FRC fires warning shot over audit quality

THE PRICE WAR raging between accounting firms is damaging the quality of audit work as firms cut corners in an attempt to reduce costs, the industry watchdog has warned.

Margins have been squeezed across the board as a result of savage price competition for the audit tenders of large listed entities.

The fee environment, which has been described as ‘brutal’ and ‘the most challenging’ some partners have ever seen, has resulted in firms slashing costs, putting the quality of audit work at risk.

In its annual report into the industry’s performance, the Financial Reporting Council found that firms had been cutting costs by off-shoring certain audit procedures, delegating work to junior staff, using more checklists and other efficiency measures.

“We see risks around commercial pressures and believe that needs to be managed carefully,” said Paul George, executive director of conduct at the FRC. “Audit needs to represent value for money but there needs to be appropriate controls to ensure that giving significant fee reductions doesn’t undermine the quality of work being performed.”

The report, issued by the FRC’s Audit Inspection Unit, also accused auditors of not being sceptical enough in the conduct of their work. The industry has come in for criticism from regulators for its failure to challenge management assertions before the financial crisis, and while it has undertaken actions to be more sceptical, there is still some way to go.

George said the FRC would give firms support for the initiatives that have been undertaken to improve auditor scepticism, but might equally criticise them because the benefits of those actions have yet to materialise.

Of particular concern was the way impairment of goodwill and other intangibles were audited.

According to the FRC, a ‘significant’ number of issues were identified, including insufficient evidence of challenge to the key assumptions, and concerns regarding the adequacy of the related disclosures. Auditors were also told they must challenge more what they are told about a bank’s loan loss provisions.

Significantly, the FRC’s findings suggested that audit teams did not always fully understand the accounting and reporting requirements for goodwill impairments, which resulted in impairment reviews being accepted based on profit forecasts rather than cash flows.

Questions were also raised about another contentious area of the audit market: auditor independence.Proposals by European Commissioner Michel Barnier to split the provision of audit and non-audit services has met with opposition from the profession, yet auditors are still failing to “understand or appreciate” the importance of applying ethical standards to auditor independence.

The FRC said it is concerned that, more than seven years after the Ethical Standards were introduced, there has been no improvement in this area.

George said that firms must reconsider the adequacy of their procedures and training in this area.

“They are not particularly good at identifying specific threats [to independence] and even when they do identify them, they are not very good at establishing safeguards,” he said. “The firms really need to adopt a stronger approach. If they don’t, do we need another model?”

Despite the problems, the FRC said that overall the inspections in the year to March 31 had shown an improvement in results. The number of audits requiring significant improvements fell to eight cases from 11 the previous year. The proportion of audits assessed as good with need of limited improvements remained consistent with previous years.