits, providing direct feedback and coaching to audit teams and sharing their observations with the wider audit practice.
  • In addition to the focus on coaching we continue to work on improving project management. We began work on this last year with our emphasis on early effective planning and this has been extended into a full cycle milestones programme.

We will continue to focus on these drivers of audit quality and we thank the FRC for its work and the independent perspective it brings.

2. Key findings requiring action and the firm's response

We set out below the key areas where we believe improvements are required to enhance audit quality. The firm was asked to provide a response setting out the actions it has taken or will be taking in each of these areas.

Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments

Due to the level of management judgment and potential bias, auditors need to provide an independent and rigorous level of challenge and demonstrate sufficient professional scepticism when assessing the reasonableness of management's estimates and assumptions used in impairment testing and the valuation of investments.

Given the potential impact on the financial statements, we considered either the audit of impairment assessments or the valuation of investments on every audit we reviewed. We identified findings on several of these audits, relating to whether the audit team's challenge of management was sufficiently rigorous or evidenced, including the following on one or more audits:

  • In relation to the assessment of goodwill and other assets for impairment, there was insufficient challenge of whether management's cash flow forecasts appropriately reflected the expected timing and duration of important contracts and whether short-term growth rates could be achieved.
  • In relation to the valuations of investments, there was insufficient evidence of challenge of whether management had the appropriate information to support the more subjective valuation of certain investments.

Firm's actions:

Our 2017 root cause analysis indicates that teams did not always appreciate what was required in order to convey the level of challenge and rigour they had applied. We also concluded that in some cases, teams did not step back to consider the completeness of their evidence and whether it would enable an experienced auditor, having no prior connection with the audit, to understand the full extent of the work carried out. We will address these findings through our 2017 training and through further support to audit teams from our AQST as set out below.

Our 2016 training programme included training on applying and evidencing professional scepticism in the audit of valuations and impairment assessments. We will incorporate into our 2017 training further emphasis on this area reflecting the results of our root cause analysis. This will include training on the rigour required when challenging estimates and assumptions.

Our AQST reviews have focused on judgmental areas and this will continue. During 2016/17 we have extended the scope of the AQST to include additional Focused Reviews covering selected audit areas as well as the normal cycle of full reviews. Going forward we will include the audit of valuations and impairment assessments in our Focused Review programme.

Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness

Revenue is often identified as a key performance indicator on which investors and other users of financial statements focus. It is an important driver of an entity's results and therefore may be open to manipulation or misstatement, particularly if management are under pressure to meet targets or market expectations. The auditor therefore needs to design appropriate audit procedures when performing the audit of revenue.

We have seen some improvement in the audit of revenue compared with the prior year. We have also seen an increase in the use of data analytics in the audit of revenue, which has the potential to improve audit quality further.

On some audits, however, we still identified findings on aspects of the audit approach, including the following on one or more audits:

  • Use of data analytics where the audit of revenue was dependent on a high correlation between revenue and cash. Data analytics were used to establish how much revenue was generated from cash and non-cash items. Insufficient testing was, however, planned and performed over key cash reconciliations upon which the data analytics relied.
  • Insufficient testing of the completeness of certain revenue transactions recognised during the year (for example, where the audit approach was designed to focus primarily on revenue deferred at the year-end, rather than revenue recorded in the year).
  • Insufficient sample sizes used to audit revenue (for example, where the samples did not reflect all relevant risk factors such as deficiencies in IT and other controls).

Firm's actions:

Our root cause analysis indicated that, whilst the use of data analytics resulted in overall improvements in our audit approach, teams lacked familiarity with aspects of the approach. Our root cause analysis also indicated that some audit teams had prioritised higher risk aspects of revenue but improvement was needed in the audit work addressing completeness (ie under-statement) of revenue recognised during the financial period, assessed as an area of lesser risk. We have provided training in these areas as set out below.

Our programme for auditing revenue using data analytics was issued in November 2015, with pilots run initially followed by wider usage in 2016. We delivered training and practical workshops to focus on the need to complete all aspects of the programme including the related work on cash balances.

Our winter 2016 training included guidance on the audit of revenue, including key messages relating to samples sizes, data analytics and testing for completeness of revenue. In January 2017, further practical guidance was issued to audit teams on testing for completeness. We will continue our focus on the audit of revenue in our 2017 training.

The audit of revenue was a continued focus area for our AQST in 2016 and this will continue in 2017, with particular emphasis on completeness of revenue and data analytics.

Continue to improve the quality of written communications with Audit Committees on significant findings

Auditors need to communicate relevant matters clearly to the Audit Committee, to assist them in overseeing the financial reporting process, assessing management's significant judgments and discharging their governance responsibilities.

We reviewed communications with Audit Committees on all audits we inspected. On some of these audits, insufficient detail was reported to Audit Committees on certain significant findings, including the following on one or more audits:

  • The reporting to the Audit Committee did not include the impact of management's assumptions for certain contracts on the goodwill impairment assessment and the recognition of deferred tax assets.
  • Reproducing the risks section of the auditor's report in the written communications to the Audit Committee was not an appropriate substitute for reporting the auditor's findings on significant risks.
  • Insufficient detail was provided to the Audit Committee on the rationale for, and effect of, valuing investments using assumptions that were more conservative than those used by similar third parties.

Firm's actions:

On those occasions where the extent of reporting to audit committees was less extensive, our root cause analysis indicated that teams considered that they had covered the matters in discussions or that the Audit Committee had expressed a preference for more concise reporting. Evidence of these discussions with the Audit Committee were not always sufficient.

In 2016, we issued a revised Audit Committee reporting template, designed to improve written communication of significant findings. We also provided training during which we shared examples of FRC findings in this area and we will provide further training in 2017. Our AQST continues to focus on the communication of significant findings to Audit Committees.

Make enhancements to staff appraisal processes

Staff performance appraisals, including assessment against relevant objectives, are important to ensure that individuals understand how they contribute to achieving high audit quality and other strategic priorities set out by the firm.

We reviewed a sample of staff appraisals completed in 2015 which were the most recent available at the time our work was undertaken (in early 2016). Based on this review the firm should improve the effectiveness of its staff appraisal processes by:

  • Strengthening the link between the assessment of audit quality and overall performance for staff. In the sample of staff appraisals we reviewed, audit quality did not appear to have a direct impact on the staff appraisal process. This could be improved by taking account of the results of internal and external quality reviews on staff performance and having a clearer linkage between the overall appraisal rating, the achievement of quality objectives and remuneration.
  • Enhancing controls over the completion of staff objectives. A significant number of staff had not completed their objectives three months after the firm's deadline and, in the sample we reviewed, a number of audit quality objectives set by staff were either too brief or not specific.
  • Improving the quality of information on staff appraisal forms. We identified that key information was not always included on staff appraisal forms, such as comments from appraisers, a detailed self-assessment and relevant references to adverse internal and external inspection quality ratings.

Firm's actions:

In 2016, we increased our investment into all key aspects of our annual staff appraisal process to reflect and embed the importance we place on audit quality. In particular:

  • We issued detailed guidance to staff and those involved in the staff appraisal process on the importance of audit quality in the performance management and year end rating process. This included targeted guidance on how internal and external inspection grades should be considered in the process plus further guidance on tailoring 2016/17 performance objectives to individual audit quality development needs.
  • We issued guidance for partners and team members involved in audits with adverse internal or external inspection ratings to make sure findings and specific assessment comments were accurately reflected in the following year's objectives.
  • We undertook a comprehensive compliance programme in relation to the completion of staff objectives including detailed guidance, monitoring, escalating and following up with individuals to ensure that the 2016/2017 objectives were completed by the deadline set.

Audit Quality Review FRC Audit and Actuarial Regulation Division June 2017

Appendix A – Audits inspected in 2016/17

The following chart provides a breakdown of the audits inspected in 2016/17 by type of entity:

Bar chart showing the number of reviews by type of entity for 2016/17.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 3.5 reviews
  • FTSE 250: Approximately 8 reviews
  • Other listed: Approximately 1.5 reviews
  • AIM: Approximately 3 reviews
  • Other: Approximately 3.5 reviews

The following chart provides comparative information for the audits inspected in 2015/16:

Bar chart showing the number of reviews by type of entity for 2015/16.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 2.5 reviews
  • FTSE 250: Approximately 12 reviews
  • Other listed: Approximately 2 reviews
  • AIM: Approximately 1.5 reviews
  • Other: Approximately 2.5 reviews

Appendix B – Objectives, scope and basis of reporting

| Matter | Explanation The Financial Reporting Council (FRC) is the UK's independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. The FRC sets the UK Corporate Governance and Stewardship Codes and UK standards for accounting and actuarial work; monitors and takes action to promote the quality of corporate reporting; and operates independent enforcement arrangements for accountants and actuaries. As the Competent Authority for audit in the UK the FRC sets auditing and ethical standards and monitors and enforces audit quality.

The FRC does not accept any liability to any party for any loss, damage or costs howsoever arising, whether directly or indirectly, whether in contract, tort or otherwise from any action or decision taken (or not taken) as a result of any person relying on or otherwise using this document or arising from any omission from it.

The Financial Reporting Council Limited 2017 The Financial Reporting Council Limited is a company limited by guarantee. Registered in England number 2486368. Registered Office: 8th Floor, 125 London Wall, London EC2Y 5AS

About the FRC and its Audit Quality Review team

Our objective

The FRC's mission is to promote high quality corporate governance and reporting to foster investment. The Audit Quality Review (AQR) team contributes to this objective by monitoring and promoting improvements in the quality of auditing.

What we do

The FRC is the designated competent authority for statutory audit in the UK. It is responsible for the public oversight of statutory auditors and for ensuring that the various regulatory tasks set out in legislation are carried out by the FRC or the Recognised Supervisory Bodies to whom the FRC may delegate many of those tasks. These tasks include the monitoring of audit work. The FRC is responsible for monitoring the audit work of UK firms that audit Public Interest Entities (PIEs), and certain other UK entities, and the policies and procedures supporting audit quality at those firms. The monitoring work is undertaken by the AQR team.

The AQR team also reviews audits of entities incorporated in Jersey, Guernsey or the Isle of Man whose securities are traded on a regulated market in the European Economic Area.

The AQR team

The AQR team consists of approximately 35 professional and support staff. Collectively, our professional staff have extensive audit expertise (including appropriate professional education, relevant experience in statutory audit and financial reporting, specific training on quality assurance reviews and specialist expertise). Our audit quality review work is subject to rigorous internal quality control reviews. Independent non-executives advise on and oversee our work. Independence requirements for staff and non-executives are set out in Appendix B.

Working with Audit Committees (or equivalent bodies)

Audit Committees play an essential role in reviewing and monitoring the effectiveness of the audit process. We are committed to engaging with Audit Committees to improve the overall effectiveness of our reviews and to support our common objective of promoting audit quality. From 2017/18 we are increasing the level of our pre-review discussions with Audit Committee Chairs. We send our reports on each individual audit reviewed to the Chair of the relevant Audit Committee (or equivalent body) and offer them an opportunity to meet with us at that time. We also request feedback from Audit Committee Chairs on our report and discussions held with them.

Priority sectors and areas of focus

We adopt a risk-based approach to our work, as set out in Appendix B.

Our priority sectors for inspection in 2016/17 were natural resources/extractive industries; companies servicing the extractive industries; business/support services including the public sector; and media. We reviewed a number of audits from these sectors at the firms, together with a number of first year audits (this was identified as an area of focus given the extent of changes in auditors following increased audit tendering). We also paid particular attention to the audit of revenue recognition, IT controls and tax provisioning.

Thematic reviews

In addition to our annual programme of audit reviews, we undertake thematic reviews each year. We review firms' policies and procedures in respect of a specific area, and their application in practice, enabling us to make comparisons between firms with a view to identifying both good practice and areas for improvement.

This year we have published reports on Root Cause Analysis (September 2016). The Use of Data Analytics (January 2017) and Quality Control Review Processes (March 2017).

Developments in Audit 2016/17

In addition to reports on our audit quality reviews of the major firms, the FRC intends to publish later in 2017 an overall report on the quality of audit in the UK, covering work across the FRC in relation to audit quality and other relevant developments. The first such report was published in July 2016 and an update was issued in February 2017.

We expect all the firms we inspect to make continuous improvements such that, by 2019, at least 90% of FTSE 350 audits reviewed will be assessed as requiring no more than limited improvements.¹ The next Developments in Audit report will include aggregate information on firms' performance against this target.

Contents

The AQR assesses the quality of audit work and policies and procedures supporting audit quality at firms which audit Public Interest Entities

1. Overview

This report sets out the principal findings arising from the 2016/17 inspection of Ernst & Young LLP (“EY” or “the firm”) carried out by the Audit Quality Review team of the Financial Reporting Council ("the FRC"). We conducted this inspection in the period from February 2016 to January 2017 (“the time of our inspection"). We inspect EY, and report publicly on our findings, annually.

Our report focuses on the key areas requiring action by the firm to safeguard and enhance audit quality. It does not seek to provide a balanced scorecard of the quality of the firm's audit work. Our findings cover matters arising from our reviews of both individual audits and the firm's policies and procedures which support and promote audit quality.

We are grateful for the co-operation and assistance received from the partners and staff of the firm in the conduct of our 2016/17 inspection.

Structure of report

Section 2 sets out our key findings requiring action and the firm's responses to these findings.

Appendix A provides details of the types of audits inspected in 2016/17.

Appendix B sets out our objectives, scope and basis of reporting.

Appendix C explains how we assess audit quality.

Scope of our 2016/17 inspection

We estimate that the firm audited 272 UK entities within the scope of independent inspection as at 31 December 2015. Of these entities, our records show that 179 had securities listed on the main market of the London Stock Exchange, including 11 FTSE 100 and 33 FTSE 250 companies.

We reviewed selected aspects of 17 individual audits in 2016/17. In selecting which aspects of an audit to inspect, we took account of those areas considered to be of higher risk by the auditors and Audit Committees, our knowledge and experience of audits of similar entities and the significance of an area in the context of the audited financial statements. The communications with the Audit Committee (or equivalent) were reviewed on all of these audits, and the audit of revenue was reviewed on nearly all of these audits. We also reviewed either the audit of investment valuations or impairment assessments, which were usually identified as a significant risk, on all of these audits.

We now publish periodically on our website the names of entities whose audits we reviewed.² The names are published after the entity's next Annual Report has been issued. The final list for our 2016/17 reviews will be published around the end of June 2017.

We also reviewed selected aspects of the firm's policies and procedures supporting audit quality.

The FRC issued a single revised Ethical Standard in 2016, effective at a firm-wide level from 17 June 2016 and applicable to individual audits for financial periods starting on or after this date. We discussed the firm's approach to implementing the revised Ethical Standard during our 2016/17 inspection. We will review this area in detail as part of our 2017/18 inspection, along with the firm's implementation of the revised UK Auditing Standards effective for financial periods starting on or after 17 June 2016.³

In response to the findings from our last inspection, the firm undertook to implement certain actions. We reviewed the actions taken by the firm and the extent to which they have contributed to improvements in audit quality.

Progress made in the year

We have seen an improvement in certain areas this year, in particular IT and other controls testing and the firm's independence procedures. However, we continue to identify findings relating to the challenge of management, communications with Audit Committees and the audit of revenue. For these recurring findings, while certain aspects have improved, the firm is in the process of implementing a number of actions on audits to be considered in our 2017/18 inspection and beyond.

The firm has enhanced its policies and procedures in the following areas and we believe these initiatives have contributed to the overall quality of the audits we have reviewed:

  • Continued development and enhancement of the firm's Audit Quality Programme which re-enforce the firm's 'tone from the top' in its commitment to audit quality: in the past year the firm has emphasised the importance of coaching, its Audit Quality Support Team hot reviews, sharing examples of best practice and giving timely recognition for good audit quality. The firm also engaged with a third party to analyse the behaviours and characteristics of high performing audit teams.
  • Introduction of a new global audit software tool, Canvas: this was rolled out during 2015 and was used for the first time on most of the audits we reviewed in 2016/17. Improvements have been made to the structure of the audit and the related software supporting project management. It also facilitates more effective communications between the group auditor and component auditors.
  • Simplification and rationalisation of the firm's audit methodology: the firm's audit methodology has been restructured to reflect the different phases of the audit, with more easily accessible supporting guidance.

Good practice identified

Examples of good practice we identified across a number of audits in the course of our work include:

  • The interaction of the audit team with both the firm's and management's specialists, including robust reporting by the firm's specialists to audit teams in areas of judgment.
  • The extent of the group auditor's involvement in, and evaluation of, the component auditors' work, including improved communications and exchange of audit information (partly due to the introduction of the Canvas software).
  • The testing of IT and other controls to conclude on whether they were operating effectively.

We also note the effort taken on the two first year audits we reviewed to understand the business and plan the audit.

Key findings in the current year requiring action

Our key findings in the current year requiring action by the firm, which are elaborated further in section 2 together with the firm's actions to address them, are that the firm should:

Individual audit reviews

  • Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments.
  • Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness.
  • Continue to improve the quality of written communications with Audit Committees on significant findings.

Review of firm-wide procedures

  • Make enhancements to staff appraisal processes.

Assessment of the quality of audits reviewed

Bar chart showing the results of our assessment of the quality of audits reviewed in 2016/17, with comparatives for the previous four years. The number of audits within each category in each year is shown at the top of each bar.

The chart displays five categories of audits (2016/17, 2015/16, 2014/15, 2013/14, 2012/13) against three assessment levels: "Good or limited improvements required", "Improvements required", and "Significant improvements required". Each bar shows the percentage breakdown for a given year and category, with the total number of audits in that category displayed at the top of the bar.

  • Good or limited improvements required:

    • 2016/17: 15 audits, 90%
    • 2015/16: 17 audits, approximately 70%
    • 2014/15: 10 audits, approximately 55%
    • 2013/14: 8 audits, approximately 45%
    • 2012/13: 6 audits, approximately 30%

  • Improvements required:

    • 2016/17: 2 audits, approximately 10%
    • 2015/16: 3 audits, approximately 20%
    • 2014/15: 6 audits, approximately 35%
    • 2013/14: 6 audits, approximately 35%
    • 2012/13: 4 audits, approximately 25%

  • Significant improvements required:

    • 2016/17: 0 audits, 0%
    • 2015/16: 1 audit, approximately 10%
    • 2014/15: 1 audit, approximately 10%
    • 2013/14: 2 audits, approximately 15%
    • 2012/13: 1 audit, approximately 5%

Issues driving lower audit quality assessments

The principal issues resulting in two audits being assessed as requiring improvements in 2016/17 included the following:

  • Insufficient attention to the audit completion procedures on one audit. Certain audit working papers had been amended after the date on which the audit file should have been completed or after we had notified the firm that the audit would be reviewed. There was, however, evidence that key audit working papers had been completed and reviewed by the date of the auditor's report. The firm also reported back to us, at our request, on the actions it had taken to improve its monitoring of compliance with completion deadlines.
  • On another audit there was insufficient evidence that internal development costs should be capitalised and a lack of rigour when challenging management's assumptions in goodwill impairment testing (further details are set out in section 2).

Root cause analysis

Thorough and robust root cause analysis (RCA) is necessary to enable firms to develop effective action plans which are likely to result in improvements in audit quality being achieved. The firm has performed RCA in respect of our key findings in this report.

The firm has continued to develop its process for identifying the causes for inspection findings and has implemented a number of the recommendations from our thematic report on the subject, including increasing the scope and depth of the RCA and improving its timeliness.

Firm's overall response and actions:

We share with the FRC a common objective of promoting confidence in the capital markets by a continuous focus on audit quality. We take our role in helping to sustain stable capital markets seriously and therefore maintaining and continuing to improve audit quality is a priority for us. We welcome the insights and challenges provided by the FRC's inspection.

We continue to invest in developing and supporting our audit teams. In 2014 we initiated a long-term Audit Quality Programme to help us deliver outstanding audit quality on a sustainable basis. We also established our Audit Quality Board which has executive oversight over all matters impacting audit quality. In each of the last three years we have increased our investment in the programme. We are pleased with the results of this investment, which are reflected in the table above, and in particular that more than 90% of our FTSE 350 audits inspected this year were assessed as requiring no more than limited improvements, meeting the target set by the FRC. We were also pleased to receive positive feedback on the audits inspected that were new appointments for us.

Our root causes analysis continues to be a key input into our Audit Quality Programme. We have refined our approach in light of feedback from the FRC's thematic review of root cause analysis. In Section 2, we have explained the causes we have identified for the FRC's key findings and the actions that we took during the period of the FRC's inspection, together with the further actions we plan to take in light of our root cause analysis. Our root cause analysis tells us that key to our good quality results were a consistent message from the firm's leadership and early, detailed partner involvement in audit planning, as well as the focus of our Audit Quality Programme.

We have detailed below some of our key ongoing priorities.

  • In 2016, we commissioned a project led by external cognitive psychologists to analyse the behaviours of audit teams which performed at an exceptional level so we can help coach all our teams to replicate these behaviours. The work to roll out the findings has commenced and is a major focus during 2017 helping to drive further improvements.
  • Our Audit Quality Support Team (AQST) perform hot reviews of a sample of FTSE 350 and other major audits, providing direct feedback and coaching to audit teams and sharing their observations with the wider audit practice.
  • In addition to the focus on coaching we continue to work on improving project management. We began work on this last year with our emphasis on early effective planning and this has been extended into a full cycle milestones programme.

We will continue to focus on these drivers of audit quality and we thank the FRC for its work and the independent perspective it brings.

2. Key findings requiring action and the firm's response

We set out below the key areas where we believe improvements are required to enhance audit quality. The firm was asked to provide a response setting out the actions it has taken or will be taking in each of these areas.

Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments

Due to the level of management judgment and potential bias, auditors need to provide an independent and rigorous level of challenge and demonstrate sufficient professional scepticism when assessing the reasonableness of management's estimates and assumptions used in impairment testing and the valuation of investments.

Given the potential impact on the financial statements, we considered either the audit of impairment assessments or the valuation of investments on every audit we reviewed. We identified findings on several of these audits, relating to whether the audit team's challenge of management was sufficiently rigorous or evidenced, including the following on one or more audits:

  • In relation to the assessment of goodwill and other assets for impairment, there was insufficient challenge of whether management's cash flow forecasts appropriately reflected the expected timing and duration of important contracts and whether short-term growth rates could be achieved.
  • In relation to the valuations of investments, there was insufficient evidence of challenge of whether management had the appropriate information to support the more subjective valuation of certain investments.

Firm's actions:

Our 2017 root cause analysis indicates that teams did not always appreciate what was required in order to convey the level of challenge and rigour they had applied. We also concluded that in some cases, teams did not step back to consider the completeness of their evidence and whether it would enable an experienced auditor, having no prior connection with the audit, to understand the full extent of the work carried out. We will address these findings through our 2017 training and through further support to audit teams from our AQST as set out below.

Our 2016 training programme included training on applying and evidencing professional scepticism in the audit of valuations and impairment assessments. We will incorporate into our 2017 training further emphasis on this area reflecting the results of our root cause analysis. This will include training on the rigour required when challenging estimates and assumptions.

Our AQST reviews have focused on judgmental areas and this will continue. During 2016/17 we have extended the scope of the AQST to include additional Focused Reviews covering selected audit areas as well as the normal cycle of full reviews. Going forward we will include the audit of valuations and impairment assessments in our Focused Review programme.

Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness

Revenue is often identified as a key performance indicator on which investors and other users of financial statements focus. It is an important driver of an entity's results and therefore may be open to manipulation or misstatement, particularly if management are under pressure to meet targets or market expectations. The auditor therefore needs to design appropriate audit procedures when performing the audit of revenue.

We have seen some improvement in the audit of revenue compared with the prior year. We have also seen an increase in the use of data analytics in the audit of revenue, which has the potential to improve audit quality further.

On some audits, however, we still identified findings on aspects of the audit approach, including the following on one or more audits:

  • Use of data analytics where the audit of revenue was dependent on a high correlation between revenue and cash. Data analytics were used to establish how much revenue was generated from cash and non-cash items. Insufficient testing was, however, planned and performed over key cash reconciliations upon which the data analytics relied.
  • Insufficient testing of the completeness of certain revenue transactions recognised during the year (for example, where the audit approach was designed to focus primarily on revenue deferred at the year-end, rather than revenue recorded in the year).
  • Insufficient sample sizes used to audit revenue (for example, where the samples did not reflect all relevant risk factors such as deficiencies in IT and other controls).

Firm's actions:

Our root cause analysis indicated that, whilst the use of data analytics resulted in overall improvements in our audit approach, teams lacked familiarity with aspects of the approach. Our root cause analysis also indicated that some audit teams had prioritised higher risk aspects of revenue but improvement was needed in the audit work addressing completeness (ie under-statement) of revenue recognised during the financial period, assessed as an area of lesser risk. We have provided training in these areas as set out below.

Our programme for auditing revenue using data analytics was issued in November 2015, with pilots run initially followed by wider usage in 2016. We delivered training and practical workshops to focus on the need to complete all aspects of the programme including the related work on cash balances.

Our winter 2016 training included guidance on the audit of revenue, including key messages relating to samples sizes, data analytics and testing for completeness of revenue. In January 2017, further practical guidance was issued to audit teams on testing for completeness. We will continue our focus on the audit of revenue in our 2017 training.

The audit of revenue was a continued focus area for our AQST in 2016 and this will continue in 2017, with particular emphasis on completeness of revenue and data analytics.

Continue to improve the quality of written communications with Audit Committees on significant findings

Auditors need to communicate relevant matters clearly to the Audit Committee, to assist them in overseeing the financial reporting process, assessing management's significant judgments and discharging their governance responsibilities.

We reviewed communications with Audit Committees on all audits we inspected. On some of these audits, insufficient detail was reported to Audit Committees on certain significant findings, including the following on one or more audits:

  • The reporting to the Audit Committee did not include the impact of management's assumptions for certain contracts on the goodwill impairment assessment and the recognition of deferred tax assets.
  • Reproducing the risks section of the auditor's report in the written communications to the Audit Committee was not an appropriate substitute for reporting the auditor's findings on significant risks.
  • Insufficient detail was provided to the Audit Committee on the rationale for, and effect of, valuing investments using assumptions that were more conservative than those used by similar third parties.

Firm's actions:

On those occasions where the extent of reporting to audit committees was less extensive, our root cause analysis indicated that teams considered that they had covered the matters in discussions or that the Audit Committee had expressed a preference for more concise reporting. Evidence of these discussions with the Audit Committee were not always sufficient.

In 2016, we issued a revised Audit Committee reporting template, designed to improve written communication of significant findings. We also provided training during which we shared examples of FRC findings in this area and we will provide further training in 2017. Our AQST continues to focus on the communication of significant findings to Audit Committees.

Make enhancements to staff appraisal processes

Staff performance appraisals, including assessment against relevant objectives, are important to ensure that individuals understand how they contribute to achieving high audit quality and other strategic priorities set out by the firm.

We reviewed a sample of staff appraisals completed in 2015 which were the most recent available at the time our work was undertaken (in early 2016). Based on this review the firm should improve the effectiveness of its staff appraisal processes by:

  • Strengthening the link between the assessment of audit quality and overall performance for staff. In the sample of staff appraisals we reviewed, audit quality did not appear to have a direct impact on the staff appraisal process. This could be improved by taking account of the results of internal and external quality reviews on staff performance and having a clearer linkage between the overall appraisal rating, the achievement of quality objectives and remuneration.
  • Enhancing controls over the completion of staff objectives. A significant number of staff had not completed their objectives three months after the firm's deadline and, in the sample we reviewed, a number of audit quality objectives set by staff were either too brief or not specific.
  • Improving the quality of information on staff appraisal forms. We identified that key information was not always included on staff appraisal forms, such as comments from appraisers, a detailed self-assessment and relevant references to adverse internal and external inspection quality ratings.

Firm's actions:

In 2016, we increased our investment into all key aspects of our annual staff appraisal process to reflect and embed the importance we place on audit quality. In particular:

  • We issued detailed guidance to staff and those involved in the staff appraisal process on the importance of audit quality in the performance management and year end rating process. This included targeted guidance on how internal and external inspection grades should be considered in the process plus further guidance on tailoring 2016/17 performance objectives to individual audit quality development needs.
  • We issued guidance for partners and team members involved in audits with adverse internal or external inspection ratings to make sure findings and specific assessment comments were accurately reflected in the following year's objectives.
  • We undertook a comprehensive compliance programme in relation to the completion of staff objectives including detailed guidance, monitoring, escalating and following up with individuals to ensure that the 2016/2017 objectives were completed by the deadline set.

Audit Quality Review FRC Audit and Actuarial Regulation Division June 2017

Appendix A – Audits inspected in 2016/17

The following chart provides a breakdown of the audits inspected in 2016/17 by type of entity:

Bar chart showing the number of reviews by type of entity for 2016/17.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 3.5 reviews
  • FTSE 250: Approximately 8 reviews
  • Other listed: Approximately 1.5 reviews
  • AIM: Approximately 3 reviews
  • Other: Approximately 3.5 reviews

The following chart provides comparative information for the audits inspected in 2015/16:

Bar chart showing the number of reviews by type of entity for 2015/16.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 2.5 reviews
  • FTSE 250: Approximately 12 reviews
  • Other listed: Approximately 2 reviews
  • AIM: Approximately 1.5 reviews
  • Other: Approximately 2.5 reviews

Appendix B – Objectives, scope and basis of reporting

| Matter | Explanation The Financial Reporting Council (FRC) is the UK's independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. The FRC sets the UK Corporate Governance and Stewardship Codes and UK standards for accounting and actuarial work; monitors and takes action to promote the quality of corporate reporting; and operates independent enforcement arrangements for accountants and actuaries. As the Competent Authority for audit in the UK the FRC sets auditing and ethical standards and monitors and enforces audit quality.

The FRC does not accept any liability to any party for any loss, damage or costs howsoever arising, whether directly or indirectly, whether in contract, tort or otherwise from any action or decision taken (or not taken) as a result of any person relying on or otherwise using this document or arising from any omission from it.

The Financial Reporting Council Limited 2017 The Financial Reporting Council Limited is a company limited by guarantee. Registered in England number 2486368. Registered Office: 8th Floor, 125 London Wall, London EC2Y 5AS

About the FRC and its Audit Quality Review team

Our objective

The FRC's mission is to promote high quality corporate governance and reporting to foster investment. The Audit Quality Review (AQR) team contributes to this objective by monitoring and promoting improvements in the quality of auditing.

What we do

The FRC is the designated competent authority for statutory audit in the UK. It is responsible for the public oversight of statutory auditors and for ensuring that the various regulatory tasks set out in legislation are carried out by the FRC or the Recognised Supervisory Bodies to whom the FRC may delegate many of those tasks. These tasks include the monitoring of audit work. The FRC is responsible for monitoring the audit work of UK firms that audit Public Interest Entities (PIEs), and certain other UK entities, and the policies and procedures supporting audit quality at those firms. The monitoring work is undertaken by the AQR team.

The AQR team also reviews audits of entities incorporated in Jersey, Guernsey or the Isle of Man whose securities are traded on a regulated market in the European Economic Area.

The AQR team

The AQR team consists of approximately 35 professional and support staff. Collectively, our professional staff have extensive audit expertise (including appropriate professional education, relevant experience in statutory audit and financial reporting, specific training on quality assurance reviews and specialist expertise). Our audit quality review work is subject to rigorous internal quality control reviews. Independent non-executives advise on and oversee our work. Independence requirements for staff and non-executives are set out in Appendix B.

Working with Audit Committees (or equivalent bodies)

Audit Committees play an essential role in reviewing and monitoring the effectiveness of the audit process. We are committed to engaging with Audit Committees to improve the overall effectiveness of our reviews and to support our common objective of promoting audit quality. From 2017/18 we are increasing the level of our pre-review discussions with Audit Committee Chairs. We send our reports on each individual audit reviewed to the Chair of the relevant Audit Committee (or equivalent body) and offer them an opportunity to meet with us at that time. We also request feedback from Audit Committee Chairs on our report and discussions held with them.

Priority sectors and areas of focus

We adopt a risk-based approach to our work, as set out in Appendix B.

Our priority sectors for inspection in 2016/17 were natural resources/extractive industries; companies servicing the extractive industries; business/support services including the public sector; and media. We reviewed a number of audits from these sectors at the firms, together with a number of first year audits (this was identified as an area of focus given the extent of changes in auditors following increased audit tendering). We also paid particular attention to the audit of revenue recognition, IT controls and tax provisioning.

Thematic reviews

In addition to our annual programme of audit reviews, we undertake thematic reviews each year. We review firms' policies and procedures in respect of a specific area, and their application in practice, enabling us to make comparisons between firms with a view to identifying both good practice and areas for improvement.

This year we have published reports on Root Cause Analysis (September 2016). The Use of Data Analytics (January 2017) and Quality Control Review Processes (March 2017).

Developments in Audit 2016/17

In addition to reports on our audit quality reviews of the major firms, the FRC intends to publish later in 2017 an overall report on the quality of audit in the UK, covering work across the FRC in relation to audit quality and other relevant developments. The first such report was published in July 2016 and an update was issued in February 2017.

We expect all the firms we inspect to make continuous improvements such that, by 2019, at least 90% of FTSE 350 audits reviewed will be assessed as requiring no more than limited improvements.¹ The next Developments in Audit report will include aggregate information on firms' performance against this target.

Contents

The AQR assesses the quality of audit work and policies and procedures supporting audit quality at firms which audit Public Interest Entities

1. Overview

This report sets out the principal findings arising from the 2016/17 inspection of Ernst & Young LLP (“EY” or “the firm”) carried out by the Audit Quality Review team of the Financial Reporting Council ("the FRC"). We conducted this inspection in the period from February 2016 to January 2017 (“the time of our inspection"). We inspect EY, and report publicly on our findings, annually.

Our report focuses on the key areas requiring action by the firm to safeguard and enhance audit quality. It does not seek to provide a balanced scorecard of the quality of the firm's audit work. Our findings cover matters arising from our reviews of both individual audits and the firm's policies and procedures which support and promote audit quality.

We are grateful for the co-operation and assistance received from the partners and staff of the firm in the conduct of our 2016/17 inspection.

Structure of report

Section 2 sets out our key findings requiring action and the firm's responses to these findings.

Appendix A provides details of the types of audits inspected in 2016/17.

Appendix B sets out our objectives, scope and basis of reporting.

Appendix C explains how we assess audit quality.

Scope of our 2016/17 inspection

We estimate that the firm audited 272 UK entities within the scope of independent inspection as at 31 December 2015. Of these entities, our records show that 179 had securities listed on the main market of the London Stock Exchange, including 11 FTSE 100 and 33 FTSE 250 companies.

We reviewed selected aspects of 17 individual audits in 2016/17. In selecting which aspects of an audit to inspect, we took account of those areas considered to be of higher risk by the auditors and Audit Committees, our knowledge and experience of audits of similar entities and the significance of an area in the context of the audited financial statements. The communications with the Audit Committee (or equivalent) were reviewed on all of these audits, and the audit of revenue was reviewed on nearly all of these audits. We also reviewed either the audit of investment valuations or impairment assessments, which were usually identified as a significant risk, on all of these audits.

We now publish periodically on our website the names of entities whose audits we reviewed.² The names are published after the entity's next Annual Report has been issued. The final list for our 2016/17 reviews will be published around the end of June 2017.

We also reviewed selected aspects of the firm's policies and procedures supporting audit quality.

The FRC issued a single revised Ethical Standard in 2016, effective at a firm-wide level from 17 June 2016 and applicable to individual audits for financial periods starting on or after this date. We discussed the firm's approach to implementing the revised Ethical Standard during our 2016/17 inspection. We will review this area in detail as part of our 2017/18 inspection, along with the firm's implementation of the revised UK Auditing Standards effective for financial periods starting on or after 17 June 2016.³

In response to the findings from our last inspection, the firm undertook to implement certain actions. We reviewed the actions taken by the firm and the extent to which they have contributed to improvements in audit quality.

Progress made in the year

We have seen an improvement in certain areas this year, in particular IT and other controls testing and the firm's independence procedures. However, we continue to identify findings relating to the challenge of management, communications with Audit Committees and the audit of revenue. For these recurring findings, while certain aspects have improved, the firm is in the process of implementing a number of actions on audits to be considered in our 2017/18 inspection and beyond.

The firm has enhanced its policies and procedures in the following areas and we believe these initiatives have contributed to the overall quality of the audits we have reviewed:

  • Continued development and enhancement of the firm's Audit Quality Programme which re-enforce the firm's 'tone from the top' in its commitment to audit quality: in the past year the firm has emphasised the importance of coaching, its Audit Quality Support Team hot reviews, sharing examples of best practice and giving timely recognition for good audit quality. The firm also engaged with a third party to analyse the behaviours and characteristics of high performing audit teams.
  • Introduction of a new global audit software tool, Canvas: this was rolled out during 2015 and was used for the first time on most of the audits we reviewed in 2016/17. Improvements have been made to the structure of the audit and the related software supporting project management. It also facilitates more effective communications between the group auditor and component auditors.
  • Simplification and rationalisation of the firm's audit methodology: the firm's audit methodology has been restructured to reflect the different phases of the audit, with more easily accessible supporting guidance.

Good practice identified

Examples of good practice we identified across a number of audits in the course of our work include:

  • The interaction of the audit team with both the firm's and management's specialists, including robust reporting by the firm's specialists to audit teams in areas of judgment.
  • The extent of the group auditor's involvement in, and evaluation of, the component auditors' work, including improved communications and exchange of audit information (partly due to the introduction of the Canvas software).
  • The testing of IT and other controls to conclude on whether they were operating effectively.

We also note the effort taken on the two first year audits we reviewed to understand the business and plan the audit.

Key findings in the current year requiring action

Our key findings in the current year requiring action by the firm, which are elaborated further in section 2 together with the firm's actions to address them, are that the firm should:

Individual audit reviews

  • Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments.
  • Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness.
  • Continue to improve the quality of written communications with Audit Committees on significant findings.

Review of firm-wide procedures

  • Make enhancements to staff appraisal processes.

Assessment of the quality of audits reviewed

Bar chart showing the results of our assessment of the quality of audits reviewed in 2016/17, with comparatives for the previous four years. The number of audits within each category in each year is shown at the top of each bar.

The chart displays five categories of audits (2016/17, 2015/16, 2014/15, 2013/14, 2012/13) against three assessment levels: "Good or limited improvements required", "Improvements required", and "Significant improvements required". Each bar shows the percentage breakdown for a given year and category, with the total number of audits in that category displayed at the top of the bar.

  • Good or limited improvements required:

    • 2016/17: 15 audits, 90%
    • 2015/16: 17 audits, approximately 70%
    • 2014/15: 10 audits, approximately 55%
    • 2013/14: 8 audits, approximately 45%
    • 2012/13: 6 audits, approximately 30%

  • Improvements required:

    • 2016/17: 2 audits, approximately 10%
    • 2015/16: 3 audits, approximately 20%
    • 2014/15: 6 audits, approximately 35%
    • 2013/14: 6 audits, approximately 35%
    • 2012/13: 4 audits, approximately 25%

  • Significant improvements required:

    • 2016/17: 0 audits, 0%
    • 2015/16: 1 audit, approximately 10%
    • 2014/15: 1 audit, approximately 10%
    • 2013/14: 2 audits, approximately 15%
    • 2012/13: 1 audit, approximately 5%

Issues driving lower audit quality assessments

The principal issues resulting in two audits being assessed as requiring improvements in 2016/17 included the following:

  • Insufficient attention to the audit completion procedures on one audit. Certain audit working papers had been amended after the date on which the audit file should have been completed or after we had notified the firm that the audit would be reviewed. There was, however, evidence that key audit working papers had been completed and reviewed by the date of the auditor's report. The firm also reported back to us, at our request, on the actions it had taken to improve its monitoring of compliance with completion deadlines.
  • On another audit there was insufficient evidence that internal development costs should be capitalised and a lack of rigour when challenging management's assumptions in goodwill impairment testing (further details are set out in section 2).

Root cause analysis

Thorough and robust root cause analysis (RCA) is necessary to enable firms to develop effective action plans which are likely to result in improvements in audit quality being achieved. The firm has performed RCA in respect of our key findings in this report.

The firm has continued to develop its process for identifying the causes for inspection findings and has implemented a number of the recommendations from our thematic report on the subject, including increasing the scope and depth of the RCA and improving its timeliness.

Firm's overall response and actions:

We share with the FRC a common objective of promoting confidence in the capital markets by a continuous focus on audit quality. We take our role in helping to sustain stable capital markets seriously and therefore maintaining and continuing to improve audit quality is a priority for us. We welcome the insights and challenges provided by the FRC's inspection.

We continue to invest in developing and supporting our audit teams. In 2014 we initiated a long-term Audit Quality Programme to help us deliver outstanding audit quality on a sustainable basis. We also established our Audit Quality Board which has executive oversight over all matters impacting audit quality. In each of the last three years we have increased our investment in the programme. We are pleased with the results of this investment, which are reflected in the table above, and in particular that more than 90% of our FTSE 350 audits inspected this year were assessed as requiring no more than limited improvements, meeting the target set by the FRC. We were also pleased to receive positive feedback on the audits inspected that were new appointments for us.

Our root causes analysis continues to be a key input into our Audit Quality Programme. We have refined our approach in light of feedback from the FRC's thematic review of root cause analysis. In Section 2, we have explained the causes we have identified for the FRC's key findings and the actions that we took during the period of the FRC's inspection, together with the further actions we plan to take in light of our root cause analysis. Our root cause analysis tells us that key to our good quality results were a consistent message from the firm's leadership and early, detailed partner involvement in audit planning, as well as the focus of our Audit Quality Programme.

We have detailed below some of our key ongoing priorities.

  • In 2016, we commissioned a project led by external cognitive psychologists to analyse the behaviours of audit teams which performed at an exceptional level so we can help coach all our teams to replicate these behaviours. The work to roll out the findings has commenced and is a major focus during 2017 helping to drive further improvements.
  • Our Audit Quality Support Team (AQST) perform hot reviews of a sample of FTSE 350 and other major audits, providing direct feedback and coaching to audit teams and sharing their observations with the wider audit practice.
  • In addition to the focus on coaching we continue to work on improving project management. We began work on this last year with our emphasis on early effective planning and this has been extended into a full cycle milestones programme.

We will continue to focus on these drivers of audit quality and we thank the FRC for its work and the independent perspective it brings.

2. Key findings requiring action and the firm's response

We set out below the key areas where we believe improvements are required to enhance audit quality. The firm was asked to provide a response setting out the actions it has taken or will be taking in each of these areas.

Apply increased rigour or improve evidence of the challenge of management's estimates and assumptions in impairment testing and valuations of investments

Due to the level of management judgment and potential bias, auditors need to provide an independent and rigorous level of challenge and demonstrate sufficient professional scepticism when assessing the reasonableness of management's estimates and assumptions used in impairment testing and the valuation of investments.

Given the potential impact on the financial statements, we considered either the audit of impairment assessments or the valuation of investments on every audit we reviewed. We identified findings on several of these audits, relating to whether the audit team's challenge of management was sufficiently rigorous or evidenced, including the following on one or more audits:

  • In relation to the assessment of goodwill and other assets for impairment, there was insufficient challenge of whether management's cash flow forecasts appropriately reflected the expected timing and duration of important contracts and whether short-term growth rates could be achieved.
  • In relation to the valuations of investments, there was insufficient evidence of challenge of whether management had the appropriate information to support the more subjective valuation of certain investments.

Firm's actions:

Our 2017 root cause analysis indicates that teams did not always appreciate what was required in order to convey the level of challenge and rigour they had applied. We also concluded that in some cases, teams did not step back to consider the completeness of their evidence and whether it would enable an experienced auditor, having no prior connection with the audit, to understand the full extent of the work carried out. We will address these findings through our 2017 training and through further support to audit teams from our AQST as set out below.

Our 2016 training programme included training on applying and evidencing professional scepticism in the audit of valuations and impairment assessments. We will incorporate into our 2017 training further emphasis on this area reflecting the results of our root cause analysis. This will include training on the rigour required when challenging estimates and assumptions.

Our AQST reviews have focused on judgmental areas and this will continue. During 2016/17 we have extended the scope of the AQST to include additional Focused Reviews covering selected audit areas as well as the normal cycle of full reviews. Going forward we will include the audit of valuations and impairment assessments in our Focused Review programme.

Improve the design of audit procedures for revenue in particular in relation to data analytics and completeness

Revenue is often identified as a key performance indicator on which investors and other users of financial statements focus. It is an important driver of an entity's results and therefore may be open to manipulation or misstatement, particularly if management are under pressure to meet targets or market expectations. The auditor therefore needs to design appropriate audit procedures when performing the audit of revenue.

We have seen some improvement in the audit of revenue compared with the prior year. We have also seen an increase in the use of data analytics in the audit of revenue, which has the potential to improve audit quality further.

On some audits, however, we still identified findings on aspects of the audit approach, including the following on one or more audits:

  • Use of data analytics where the audit of revenue was dependent on a high correlation between revenue and cash. Data analytics were used to establish how much revenue was generated from cash and non-cash items. Insufficient testing was, however, planned and performed over key cash reconciliations upon which the data analytics relied.
  • Insufficient testing of the completeness of certain revenue transactions recognised during the year (for example, where the audit approach was designed to focus primarily on revenue deferred at the year-end, rather than revenue recorded in the year).
  • Insufficient sample sizes used to audit revenue (for example, where the samples did not reflect all relevant risk factors such as deficiencies in IT and other controls).

Firm's actions:

Our root cause analysis indicated that, whilst the use of data analytics resulted in overall improvements in our audit approach, teams lacked familiarity with aspects of the approach. Our root cause analysis also indicated that some audit teams had prioritised higher risk aspects of revenue but improvement was needed in the audit work addressing completeness (ie under-statement) of revenue recognised during the financial period, assessed as an area of lesser risk. We have provided training in these areas as set out below.

Our programme for auditing revenue using data analytics was issued in November 2015, with pilots run initially followed by wider usage in 2016. We delivered training and practical workshops to focus on the need to complete all aspects of the programme including the related work on cash balances.

Our winter 2016 training included guidance on the audit of revenue, including key messages relating to samples sizes, data analytics and testing for completeness of revenue. In January 2017, further practical guidance was issued to audit teams on testing for completeness. We will continue our focus on the audit of revenue in our 2017 training.

The audit of revenue was a continued focus area for our AQST in 2016 and this will continue in 2017, with particular emphasis on completeness of revenue and data analytics.

Continue to improve the quality of written communications with Audit Committees on significant findings

Auditors need to communicate relevant matters clearly to the Audit Committee, to assist them in overseeing the financial reporting process, assessing management's significant judgments and discharging their governance responsibilities.

We reviewed communications with Audit Committees on all audits we inspected. On some of these audits, insufficient detail was reported to Audit Committees on certain significant findings, including the following on one or more audits:

  • The reporting to the Audit Committee did not include the impact of management's assumptions for certain contracts on the goodwill impairment assessment and the recognition of deferred tax assets.
  • Reproducing the risks section of the auditor's report in the written communications to the Audit Committee was not an appropriate substitute for reporting the auditor's findings on significant risks.
  • Insufficient detail was provided to the Audit Committee on the rationale for, and effect of, valuing investments using assumptions that were more conservative than those used by similar third parties.

Firm's actions:

On those occasions where the extent of reporting to audit committees was less extensive, our root cause analysis indicated that teams considered that they had covered the matters in discussions or that the Audit Committee had expressed a preference for more concise reporting. Evidence of these discussions with the Audit Committee were not always sufficient.

In 2016, we issued a revised Audit Committee reporting template, designed to improve written communication of significant findings. We also provided training during which we shared examples of FRC findings in this area and we will provide further training in 2017. Our AQST continues to focus on the communication of significant findings to Audit Committees.

Make enhancements to staff appraisal processes

Staff performance appraisals, including assessment against relevant objectives, are important to ensure that individuals understand how they contribute to achieving high audit quality and other strategic priorities set out by the firm.

We reviewed a sample of staff appraisals completed in 2015 which were the most recent available at the time our work was undertaken (in early 2016). Based on this review the firm should improve the effectiveness of its staff appraisal processes by:

  • Strengthening the link between the assessment of audit quality and overall performance for staff. In the sample of staff appraisals we reviewed, audit quality did not appear to have a direct impact on the staff appraisal process. This could be improved by taking account of the results of internal and external quality reviews on staff performance and having a clearer linkage between the overall appraisal rating, the achievement of quality objectives and remuneration.
  • Enhancing controls over the completion of staff objectives. A significant number of staff had not completed their objectives three months after the firm's deadline and, in the sample we reviewed, a number of audit quality objectives set by staff were either too brief or not specific.
  • Improving the quality of information on staff appraisal forms. We identified that key information was not always included on staff appraisal forms, such as comments from appraisers, a detailed self-assessment and relevant references to adverse internal and external inspection quality ratings.

Firm's actions:

In 2016, we increased our investment into all key aspects of our annual staff appraisal process to reflect and embed the importance we place on audit quality. In particular:

  • We issued detailed guidance to staff and those involved in the staff appraisal process on the importance of audit quality in the performance management and year end rating process. This included targeted guidance on how internal and external inspection grades should be considered in the process plus further guidance on tailoring 2016/17 performance objectives to individual audit quality development needs.
  • We issued guidance for partners and team members involved in audits with adverse internal or external inspection ratings to make sure findings and specific assessment comments were accurately reflected in the following year's objectives.
  • We undertook a comprehensive compliance programme in relation to the completion of staff objectives including detailed guidance, monitoring, escalating and following up with individuals to ensure that the 2016/2017 objectives were completed by the deadline set.

Audit Quality Review FRC Audit and Actuarial Regulation Division June 2017

Appendix A – Audits inspected in 2016/17

The following chart provides a breakdown of the audits inspected in 2016/17 by type of entity:

Bar chart showing the number of reviews by type of entity for 2016/17.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 3.5 reviews
  • FTSE 250: Approximately 8 reviews
  • Other listed: Approximately 1.5 reviews
  • AIM: Approximately 3 reviews
  • Other: Approximately 3.5 reviews

The following chart provides comparative information for the audits inspected in 2015/16:

Bar chart showing the number of reviews by type of entity for 2015/16.

The horizontal axis represents the "Number of reviews" from 0 to 14. The vertical axis lists the "Type of entity": FTSE 100, FTSE 250, Other listed, AIM, Other.

  • FTSE 100: Approximately 2.5 reviews
  • FTSE 250: Approximately 12 reviews
  • Other listed: Approximately 2 reviews
  • AIM: Approximately 1.5 reviews
  • Other: Approximately 2.5 reviews

Appendix B – Objectives, scope and basis of reporting

| Matter | Explanation | |:------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ [TOC]

## Introduction

This standard covers...
```

**Example 3 - Good Heading Hierarchy:**
```
## Strategic Report                         (Major section - H2)

### 1. Performance Overview                 (Subsection - H3)

Key achievements and financial highlights...  (Body text)

### 2. Stakeholder Engagement               (Subsection - H3)

Our approach to engagement...               (Body text)

## Governance                               (Major section - H2)

### Board Structure                         (Subsection - H3)
```

**Example 4 - Complex Nested Hierarchy (CORRECT):**
```
## 3. Financial Performance {: #section-3 }

### Revenue Analysis

Detailed revenue breakdown...

#### Regional Performance

Performance by region...

### Cost Management

Our approach to costs...

#### Operating Expenses

Details of operating costs...

## 4. Risk Management {: #section-4 }

### Assessment Process

How we assess risks...
```

**Example 5 - ANTI-PATTERN (WRONG - Don't Do This):**
```
## 3. Financial Performance {: #section-3 }

### Revenue Analysis

Detailed revenue breakdown...

#### Regional Performance

Performance by region...

## Cost Management                          WRONG - should be ### not ##
                                        (This breaks the hierarchy of Section 3)

### Operating Expenses

Details of operating costs...
```

**Example 6 - Numbered Sections with Custom IDs:**
```
## 1. Executive Summary {: #section-1 }

This report covers our performance...

## 2. Strategic Objectives {: #section-2 }

### 2.1 Financial Performance {: #section-2-1 }

Our financial results show...

## Governance

Our board structure and processes...
```
(Note: Use `{: #id }` syntax for numbered sections only. Regular headings like "Governance" get auto-generated IDs.)

**Example 7 - Alphabetical Lists:**
```
## Requirements

The following conditions must be met:

<ol markdown="1" type="a">
  • The entity must be registered in the UK or ROI
  • Annual revenue must exceed £10 million
  • The auditor must be struck through independent
    • For uppercase alphabetical lists:

<ol markdown="1" type="A">
  • First criterion
  • Second criterion with bold text
  • Third criterion

    • `` (Note: Use HTML

      for lowercase or
        for uppercase alphabetical lists. Always includemarkdown="1"` to ensure markdown formatting inside list items is parsed.)

        **Example 8 - Hyperlink Handling (CRITICAL):**

**CORRECT - Explicit Link:**
Text in PDF: "Visit our website at www.frc.org.uk"
Markdown: `Visit our website at www.frc.org.uk`

**CORRECT - Clickable Text:**
Text in PDF: "Read the full report" (hyperlinked to https://example.com/report)
Markdown: `Read the full report`

**CORRECT - No Link:**
Text in PDF: "Guidance on Audit Matters" (bold text, no hyperlink)
Markdown: `**Guidance on Audit Matters**`

**WRONG - Hallucinated Link (Don't do this):**
Text in PDF: "Guidance on Audit Matters" (no hyperlink)
Markdown: `Guidance on Audit Matters` -&gt; WRONG! Don't guess URLs.
Markdown: `Guidance on Audit Matters` -&gt; WRONG! Don't make the text the URL.

**Requirements:**

1.  **Table of Contents Handling:**
-   **Begin with first substantive content:** Start your markdown output with the first real content section, omitting cover pages, title pages, and decorative elements
-   **When PDF has a Table of Contents page:** Insert the placeholder `[TOC]` on a new line where the original Contents page was located
    *   The Contents heading and its list items become: `[TOC]`
    *   This single marker will be replaced with an auto-generated, linked table of contents
    *   Document flow: cover pages (omitted) → `[TOC]` marker → main content
-   **When PDF has no Table of Contents:** Begin directly with the first content section - do not insert `[TOC]`

2.  **Document Structure:**
-   **Use proper markdown heading levels (# ## ###) to preserve document hierarchy**
    *   **H1 (#):** Never use - reserved for page title
    *   **H2 (##):** ONLY for major top-level sections (e.g., "1. Introduction", "2. Methodology", "Appendices")
    *   **H3 (###)::** For subsections under H2 (e.g., "Background", "Purpose", "Assessment Process")
    *   **H4 (####):** For sub-subsections under H3
    *   **CRITICAL:** Once you open a numbered section (e.g., "## 3. Risk Assessment"), ALL subsections within that section MUST use H3 or deeper - NEVER promote them back to H2 until you reach the next numbered section (e.g., "## 4. Next Section")
    *   **Heading hierarchy must be continuous** - don't skip levels (e.g., don't go from H2 to H4 without an H3)
-   Remove any running headers, footers, and page numbers
-   Include ALL substantive content including legal disclaimers, copyright notices, and appendices
-   Skip only purely decorative elements (page borders, background graphics, etc.)
-   Use semantic structure rather than visual formatting
-   Add blank lines before headings for readability
-   **For lists:**
    *   Each list item MUST start on a new line
    *   Use `-` for unordered lists, numbers for ordered lists (e.g., `1.`, `2.`, `3.`)
    *   Maintain proper indentation for nested lists
    *   If a list continues from a previous page/chunk, continue the numbering sequence
    *   Ensure there are blank lines before and after lists for proper rendering
    *   **For alphabetical lists (a., b., c. or A., B., C.):** Use HTML ordered lists with `type` and `markdown="1"` attributes:
        -   Lowercase: `<ol markdown="1" type="a"><li markdown="1">First item</li><li markdown="1">Second item</li></ol>`
        -   Uppercase: `<ol markdown="1" type="A"><li markdown="1">First item</li><li markdown="1">Second item</li></ol>`
        -   **CRITICAL: Always include `markdown="1"`** to ensure markdown formatting inside list items (bold, italic, strikethrough, links, etc.) is properly parsed
-   **For tables:**
    *   **CRITICAL: Wrap all tables in a container div for horizontal scrolling:** `<div class="table-container" markdown="1">` before the table and `

    after * Each table row MUST be on its own line * Use|delimiters with proper spacing:| Column 1 | Column 2 |* Include header separator row:|----------|----------|` * For tables, you MUST include a header row. If the original document provides no headers, create a header row with blank cells. * Do not merge rows or cells * If a table continues from a previous page/chunk, do not repeat the header * Ensure proper alignment using colons in separator row if needed * Example structure: ``` 

            | Header 1 | Header 2 |
        |----------|----------|
        | Data 1   | Data 2   |

            ```
-   **Heading Cleanup and Hierarchy Verification:**
    *   Delete any titles or headings that contain "(continued)"
    *   If a heading is exactly "Financial Reporting Council", convert it to a bold paragraph (`**Financial Reporting Council**`) instead of a heading.
    *   Delete any heading that is identical to the immediately preceding heading at the same level.
    *   **Before creating an H2 heading, verify:** Is this truly a major top-level section, or is it a subsection of the current numbered section? If it's a subsection (like "Assessment Period", "Reporting Requirements", "Summary of Requirements" within a numbered section), use H3 (###) instead.
    *   **Watch for PDF layout tricks:** Sometimes PDFs make subsection titles look prominent (bold, larger font), but they're still subsections. Look at the numbering and logical flow, not just visual appearance.
-   **Extraneous Elements:**
    *   Remove any purely decorative horizontal lines (e.g., `---`, `***`).

3.  **Content Preservation:**
-   Include legal disclaimers, copyright notices, and important notices
-   Preserve all tables, even if they contain legal or administrative information
-   Maintain all substantive text regardless of whether it appears "administrative"
-   Only skip content that is purely decorative or redundant page elements

4.  **Content Formatting:**
-   **Emphasis:** Preserve bold and italic text using markdown syntax (`**bold**`, `*italic*`)
-   **Footnotes:** Convert to markdown format using [^1] syntax, with footnotes collected at end of document
-   **Hyperlinks:**
    *   Convert ALL hyperlinks to markdown format `text`.
    *   **CRITICAL:** Only include URLs that are explicitly present in the PDF (either visible in text or as a clickable link).
    *   **NEVER invent URLs.** If text looks like a title but has no link in the PDF, leave it as plain text.
    *   **NEVER create links where the URL is just the text itself.** (e.g., `Title` is WRONG).
    *   **NEVER guess URLs** based on the text content.
-   **Amendment Documents (e.g. FRED, draft standards):** Preserve editing marks:
    *   Strikethrough text → `~~deleted text~~`
    *   Underlined insertions → `<ins>inserted text</ins>`
    *   (Regular underline for emphasis uses standard markdown)
-   **HTML Elements with Markdown Content:** When using HTML block-level elements that contain markdown-formatted content (bold, italic, lists, etc.), always add `markdown="1"` attribute to the opening tag. Examples:
    *   `<blockquote markdown="1">Governments lie; bankers lie; even auditors sometimes lie: gold tells the truth.</blockquote>`
    *   `<div class="chart-description" markdown="1">**Chart showing quarterly results:**

Revenue increased by *25%* over the previous quarter.

    *

    ## Financial Reporting Framework

    The diagram illustrates the relationship between:

1.  **IFRS Standards** - International requirements
2.  **FRS 102** - UK GAAP for most entities
3.  **The Code** - UK Corporate Governance requirements
</div>`
-   **Blockquotes:** Do NOT wrap the entire blockquote content in `**bold**` -- only use bold for specific emphasized words/phrases that are bold in the original PDF. Blockquotes should use normal body text weight by default.
    *   **Correct:** `<blockquote markdown="1">Companies should ensure that all requirements are met when presenting disclosures.</blockquote>`
    *   **Correct with selective emphasis:** `<blockquote markdown="1">Companies should ensure that **all** requirements are met.</blockquote>`
    *   **WRONG:** `<blockquote markdown="1">**Companies should ensure that all requirements are met when presenting disclosures.**</blockquote>`

5.  **Numbered Sections and Paragraphs for Web Linking:**
-   **Identify numbered sections/paragraphs:** Look for content with explicit numbering like "1.", "2.1", "3.a)", "Section 1", "Paragraph 5", etc.
-   **Handle numbered paragraphs and sections differently:**
    *   **For numbered paragraphs:** Create self-linking anchor tags: `<a class="section__global-number" href="#paragraph-N" id="paragraph-N">N</a>Content goes here...`
    *   **For numbered section headings:** Use markdown headings with attr_list syntax to add IDs: `## Section 2.1 Overview {: #section-2-1 }`
    *   **IMPORTANT:** Always use markdown syntax (##, ###) for headings, NOT HTML tags. The markdown processor will automatically make all headings self-linking.
-   **Anchor ID formatting rules:**
    *   Use lowercase for the prefix ("paragraph-" or "section-")
    *   Keep numbers and letters exactly as they appear
    *   For hierarchical numbering: Use dashes instead of dots for IDs (e.g., `#section-2-1` not `#section-2.1`)
    *   **For parenthetical numbering:** Convert to dashes (e.g., "3.a)" becomes `#paragraph-3-a` or `#section-3-a`)
    *   For attr_list IDs, use the syntax `{: #id-name }` with spaces inside the braces
-   **ID Uniqueness:** All `id` attributes MUST be unique within the document. If a number is repeated (e.g., paragraph 1 in multiple sections), create a unique ID by appending a letter or number (e.g., `#paragraph-1`, `#paragraph-1-a`, `#paragraph-1-b`).
-   **Examples of numbered content to mark:**
    *   **Numbered paragraphs:** "1. The Panel is authorised..." → `<a class="section__global-number" href="#paragraph-1" id="paragraph-1">1</a>Content goes here...`
    *   **Numbered paragraphs:** "2.1 Overview details" → `<a class="section__global-number" href="#paragraph-2-1" id="paragraph-2-1">2.1</a>Overview details`
    *   **Section headings:** "Section 2.1 Overview" → `## Section 2.1 Overview {: #section-2-1-overview }` (Note: ID includes heading text to ensure uniqueness)
    *   **Section headings:** "3.a) Requirements" → `### 3.a) Requirements {: #section-3-a-requirements }`
    *   **Section headings without explicit "Section" word:** "1. 2024/25 highlights" → `## 1. 2024/25 highlights {: #section-1-2024-25-highlights }`
    *   **Regular headings (no numbers):** "Financial Statements" → `## Financial Statements` (gets auto-generated ID)
-   **Custom IDs only for numbered content:** Add attr_list IDs `{: #section-N }` only for headings with explicit numbering. Regular headings get auto-generated IDs from their text for TOC linking.

6.  **Image Handling:**
-   I'm providing an IMAGE REPORT below containing meaningful embedded images that were extracted and uploaded
-   When you encounter an embedded image that corresponds to an entry in the IMAGE REPORT, replace it with: `![description from report](URL from report)`
-   For charts, diagrams, or illustrations that appear visual but are NOT in the IMAGE REPORT (likely drawn as vector graphics/text), wrap descriptions in semantic HTML: use `<div class="chart-description" markdown="1">` for charts/graphs, `<div class="diagram-description" markdown="1">` for technical diagrams, `<div class="illustration-description" markdown="1">` for other visual elements
-   For purely decorative visual elements (borders, design patterns, logos used decoratively), skip them entirely
-   Include any image captions or titles as part of the surrounding text context

7.  **Content Guidelines:**
-   Focus on capturing the semantic meaning of the document
-   Preserve the logical flow and relationships between content
-   Ensure all content is presented in a screen-reader friendly format
-   Include all pages unless they contain only decorative elements
-   Keep the output clean and well-structured without extraneous formatting

**IMAGE REPORT:**
No images were found in this document.

---

Provide ONLY the markdown content.
```</div></div></div></ol></ol></div></div></div>

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    Publication date 27 September 2023
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