FRC to update ethics standards to bolster audit independenceby
The UK’s accounting watchdog is to revise its ethical standards for auditors in an effort to “further enhance and clarify the principles of integrity, objectivity and independence” the profession commits to.
Industry experts welcomed the Financial Reporting Council’s (FRC) proposals, which aim to strengthen conflict of interest restrictions relating to fees an auditor receives from certain clients amongst other tweaks.
Presently, accounting firms cannot earn more than 15% of total fee income from one client, or 10% if the client is classed as a “public interest entity”. The rules are not clear on whether companies that are under common ownership or control can be treated as a single entity when calculating the fee cap, if they are not formally part of a single corporate group.
The FRC is bidding to eliminate a loophole, by updating its standards to make it clear that the fee limits apply to “a collection of entities with the same beneficial owner or controlling party” along with the total fees received from a company and its offshoots.
“High standards of ethical behaviour go to the heart of high-quality audit and are designed to ensure auditors act with independence, objectivity and integrity at all times,” said FRC executive director of regulatory standards, Mark Babington.
“While many of these proposed changes reflect developments at the international level, additional enhancements have also been introduced to ensure the ethical requirements are clearly understood and abided by so that there can be no uncertainty of the standards expected.”
Gupta and the fee limit question
The Financial Times reported in 2021 that a small auditor, King & King, had approved the accounts of almost 60 entities in steel magnate Sanjeev Gupta’s business portfolio.
King & King was subject to an FRC investigation into four audits of Gupta’s Liberty Steel belonging to Sanjeev Gupta.
Gupta’s empire consists of hundreds of separately audited companies, with combined revenues of nearly £2.5bn, however there is no single consolidated set of accounts.
King & King partner Milan Patel told MPs that the auditor considered each GFG company individual, and did not confirm or deny whether the entire GFG portfolio in total accounted for more than 15% of audit fees received by his firm.
“We welcome the regulator looking at this issue,” said Labour MP and business committee chair Darren Jones. “As we saw during our inquiry into Sanjeev Gupta’s use of King & King, a small or medium sized auditor relying on a dominant client for fee income can result in unacceptable conflicts of interest and questionable independence.”
The extension is “a very sensible idea”, said Julia Penny, director of JS Penny and former ICAEW president. “The same threats to independence arise whether they are strictly in a group or not, as ultimately it’s about whether you are in a position of ‘lose one, lose all’ if you issue an audit report that the client doesn’t like.”
With a single person behind all the entities, it may be easy for an auditor to upset the client in regard to one set of books and feel the repercussions elsewhere, she said.
While clients don’t necessarily change their auditors just because of a qualified report, “it is the threat or perceived threat which causes the issue”, she said.
“Depending on the number of non-audit companies and quantum of connected fees provided, I could see this contributing to the continuing trend of smaller audit firms dropping audits, which may be an unintended consequence of trying to bring some equivalence to ‘normal’ groups,” added John Toon, chartered accountant and senior manager at Beever and Struthers.
Engagements, rotations and breaches
Also updated are changes to the length of time an engagement partner can be involved with a single audit. When rotating after a five-year engagement, auditors will not be able to extend for an additional time-frame of two years.
“Inevitably they are rather arbitrary figures, but the concept of not being involved too long in an audit is important,” said Julia Penny, director of JS Penny and former ICAEW president.
“It is difficult to maintain your scepticism over many, many years,” she told AccountingWEB. “On balance this is probably helpful, but it was only supposed to be seven years where circumstances meant it was an awkward point at which to change partners.
“With no leeway it is possible that partners have to change even though logically you might think quality would be better if they stayed for a certain period, for example following some big change at the entity,” Penny said.
The standard has also been revised to ensure breaches of ethical standards are reported to the FRC “on a more timely basis”.
Toon noted the potential introduction of a breaches register, which is a feature of other regulated sectors such as financial services and law.
He said it “should serve as a prompt, not to wield the big stick when, inevitably, a breach occurs”, and add context to breach responses allowing for trends to be analysed.
On whether the proposals will do much to improve the public’s view of the sector, Toon was less confident.
“I think ethical challenges, whilst extremely important, are not what makes the headlines anymore,” he said. The challenge with fixing this is that no one is doing anything to close the public expectation gap and we don’t, in my view, have an effective way, as a profession, to learn from mistakes being made. Let's not forget that lots of firms, and their staff, deliver high quality audits every day which never make headlines and rarely get celebrated.”