Director JS Penny Ltd
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Big Four audit practices face separation test

On 6 July 2020 the FRC issued its principles for the operational separation of audit practices within the Big Four firms PwC, Deloitte, EY and KPMG. Julia Penny reviews the likely challenges ahead.

9th Jul 2020
Director JS Penny Ltd
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Big Four firms face 'operational separation' of audit practices
iStock_Separate business_Martin Barraud

These proposals follow intense scrutiny of the audit profession in the UK over several years, with headlines about actual or suspected audit failures at big name companies such as BHS, Carillion and Patisserie Valerie.

Official investigations were commissioned by the bucket load, including the Kingman report on the Financial Reporting Council (FRC), which is the regulator for public interest entity (PIE) audit and accounts, as well as the Brydon review into improving audit quality together. Not to mention the Competition and Market Authority (CMA) audit services market study.

The CMA report came down with the firmest recommended for an operational, or even structural, split of audit from non-audit elements of the practice to enhance independence.

Why separate audit?

One of the clear concerns coming out of these investigations is that audit firms are too close to those that they audit.

Although the ultimate beneficiary of the audit should be the shareholders and other stakeholders, the working relationship is with the company management. Despite strict rules prohibiting firms from carrying out most non-audit services for audit clients (which have already been further tightened), there are still concerns that the substantial, and possibly more profitable, non-audit activities of firms might leave audit as the poor relation.

Being the “poor relation” could impact on upholding the vital ethical standards which ensure the independence of the auditor, as pressures other than the need for audit quality could influence auditor’s actions and attitudes. Even as I write, the FRC has issued sanctions and reprimands to Grant Thornton, in respect of failings in its ethics policies and procedures, as well as specific ethical breaches in respect of the audit of Conviviality.

The CMA recommendation of an operational split was further supported by the Brydon review, which proposed that there should be transparency over the profitability of the audit practice, as well as over the remuneration of statutory auditors. The FRC has now issued the new principles for such operational separation, which set out two objectives:

  1. Improve audit quality by ensuring that people in the audit practice are focused above all on delivery of high-quality audits in the public interest.
  2. Improve audit market resilience by ensuring that no material, structural cross subsidy persists between the audit practice and the rest of the firm.

The principles and desired outcomes

The principles go on to set out the desired outcome of the changes, which include creating an environment in the audit practice which prioritises audit quality and protects auditors from the influences of the rest of the firm.

In essence, there seems to be a presumption that the rest of the firm is somehow a little “grubby”, but audit must be pure and independent so needs a virtual “wall” (or in today’s parlance some social distance) from the source of contamination.

Being serious though, audit is different – the true “client” is not anybody that the auditor deals with day to day, so there is always a risk that the auditor acts too much for the management of the entity they are auditing, rather than for the members and in the public interest.

The FRC’s changes are designed to encourage audit practices to develop their own culture to enhance audit quality and the public interest with more emphasis on ethical behaviour, openness, teamwork, challenge and professional scepticism and judgement. Arguably these are good characteristics for an entire firm, but it might be easier to develop an audit-specific culture with an operational split. After all, audit does require a much greater degree of scepticism and judgment, and often the impact of audit failure can affect a very wide range of stakeholders, so is truly in the public interest.

Changes are on the menu to ensure audit partners’ remuneration is designed to reward good audit behaviours with a sensible focus on audit quality so good quality brings greater reward than poor quality. One would hope this was already the case, but in such large firms more generic criteria than audit quality are used to determine remuneration.

Another principle is that distribution of profits to audit partners is based on the profitability of the audit practice. This principle puts audit partners at a potential risk of getting less than other partners, as audit is less profitable. In which case, audit would become a less attractive career option which might ultimately affect quality.

Alternatively, if there has been cross-subsidisation, then an operational split will reveal the inequities and possibly lead to increased audit fees to reflect the true nature and value of audit work.

There are, in total, 22 principles for separation, so we are only touching on the key ones here, but the FRC has planned for a transition period lasting until 30 June 2024 for firms to fully comply. This period might seem excessively generous, but we should not underestimate what it will take to achieve the split and the FRC is requiring implementation plans from the firms by 23 October 2020.

Audit quality and fraud

It’s good to see some of the many audit reform recommendations being implemented, yet there is still much to be done to meet public interest expectations. There are widespread concerns that the auditor’s ability to find fraud is not what it needs to be. Despite various misrepresentations reported in the press that auditors don’t have a duty to look for fraud, they do. They must plan and perform their work to identify any material misstatement, whether caused by fraud or by error.

Whilst a sophisticated fraud could be much more difficult for the auditor to find, so far we haven’t any information to suggest that it is only the sophistication of a fraud that caused it to be missed, rather than a lack of basic audit procedures. We will not know this for certain until full reports are published on the audits concerned such as Patisserie Valeria and in recent days the Lookers collapse and the Wirecard scandal. The German payment technology company’s collapse suggests that the issues auditors are facing here are not that different to those elsewhere.

Even without any regulatory changes, auditors could improve their awareness of fraud, its methods and warning signs to ensure their audit is not the next one to hit the headlines. Given the pressures on businesses  and individuals due to Covid-19, the different working practices being used and the availability of government support, an almost perfect storm is being created that will increase the probability of fraud – some of it small and some of it very definitely material.  

So, whilst the FRC operational separation within the largest firms might go some way to improving audit quality, much can be done within firms themselves and indeed, is being done, to address independence and quality issues.

Replies (4)

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By Mr J Andrews
15th Jul 2020 09:48

More principles. How soon before we read of one , if not all , of the so called 'Big 4' not adhering to the so called ' Principles'. And where do we go from there ?

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By Nebs
15th Jul 2020 10:47

Start by scrapping the audit requirement for all private limited companies regardless of size, shareholders can request one but the starting point should be no audit required.
Virtually (I have no idea of the actual percentage) all audits give a clean bill of health, you only find out about the small minority of crooks when someone other than the auditor discovers the problem.

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By grantth
16th Jul 2020 01:01

The objective of an audit is to provide assurance that the financial report is not materially misstated. Fraudsters go to a lot of trouble to disguise their fraudulent schemes. Fraud is not designed to be found. So the auditor's contribution to fraud detection is to ensure that control systems are operating effectively and consistently throughout the reporting period. However, fraud should be divided into two categories: smaller and not having a material effect on the financial results and position, and the other being material fraud. Auditors could spend and waste a lot of time looking for immaterial fraud with the only certainty being higher fees. Discussions about auditors' responsibility for fraud detection should therefore focus only on material fraud which affects the reliability of a client's financial report.

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By grantth
16th Jul 2020 01:01

The objective of an audit is to provide assurance that the financial report is not materially misstated. Fraudsters go to a lot of trouble to disguise their fraudulent schemes. Fraud is not designed to be found. So the auditor's contribution to fraud detection is to ensure that control systems are operating effectively and consistently throughout the reporting period. However, fraud should be divided into two categories: smaller and not having a material effect on the financial results and position, and the other being material fraud. Auditors could spend and waste a lot of time looking for immaterial fraud with the only certainty being higher fees. Discussions about auditors' responsibility for fraud detection should therefore focus only on material fraud which affects the reliability of a client's financial report.

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