PracticeAuditThe ‘uncomfortable truth’ behind FRC’s Big Four fines recommendations

The ‘uncomfortable truth’ behind FRC’s Big Four fines recommendations

Could large fines for the Big Four even the playing field for smaller firms?

The ‘uncomfortable truth’ behind FRC’s Big Four fines recommendations

According to a recent independent review of enforcement sanctions by the Financial Reporting Council (FRC), The Big Four accountancy firms may be subject to fines in excess of £10m when evidence is found of ‘seriously poor quality audit work’.

The review panel report – which was published in November – recommended that ‘where one of the Big 4 firms was guilty of seriously bad incompetence, in respect of the audit of a major public company’, and where the errors amounted to nine figures or more ‘and there had, in consequence, been either widespread actual loss or risk thereof’, a penalty of £10m or more could be appropriate.

The report suggested that such fines would represent a penalty equal to the seriousness of the wrongdoing as well as forming a meaningful deterrent to other firms.

Is there a precedent for such large fines?

In short, no. A fine in the region of £10m would eclipse the current record fine issued by the FRC – namely, the £5.1m sanction handed to PwC earlier this year in respect of its serious misconduct over the 2011 audit of RSM Tenon. As recently as October, a penalty of £2.75m was handed to another of the Big Four firms – EY – for misconduct during the 2012 audit of Tech Data Limited. Steps to increase fines to £10m or more would represent a considerable escalation in the FRC’s approach to financial penalties.

Why is the FRC proposing the change?

It has often been a common complaint from commentators that the financial penalties levied by the FRC to date do not provide a meaningful deterrent as their actual financial impact is limited.

However, the £2.75m fine issued to EY earlier this year – later reduced to £1.8m for mitigating features and settlement – represented just a fraction of the firm’s £2.15bn yearly turnover. That’s just 0.12%.

While fines of £10m might be considerably more headline grabbing than those which have gone before, it is important to view the proposed penalties in light of the firms which they would be levied against. For example, earlier this year, PwC UK announced a turnover of £3.5bn. £10m would represent a mere 0.27 per cent dent in the firm’s financials.

Are financial penalties the only option?

There is considerable frustration among smaller practitioners at who allege that even in cases where serious breaches have taken place, the Big Four firms do not face the same consequences as smaller regulated firms. Sole practitioners and small-to-medium sized firms will often face restriction, suspension or even removal of their audit certificates when they are found to have committed serious breaches of audit standards by the ICAEW’s Audit Registration Committee or ACCA’s Admissions and Licensing Committee. In a smaller practice, where audit work can account for nearly half of overall turnover, such sanctions can represent an existential threat to the business. The same cannot be said of The Big Four.

Given this disparity, it is understandable why the FRC’s proposals might be greeted with cynicism from those in the sector with many believing that financial penalties alone cannot be considered an appropriate response to serious breaches by The Big Four.

How might the FRC address this problem?

This sense of unfairness might be addressed if the FRC were to make greater use of its other sanctioning powers in high profile cases and cases involving larger firms. Such cases present an opportunity for the FRC to generate its own positive public relations and to show that its regulatory powers are consistently applied across all firms and practitioners, regardless of size and financial position.

The authors of the independent review stress the importance of non-financial penalties, citing the enforcement action taken against Deloitte Brazil following its audit of Gol Linhas Aereas Inteligentes SA as a ‘good example, in a very serious case, of the combination of financial and non-financial sanctions’. The final penalty – in which Deloitte Brazil agreed a wide-ranging settlement with the Public Company Accounting Board (PCAOB) in the United States – included an $8m fine, a restriction on accepting certain audit clients, the appointment of an independent monitor to assess remedial action and additional training for audit staff.

If the FRC demonstrates a willingness to impose similar sanctions – alongside its proposed increase in financial penalties – it may create a greater sense of fairness within the sector. It may also lead to a greater sense of parity: that The Big Four are held to account in the same way as smaller firms and, more importantly, face the same scale of punishment when those standards are breached.

How likely are such changes?

In practice, one has to question the likelihood of any serious enforcement action being levied against a Big Four firm’s audit registration.

Much of this is down to the power and influence that these firms hold. 99% of FTSE 100 companies and 96% of FTSE 250 companies are audited by the Big Four. Any regulatory action which would have a tangible effect on the firm’s ability to carry out audit work would have cause serious disruption, not just to the accountancy sector, but perhaps to the wider economy. As such, placing auditing restrictions on any of The Big Four firms may be a power the FRC is unwilling – or perhaps unable – to use.

The independent review recognises these concerns as ‘problematic’ and suggests that this type of enforcement action could have an unwanted effect on members, employees and the wider public who are ultimately blameless in the underlying misconduct.

What’s more, any steps to enforce restrictions on audit activity could result in a protracted and costly legal battle, putting the FRC at a significant disadvantage given the financial means at the disposal of The Big Four. Perhaps it is in light of this uncomfortable truth, that the FRC would much rather impose financial penalties which are more likely to be accepted by the firm as operational costs accrued in the running of a large firm.

In short, therefore, it seems unlikely that the recommendations in the independent review will result in any tangible impact on the firms in question and any enforcement action to seriously restrict audit certification will continue to be a power wielded almost exclusively over smaller practices.

Carl Johnson is a partner and regulatory solicitor at the national law firm, Stephensons.

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