Auditors will shoulder disproportionate burden of disciplinary action under new FRC regime

THE FRC’s conduct and disciplinary arm has been through various guises over recent years – the AIDB, the AADB, and most recently, the FRC Conduct Division. But the Disciplinary Accountancy Scheme, setting out the rules under which it operates, has altered little. All is about to change.

On 17 June 2016, the EU Audit Regulation and EU Audit Directive will come into force. The regulation and directive set out a number of requirements for the regulation of statutory audits, including a new regime in relation to the audits of public interest entities (PIEs). PIEs are entities listed on the London Stock Exchange (but not AIM), credit institutions and insurance businesses. The FRC will become the UK’s designated “competent authority” responsible for the regulation of statutory audits.

To meet the requirements of the new EU legislation, the FRC is establishing a new enforcement procedure to apply to PIE audit work, and has recently issued a consultation on the new proposals.  Responses are due by 4 May 2016.

As things stand, the FRC operates two processes. The scheme is designed to deal with high public interest, high value cases.  Separately, the FRC can apply sanctions for more minor issues arising out of the Audit Quality Review (AQR) process.  The new procedure is designed to address both simple misdemeanours, and the more serious cases involving allegations of professional misconduct.

New regime

The new regime will apply to PIE audit work. It seems likely that the FRC will delegate to the professional bodies (such as the ICAEW) non-PIE public interest cases. A number of the cases currently being dealt with under the Scheme would not, therefore, be dealt with by the FRC if they arose now. It is unclear how new cases which fall outside the scope of the new process, but which still raise issues of public interest, will be addressed.

The regime will also only apply to enforcement action against an audit firm or individual auditor. It will not address the conduct of accountants in business. The balance of responsibility between executives and auditors has been a recurring theme in a number of cases under the scheme.

It appears that auditors will shoulder the burden of disciplinary action when those who prepared the accounts in the first place will not be subject to the same scrutiny.

There must be a case that an area of concern in financial reporting is the conduct of those who prepare inaccurate financial statements, but this public policy issue is not addressed at all by the new regime.

Perhaps the most significant change is the threshold for disciplinary action. Under the scheme, the FRC must establish that the member or member firm is guilty of “misconduct”. This is defined as conduct which “falls significantly short of the standards to be expected of a member or member firm”.  It is clear that this threshold requires the FRC to establish something more than negligence.

The new regime, on the other hand, is triggered by breach of what is called “a relevant requirement”.  That will be defined in the (still draft) regulation, but the current draft legislation suggests a much lower threshold for the FRC to meet in pursuing its enforcement process.

More frequent enforcement

How the new test will be applied in practice remains to be seen but it is clear that the FRC envisages that the new disciplinary process will be invoked in cases of more minor alleged breaches on PIE audits – say, those which emerge from the AQR process – than has previously been the case.  It looks, therefore, as if we will see more frequent enforcement action by the FRC in relation to PIE audit work, bringing with it the challenges of unwelcome publicity for those firms and individuals caught up in the new process.

The procedure itself bears a number of similarities to the FCA’s enforcement regime. There is a welcome opportunity for early settlement, and there are rights of appeal to a tribunal in contested cases.  There is a wide range of potential sanctions.

A key problem with the scheme in recent years has been excessive delay in the process. This point has not been addressed at all in the new consultation, although the fact that the FRC will now have a statutory power to seek material from third parties may help streamline the investigative stages in some cases.

There are many questions to be answered therefore. No doubt things will become clearer in the coming months, but time is very short before the implementation date of 17 June 2016.

What is clear, though, is the direction of travel. Regulators are increasingly under pressure to take action in response to corporate scandals, as we have seen recently in the Treasury Select Committee’s urging of the FRC in relation to HBOS. For the profession involved in PIE audit work, the regulatory and enforcement regime will only become more challenging.

Andrew Howell and Stephen Flaherty are partners in the Accountants Liability team at law firm Taylor Wessing

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