bonnet It might not be the highlight of every large under the

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1 n audit inspections briefing august accountancy under the bonnet 14 Every year, audit firms receive quality review report cards. Some are good, some are bad, but are these reports useful, asks Philip Smith It might not be the highlight of every large accountancy firm s calendar, but once a year the audit profession gets to see its school report and to be told it could do better. Big Four auditors and their peers in the larger mid-tier firms will be graded on their performance some will be at the top of the class, others will have to stay behind and do extra work. For the best part of a decade, the work of large audit firms has been the subject of detailed, independent reviews the Financial Reporting Council s (FRC) Audit Quality Review Team (AQRT), previously known as the Audit Inspection Unit (AIU) until last year, has to date picked over the files of more than 800 audits, including those of 145 FTSE 100 and 192 FTSE 250 companies. With the predictability of rain at a Test match at Lord s, the AQRT will tell auditors to remember their ethics when selling non-audit services to their audit clients. It will remind them of the importance of documenting evidence to support judgments and it will warn about the difficulties in assessing revenue recognition, goodwill impairment and going concern. Auditors will be urged to exercise greater professional scepticism. Above all, they will be admonished if they let anything get in the way of audit quality, particularly in these times of economic difficulty. We have flagged up the risk that the current economic conditions and the level of tendering activity that is taking place puts pressure on firms to sharpen their pencils and ensure that their audit is priced competitively, said Paul George, FRC director of conduct, at the launch of the latest round of reports, and in order to protect margins, look to achieve some audit efficiencies. This can create risk to audit quality. It is this emphasis on audit quality that has guided the tone of the reports since their inception. When the reviews began in 2004, in the wake of the accounting scandals of the early 2000s, the reporting process consisted of one public report that only spoke in general terms without pointing a finger at individual firms. This has now evolved into a series of individual public reports that cover all of the Big Four and a number of the mid-tier firms, together with an all-encompassing annual

2 accountancy august audit audit inspections n performance audits requiring significant improvements (Highlighted) against annual total Deloitte Ernst & Young KPMG PwC report that seeks to draw together the disparate threads from the individual inspections. Review details The reports look at individual, though unnamed, audits together with an examination of firmwide policies and procedures. They review the tone from the top, methodologies, ethics and performance evaluation. Behind the scenes, a more detailed private report is prepared by the AQRT for the individual firms, detailing corrective plans which will be expected to be put in place. These reports are now also shared with the audit committee chairman of the companies whose audit has been inspected. The auditors work will also be graded into one of three categories: good with limited improvements required, acceptable overall with improvements required, and significant improvements required. Inevitably, attention will be focused on the number of audits that fall into this final category. Back in 2005, the inspectors first annual report did not grade individual reports this practice began in the report, which found that out of the 82 audits reviewed, 18 (22%) required significant improvements. By this figure stood at 13 out of 85 (15%) audits. Although the FRC and audit firms would urge readers of these reports to look at the overall picture, attention has always been focused on the weaknesses, rather than the strengths, revealed in them. My worry is of too great a focus on 16

3 n audit inspections briefing august accountancy viewpoint nick land Audit committee chairman, Vodafone, BBA Aviation A good audit file did not necessarily indicate a good audit as what was on the file might not necessarily reflect the scepticism exercised by the auditor 16 the tables, says Robert Overend, UK director of professional practice at EY (Ernst & Young). It s important that people who want to read the reports get into the detail in the round, as there are positive comments in these reports. It is better to understand what lies behind [the inspectors ] findings rather than have people in the know talking in code. The figures would suggest that the overall quality of audit work has improved over the past decade, a point that is accepted by George. The 80% of FTSE 350 company audits that are in the good categories reflects the efforts firms are making, especially with professional scepticism, he says. But it is not uniform and there is still room for improvement. This is evident from the recurring themes and criticisms that crop up in the reports each year, an aspect that George finds frustrating. My frustration with professional scepticism is now not so great and we are beginning to see the actions of the firms are bearing fruit, though I would like to see more action, more quickly, he says. However, his frustration over issues of ethics and independence is more acute. We are somewhat disappointed that although our messages on independence and ethics are getting through, we continue to see examples where partners and staff seek to get credit for selling non-audit services to audit clients. Allied to this, he is also concerned about the reporting of independence and ethical issues to audit committees, which the AQRT says is still too vague. Audit committee reviews Audit committees are becoming an increasingly important audience for the FRC and it is consulting on how communications between the regulator, audit committees and their auditors can be improved. In this respect, the AQRT reports are becoming much more important, particularly during increasingly prevalent tendering processes. Paul George Director of conduct, FRC We continue to see examples where partners and staff seek to get credit for selling non-audit services to audit clients We are seeing increasing reference to our work and are in regular dialogue with audit committee chairs to see how we can improve the reports, George explains. This is a point picked up by Nick Land, former senior partner at EY and now audit committee chairman for Vodafone, BBA Aviation, Alliance Boots and the Ashmore Group as well as chair of the FRC s audit and assurance council. He recently told the Competition Commission, which is investigating the larger audit market, that the reports were important and of value to audit committees, although he would like to see more emphasis given to oral examination of the audit engagement partner, rather than just scrutiny of the audit files. In Land s view, audit files are only part of the evidence of quality. A good audit file did not necessarily indicate a good audit, as what was on the file might not necessarily reflect the level of challenge to management or the scepticism exercised by the auditor, he says. Land also questions whether the focus on a standard set of themes for all audit files reviewed in a given year by the AQRT added greatest value. Instead, he suggests that more focus

4 accountancy august audit audit inspections n stephen haddrill Chief executive, Financial Reporting Council We have serious doubts as to the remedy s success Tony cates Head of audit, KPMG I welcome the openness it can be painful but it is an improvement should be given to the key audit risks for each company s audit. For its part, the Competition Commission (CC) has suggested that the FRC could increase the transparency of its AQRT reports so that companies and shareholders are better able to assess the quality of their auditors and make comparisons between the audit firms. This point was reinforced in the recent CC draft final proposals for reform of the UK audit market. Responding to this suggestion, the FRC s chief executive Stephen Haddrill, says that audit Mark cardiff Head of audit, Grant Thornton There is still some easy progress to be made to get to a point to enable greater comparison committees and investors already have access to a great deal of information on the largest firms and that this was being reviewed during tender exercises. Haddrill is particularly concerned that putting a league table of auditors into the market will result in a battle with the firms on the grades of individual audits, which could distract them from promoting audit quality. We have serious doubts as to the remedy s success, he says. But notwithstanding the FRC s stance on the matter, it is clear that the reports themselves are a useful tool for audit committees when they are evaluating their auditor s work, or putting the audit out to tender. Indeed, a number of FTSE 350 audit committee reports make explicit reference to the inspections in their own annual reports. For instance, in the annual report, Computacenter s audit committee chairman John Ormerod details how his committee checked the independence and effectiveness of the external auditor, EY, through a review of the AIU s published report on the firm, in addition to receiving feedback from the company s management team. Ormerod was, of course, a former partner at Deloitte, having previously been senior partner at Andersen, so he would know what to look for in the report. Dairy Crest s audit committee at its meeting in May considered the appropriateness of the re-appointment of EY as the Group s external auditor for the /13 year, taking into account the public report on the /11 inspection of EY published by the FRC s AIU, the annual report of the AIU (/11), the committee s review of the external auditor s independence and objectivity, and the effectiveness of the audit process, together with other relevant review processes conducted throughout the year. At James Fisher, the [audit] committee considered the / Audit Quality Inspections annual report and the / public report on KPMG issued by the 18 17

5 n audit inspections briefing august accountancy Baker Tilly BDO performance audits requiring significant improvements (highlighted) against annual total FRC and noted the conclusions. The audit committee at Greggs Group, the UK s largest bakery chain, also reported this year that it had reviewed the report by the AQRT on the performance of KPMG on the Group s audit. As Mark Cardiff, head of audit at Grant Thornton says: The reports are very much referred to. I agree with the FRC that it is difficult to get true comparability between the reports, but I think there is still some easy progress to be made to get to a point to enable greater comparison. Cardiff suggests that it could be possible to improve the comparability of the companies whose audits are being reviewed, and also improve the consistency between the scoring and qualitative comments within the reports. We have always taken the inspections very seriously, says Tony Cates, head of audit at KPMG, and even more so now as the number of tenders is increasing. Cates describes how the firm will go through all the reports, including the more detailed confidential ones that are not made public, line by line, to ensure that the firm takes on board all the comments made by the inspectors. He also comments on how the inspections have evolved and are more detailed today. I welcome the openness, he says, it can be painful but it is an improvement. Looking ahead So what is the future direction for the AQRT? The team is aiming to be more focused in the coming years, and as such will reduce its inspection cycle for firms such as Baker Tilly, Crowe Clark Whitehill and Mazars to once every three years instead of the current two. Visits to BDO and Grant Thornton will continue to be made every two years. But the Big Four, which are responsible for the lion s share of the audits that fall within the remit of the AQRT, will continue to be inspected every year. Inspections of smaller firms will be delegated to the appropriate accountancy institute. Dialogue with audit committees will be increased the AQRT is planning to hold preliminary meetings with audit committee chairs at the start of individual audit inspections. Much will also depend on the outcome of deliberations in Europe and the UK on the wider aspects of competition and independence in the auditing profession George is conscious that this may place an additional workload on FRC resources, but remains determined to keep the pressure up on the firms. Our real job is to hold audit firms to account, he says. You ll never be able to claim victory, but we can at least claim it is sufficiently front of mind. Common complaints The most common faults exposed by the inspections fall broadly into three categories: technical, procedural and ethical. In the technical box, you are likely to see questions raised on how impairment, goodwill and revenue recognition have been calculated and audited. Under procedural, far and away the most frequent complaint is a lack of documented evidence to justify audit decisions. A lack of planning and strategy is also frequently criticised. Ethical issues raised often come down to independence, such as when an audit partner seeks reward for selling non-audit services, or when an engagement partner is rotated off a client but remains in close contact with the client. Professional scepticism cuts across all three categories. An auditor may not have the technical knowledge to understand the need to question a client s position, procedures may not allow appropriate time to push back, or a perceived fear of losing work could equally compromise the degree of investigation. Who pays? As a key part of the FRC s conduct division, the AQRT has a staff of approximately 21 full-time equivalents engaged in audit inspections. The direct costs of inspection activities are funded by the relevant professional accountancy bodies, such as the ICAEW and ICAS. Inspection activities outside its normal scope, such as public sector bodies including the National Audit Office and auditors of Crown Dependency entities, are funded separately so that costs for the inspections are recovered.

6 accountancy august audit audit inspections n Crowe Clark Whitehill Grant Thornton Mazars PKF FRC inspectors rank audit quality from good to requiring significant improvement Firm Big four Deloitte 2 14 Insufficient evidence on file Inapporpriate basis for judgment on going concern Evaluation of goodwill Unclear division of repsonsibility between group and subsidiary auditor Improvement needed for scoping of subsidiary audit Audit of revenue and journal testing EY Improvement needed in assessment of impairment of goodwill Audit of revenue and risk assessment; insufficient evidence on internal controls Revenue recognition, impairment of goodwill, group audit considerations KPMG 2 14 Insufficient evidence Planning audit work, inadequate controls and substantive testing State of completion accounts, audit evidence in a number of areas Revenue and profit recognition; loan impairments and IT general controls Impairment of goodwill PwC Insufficient evidence for revenue, related balances, direct expenses, trade, payables Insifficient support for goodwill impairment judgments Insufficient evidence from subsidiary auditors Insufficient evidence of evaluation of five-year plan, going concern, goodwill impairment Insufficient evidence of audit of service provider records; investment valuation Mid-tier Baker Tilly Insufficient audit evidence; reliance on service organisation; transaction not reported to AC BDO 2 5 Insufficient audit evidence; stock audit strategy unclear Insufficient audit evidence for loans payable and receivable, and related parties Lack of involvement in group audit; audit of revenue, fixed assets and stock Crowe Clark Whitehill Grant Thornton Insufficient audit evidence for material transaction after year-end; related disclosure evidence Audit strategy for stock, audit evidence for acquisition Evidence of valuation of assets and going concern, evidence of income, payroll, impairment Evidence of financial assets and intangibles; carrying value of fixed assets; loss of audit papers Mazars Engagement partner failed to consult risk management team prior to accepting reappointment PKF (now BDO) Year Good Acceptable Poor Total Problem areas 3 5 Insufficient evidence; inadequate consideration of subsidiary auditors; overstatement of provisions Insufficent evidence of inventory and revenue; insufficent evidence for provisioning Source: FRC 19