The Financial Reporting Council (FRC) outlines how it intends to implement proposals to enhance transparency of its Audit Quality Review (AQR) findings recommended by the Competition Commission (now the Competition and Markets Authority) following its investigation of the Statutory Audit Services Market. The CMA recommended that audit committees of FTSE 350 companies whose audit had been reviewed by the FRC should disclose the principal findings and grade assigned to it in the annual report and accounts together with how they and the auditors were responding to the issues raised.
The FRC announced in April 2014 that it will consult on the CMA’s recommendation in time for updates to the UK Corporate Governance Code to be made in 2016. This is in line with the FRC’s commitment not to amend the Code more than once every two years. That consultation will also address other changes to the Code that might be needed as part of the implementation of the CMA’s report and the EU Audit Directive, in order to avoid making piecemeal changes to the Code. It will take place in the latter part of 2015 and 2016, and will take account of any experience gained from any early adoption as described below.
Some audit committees have indicated that they may wish to implement aspects of the CMA’s recommendation in advance of any changes to the Code in 2016, and the FRC is supportive of investors having additional and better information about the quality of an audit. However, Audit Committees should take into account, in making such disclosures, that the AQRs’ work is focussed on the audit. It is not designed to comment on the contents of the report and accounts. The inspections also generally cover selected aspects of the audit and are also not designed to confirm the audit opinion. Therefore in considering how to report on an inspection it is important that companies do not give false assurance to investors or raise unnecessary concerns.
Our advice to Audit Committees is that in accordance with the Code they should report how they have made their own assessment of the effectiveness of the audit process. Where a company’s audit has been reviewed by the AQR, the FRC would expect audit committees to discuss the findings with their auditors and consider whether any of those findings are significant for these purposes and, if so, to make appropriate disclosures. Such disclosures should be in the audit committee’s own words and deal with what action they and the auditors plan to take. It is important that investors understand what the company itself believes to be important and how it has applied its judgement. Such reports should meet the Code’s expectation of reports being fair, balanced and understandable.
In making their report Audit Committees should not disclose the inspection grade. The current grading system was designed to help audit committees understand the significance of the issues identified and their implications. As noted above, the grades are not intended to provide an assessment of the reliability of the financial statements as a whole or the audit opinion and we are concerned that the publication of such a ‘single figure’ could mislead and distract attention from the key issues identified by the Committee. The question of whether these grades should be published will therefore be considered more fully through the consultation in 2015 and 2016.
AQR reports are confidential and currently shared only with the audit committee and auditor. In line with the above advice the FRC will waive its confidentiality rights to the information, other than the grade awarded to the audit, contained in its reports for the sole purpose of allowing the company and its auditor (who also has confidentiality rights) to determine how and what information arising from the inspection is reported to shareholders.
The CMA recommended that audit committees of FTSE 350 companies should report on
i. Whether the AQR team has concluded a review of the audit of the company’s financial statements in the reporting period;
ii.What the principal findings were, including grade; and
iii.How both the audit committee and auditor are responding to these findings.
Implementation of the CMA’s recommendation would significantly increase the transparency of the FRC’s inspections of individual audit engagements, with the existence of an AQR audit engagement review and the key findings (including the grade) becoming public information for the first time, together with details of how the audit committee and the auditor had responded to these findings.
The FRC recognises that there are a number of risks that could arise from the adoption of the CMA’s recommendation, and in particular how it is implemented. The CMA itself identified a number of risks and explained how it had considered them in designing its recommendation.
The FRC considers the risk factors to include:
- The potential for misunderstanding (by audit committees or users of audit committee reports) about:
o limitations in the scope of AQR reviews;
o the significance of particular grades for the quality of the audit;
o the relevance of the grade to the quality of the financial statements.
- The potential for public reporting of AQR findings and grades for particular audit engagements to reduce user confidence in the particular audited financial statements.
The FRC’s Audit Quality Review team (AQR) assesses whether the group auditor has complied with the requirements of relevant auditing and ethical standards and other aspects of the regulatory framework for auditing. An AQR review covers only selected aspects of the audit. It is not designed, nor would it be possible for a review, to identify all weaknesses which may exist in the audit approach, inappropriate audit judgements or failures to follow the requirements or underlying principles of professional standards or the firm’s audit methodology. For example it is not a comprehensive inspection of all subsidiary audit working papers, particularly overseas papers and is not a technical review of the accounts.