Discussing the FRC's annual Tier 1 audit firm inspections results
Published: 30 July 2024
12 minute read
In this In Conversation episode, Sarah Rapson, Executive Director of Supervision at the FRC, joins Kate O'Neill, Director of Stakeholder Engagement and Corporate Affairs, to discuss the key findings from the FRC's latest Annual Report on Audit Quality in Tier 1 firms. They explore the FRC's efforts to address market developments and maintain high-quality audits in the UK, emerging trends in the audit market, and challenges facing the audit profession.
Transcript
0:09
Good morning and welcome to another FRC in Conversation.
0:13
My name is Kate O'Neill.
0:14
I'm the Director of Stakeholder Engagement and Corporate Affairs here at the FRC.
0:18
And today I'm joined by Sarah Rapson, the Executive Director of Supervision here at the FRC.
0:25
Welcome, Sarah.
0:26
Thanks, Kate.
0:26
Good to be here.
0:27
And it feels like it's been a minute since we recorded this podcast last year to announce the annual report of audit quality in Tier 1 firms.
0:38
And I guess this is a real cornerstone report for the FRC, Sarah, because it really goes to the heart of the importance of one of our key planks of regulation, which is encouraging and developing consistent audit quality across the audit market.
0:52
Yes, So we're publishing the latest annual report of audit quality on the Tier 1 firms.
0:57
Kate, you're right.
0:58
It does seem like 5 minutes ago.
0:59
These firms are really important because they take the largest share of the pie market and it sets out our inspection and supervision results and there are 6 accompanying reports for each of the six Tier 1 firms that go into more detail.
1:12
It provides the market with a good representation of audit quality.
1:16
But I would put a caveat in here, which is that we take a risk based approach to selecting the audits for inspection.
1:21
So it's also really important not to extrapolate the findings or the assessment of quality to the whole population of audits performed by the firm.
1:29
But audit quality is really important.
1:31
Audit enables access to capital, which in turn enables economic growth and stability.
1:35
And that's why this report is really important today.
1:38
You're right Sarah.
1:39
I mean the risk based approach is the best way in which to really take a view of how the audits are being undertaken.
1:44
Because reminding our listeners of what a pie is, it's a public interest entity, large and sometimes complex entities, which sometimes have varying degrees of complexity either because of the business they undertake or the sector they're in.
1:59
Do you think people understand this public interest entity and why it is at the heart of audit and some of the work of the FRC?
2:07
Depends.
2:07
If you follow the market in a lot of detail, it does relate to the largest listed companies.
2:12
Of course, it excludes the large private companies, doesn't it?
2:15
And you know, true, so it's not the whole market, but it does pick up the vast majority of the public companies that you and I would care about.
2:22
South Sarah, who are the reports aimed at and how should they be used by parts of our stakeholder ecosystem?
2:29
I mean, of course the firms who are part of the report would read them with great interest, but who else should be looking at this report and helping decision?
2:37
You're absolutely right that the audit firms themselves, not just the Tier 1, by the way, the smaller firms in Tier 2 and three will also glean some useful insight into what good audit quality looks like from these reports.
2:49
But actually it's wider than that.
2:50
So, you know, audit committees should look at them to assess the audit quality from their current audit firm and also take into consideration when they're tendering.
2:58
And investors and users of financial reports can also use it to make assessments of audit quality in their relevant markets.
3:04
So not just for the firms, for a wider range of stakeholders, Cake.
3:08
And I think that's often not understood that this is really designed to help better information inform better decisions around auditors and their place in the investment chain, but also the corporate ecosystem.
3:19
So how do you engage with and supervise the Tier 1 firms to ensure that there's this commitment to good audit quality?
3:26
Because some people would say, well, isn't that a given?
3:28
But it'd be great to hear from you on the supervisory model and activity that the FRC undertakes.
3:34
The first thing we do is set out clear expectations.
3:37
We continue to work with the firms and actually the professional bodies as well to assure that better behaviours and judgments and audit quality are priorities.
3:44
Our supervision is risk based, assertive and proportionate.
3:48
Our inspections, the results of which are in this report today, focus on areas with significant potential impact on financial statements that investors rely on.
3:56
We hold firms to account and we support via good practise.
4:00
We have dedicated supervisors.
4:02
Each firm has a single quality plan with priority areas that they need to improve on.
4:06
That might be culture and conduct, it could be following up on enforcement outcomes, improvements to their root cause analysis approach, audit methodologies and leadership and governance.
4:16
These are all areas that we work with the firms we support and we challenge in service of the objectives of good audit quality and market resilience.
4:23
To ensure balance, the FRC also adopts the Four Faces approach to regulation.
4:28
So we're not only an effective supervisor and enforcement, we very much see ourselves as a system partner and facilitator.
4:34
So we're really keen and focused on improving standards and practises as well as supervising and enforcing where we feel that the stands are not being effectively applied and we do hold people to account.
4:45
So a real balanced approach between the four faces.
4:47
So can you give us a summary of the findings in this year's report and any differences that we can see compared to last year's report?
4:54
For example, any themes emerging or issues that are developing for the future?
4:59
And are there any trends in the delivery of audit quality that we have seen from the firms?
5:03
So of the audits inspected this year, 74, 4% were categorised as good or acquiring limited improvements.
5:10
The 76 percent last year.
5:12
There's been a trend of general improvements over the last five years, in particular from the largest 4 firms.
5:18
So Deloitte, EY, KPMG and PwC, we're really pleased with the results for FTSE 350.
5:24
Overall, we're pleased that audit quality in UK for the largest listed businesses is strong and also it compares favourably internationally.
5:32
All six Tier 1 firms have put considerable effort into improving audit quality, and we want to see them continuing to embed the culture that promotes audit quality and high ethical standards.
5:41
But there is a widened gap between the largest 4 firms and the other Tier 1 firms, BDO and Forbus Massage.
5:48
So you noted a quality gap between the largest 4 firms and other firms in the PIE market.
5:53
What measures are you and the supervisory team at the FRC considering to help narrow this gap and ensure consistent quality across all Tier 1 firms?
6:02
Yeah, this is a really important question.
6:04
You know, given BDO and Forbus Massage strategic importance to the audit market, both firms have got to continue to address urgently the causes of the declines in the scores and undertake significant audit quality improvement plans.
6:18
And we'll work closely with them and monitor how they're getting on.
6:21
It's fair to say that both firms have taken actions in recent years to address the inspection findings and to strengthen their related firm wide systems, but those actions have not yet had the desired impact, so they're not coming through in the results.
6:33
We'll continue to apply more intensive supervision to both firms and we'll focus on the areas that we and the firms have identified as priorities.
6:41
And we may take stronger action as we set out in the report, which could include using our pie auditor registration powers if we don't see improvements in 2025.
6:49
Sarah, I know that you and the team have spoken a lot about the scale Box and the initiative that was started over the last year or so.
6:57
Do you want to just remind our listeners why it was started and how is it helping smaller audit firms develop and maintain audit quality as they enter the pie?
7:08
Aside our engagement with tier one, we are responsible for the whole audit market.
7:12
So we do work to support smaller firms and last summer we launched the scale box.
7:17
It's intended to support smaller firms who've got either a small number of pies or who are interested in getting involved in the pie market.
7:26
There are barriers to growth for smaller firms, for example, recruitment, retention of experienced and specialist staff.
7:31
There's more lucrative opportunities in non audit services.
7:34
There is complexity in a greater degree of regulation and therefore expertise required and increased risk and liability linked to audit.
7:41
So the Scalebox helps to support tackling myths, building capability and we do it in a under a general principle that the information gathered during the Scalebox activities will not be shared across the FRC.
7:52
So it's a place that they can work closely with the regulator to build capability and capacity and confidence.
7:57
And I guess that last point, confidence is something that really drives so much of the audit market, not just in clients of audit firms, but also in the audit firms themselves as they develop capacity and capability.
8:09
So Sarah, we're a year into what we termed as Project Spring, which was a great collaboration with so many important parts of the audit market participants.
8:20
Do you want to remind listeners for what that project was designed for and how it's played out in its first year?
8:25
So about a year ago, we got together with audit committee chairs and some of the largest firms to see could we come up with a common view as to what good audit quality was?
8:36
It's really important that we engage as a regulator with interested parties, but it's not all just down to what we think about audit quality.
8:43
You know, there are lots of people with lots of views here and actually it has been really interesting to myth bust as well as actually come together with some actions and make sure that everybody understands what each other's role is in driving good audit quality.
8:55
So it sounds like from this group, Sarah, your engagement, the people who actually use reports like today's publication to inform their decision making on either choice or assessment of the effectiveness of their audit firm.
9:08
That's exactly right, Kate.
9:09
I mean, we do a lot of work with the firms, but audits are there for a purpose.
9:13
And so making sure that the users of the audits themselves are getting what they need to be able to deliver their own objectives is really important.
9:21
So moving on to another section of the report, which I think is very important for listeners to understand is the implementation of international standard on quality management, otherwise known as ISQM one.
9:34
How is this changing the way firms approach quality management and what improvements have you seen so far?
9:41
This new standard replaces the previous quality control standard which firms have been applying for many years.
9:46
It's a fundamentally different approach to quality management.
9:49
It's much more dynamic and risk based and it emphasises the role of leadership, governance, the importance of quality oriented culture and the need for continuous improvement.
9:59
So many things that we are interested in generally as it relates to our supervision approach.
10:04
This year we looked at how firms implemented ISQ one, because it's the first year, it's fair to say that all firms have invested heavily.
10:11
They've all got to some degree some areas to improve.
10:14
But frankly, you would expect that in the first year.
10:16
So it's a bit of a watch this space then, Sarah, for how it plays out now that the implementation's been done and see how they embed it, I guess in much of the work around audit in the firms.
10:27
That's right, Kate.
10:28
And I think it has the potential to make significant improvements to audit quality because it's less about specific tasks and activities and much more about culture, leadership, governance, the things that really drive improvement in audit quality.
10:42
So the report also talks about the significant developments in the audit market, including the future of the profession.
10:49
And they touched on this earlier about the retaining talent, attracting talent, but also the growing prevalence of AI, which is of course, affecting all businesses.
10:59
How do you see these factors shaping the audit landscape in the coming years?
11:03
Yeah, let's spend a bit of time on the audit profession because it it's so vital, provides hugely important services to companies and therefore to the economy.
11:11
You know, a healthy audit market attracts top talent and offers respected employment opportunities across the regions of the UK, further contributing to economic stability and growth.
11:21
So ensuring that the audit profession remains viable both now and in the future is essential and is a key aspect of responsible firm leadership.
11:29
In our supervision.
11:30
We find that UK resource is increasingly drawn from the global pool.
11:34
There is excessive overtime in some auditors, feel under unreasonable pressure and drains in work life balance.
11:42
That's a problem when we're keen that auditors do feel able to take the time to challenge management and deploy professional judgement.
11:49
So there's a whole host of issues here regarding people's experience in being in the profession, but it's really important that these are addressed particularly by the audit firm leadership themselves.
11:59
But we stand ready to support as we can as a really significant partner in the system.
12:04
For example, our professional bodies supervision team is working with the professional bodies to modernise the education side of things.
12:10
Really important to keep the focus on that.
12:13
And AII mean that is such a giant topic touching so many parts of our stakeholders ecosystem, but also the firms.
12:20
How are we thinking about even tackling the emerging themes from that?
12:25
Well, we're all learning that AI, aren't we?
12:26
I mean, it's becoming pretty ubiquitous and it's a critical focus for the future of the profession as well.
12:31
And there are opportunities and there are risks.
12:33
But what we would say to the firms is that before they roll out any technology in their audit practise as it relates to AOI, they should consider the relevant regulations, including the UK Government's own AI principles, and also keep us briefed with what they're doing.
12:47
So another watch this space.
12:48
But I think you're right, Sarah, it's a challenge for everyone, but also it's how it's going to benefit and help improve audit quality that we'll be most interested in seeing the ideas and some of the products that are being produced.
13:02
So finally, looking ahead, what do you see as the most pressing challenges from main containing improving audit quality in the UK?
13:09
And you know, how are we at the FRC really thinking about addressing these challenges?
13:15
Because some of them aren't easy fixes at all and some of them are quite systemic.
13:19
So how are you in the supervisory function at the FRC really thinking about how to address the challenges out there?
13:27
It's really important that we monitor what's happening in the audit market.
13:31
We've just created a new small team within our supervision function to monitor the market and the FRC is the developed its own market intelligence and insights function as well.
13:41
As we look at the market today, there are a number of developments that are both opportunities and risks.
13:46
We're aware that there's activity in the US for some audit firms being taking investment from private equity, some smaller firms in the UK as well to be monitored that closely with our registration team.
13:58
I mean, on the one hand, we understand that the smaller firms in particular, it's a way to access capital, to invest in new methodologies and technology to stay competitive.
14:06
On the other, that our regulatory interests are threefold, you know, who's really in control.
14:11
Our current law is that the majority of the firm is owned by auditors, the auditor independence and audit quality is preserved.
14:18
And then also how the market develops such that audit is accessible and available.
14:22
So that's private equity.
14:24
Another area, Kate, is the continued dominance of the Big Four in the audit market or work on operational separation.
14:31
This is the largest 4 firms voluntarily separating their practises between audit and non audit such that the people in the audit practise focus on audit quality in the public interest and that no material structural cost subsidy exists.
14:44
That's really important.
14:45
Culture is really important.
14:46
Audit firms should continue to cultivate a culture that promotes a strong commitment to quality and a focus on the public interest.
14:52
So that's a supervisory focus too.
14:55
And then de risking, we talked a bit about this last year, Kate, didn't we, in last year's podcast?
15:00
We don't want to see de risking by larger firms.
15:02
So de risking is the movement of challenging audits to smaller firms who may not have the capability and the resources to be able to undertake those audits well enough.
15:10
So we care a lot about that and we're monitoring that issue too.
15:14
And then the cost of audit, Kate, I mean the risk that smaller companies are priced out of access to high quality audit services.
15:20
So we are monitoring this and we want to see how we might support firms for example, in their interpreting of the auditing standards.
15:26
And I think that last point will continue to be an issue for companies across the corporate UK system because there's a lot of data out there showing that cost of has increased.
15:38
So I suppose our role there would be to help people understand where those drivers of cost increases are coming from.
15:44
But as you say, make sure that the standards are being applied proportionately and not gold plating.
15:50
Yes, I think that's something that we do need to, at the FRC have a look at.
15:54
I mean, we set standards, we interpret those standards, others advisors, audit firms interpret those standards, companies will interpret those standards.
16:02
So it is important we put a mirror up to make sure that people are doing what they need to do and not over doing it and as you say gold plating in any way because of course that in town will drive cost and this is an issue for particularly smaller companies.
16:13
Well, thanks Sarah for being so comprehensive in giving a great overview of some of the key findings but also the key drivers of the all important audit market in the UK.
16:23
I think you made a really interesting comment that whatever people's experience or views of audit are, it actually is at the heart of helping companies access capital and as an extension grow their opportunities or their aspirations.
16:37
And I'm not sure everybody in our listener group and otherwise understands that important link.
16:43
So thank you for really making that important point and also well done to you and the team for another comprehensive look at not just the audit quality inspection results, but also some of these key issues driving audit quality in the UK.
16:56
Thanks, Kate.