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FRC Principles for operational separation of audit practices

  • United Kingdom
  • Corporate
  • Financial services disputes and investigations

08-07-2020

The Financial Reporting Council (FRC) has announced its principles for operational separation of the audit practices of the Big Four accounting firms.

Background

The Competition and Markets Authority (CMA) published their final report following their statutory audit services market study in April 2019, and it contained certain recommendations to address competition issues in the audit industry. One of the recommendations made by the CMA was that the new regulator that will replace the FRC (the ‘Audit, Reporting and Governance Authority’) should have powers to design an ‘operational split’ between the audit and non-audit practices of the Big Four accountants. This recommendation was based on the CMA’s concerns regarding the potential for conflicts to arise between the firm’s non-audit activities and its audit functions and the fact that much greater revenue is generated from non-audit work.

In July 2019, the UK Government launched a consultation on the CMA recommendations. This sought views on, amongst other topics, the proposed operational split between audit and non-audit services. In the forward to the consultation, the Government stated that they strongly encouraged proposals from the audit sector outlining what they believe could be done to address the CMA’s concerns on a voluntary basis prior to legislation. The Government consultation closed on 13 September 2019.

The feedback from the Government consultation has not yet been published, and we are yet to see what legislation to implement reform of the audit profession will look like. However, the FRC published an update on their transformation programme in May 2020, in which they explained that, to make progress ahead of legislation, amongst their other activities, their Audit Firm Monitoring and Supervision team was developing principles for the operational separation of the Big Four firms’ audit practices, in order to ensure that the audit practice is focussed above all on the delivery of high-quality audit. The FRC has now, following what it describes as extensive discussions with audit firms, announced these principles for separation of audit practices.

FRC’s objectives and desired outcomes

The FRC’s objectives behind the operational separation are to ensure that audit practices are focussed above all on the delivery of high quality audits in the public interest and do not rely on cross subsidy from the rest of the firm.

The FRC’s desired outcomes include:

  • Audit practice governance that prioritises audit quality and protects auditors from influences from the rest of the firm that could divert their focus away from audit quality.
  • Profit distributions received by audit partners that do not persistently exceed the contribution to profits of the audit practice.
  • Audit partner remuneration that is determined by contribution to audit quality.
  • Transparent financial reporting in the audit practice, and a culture that supports audit quality.
  • Auditors who act in the public interest and work for the benefit of shareholders of audited entities and wider society; they are not accountable to executive management and are not (nor viewed as or considered to be) consultants.

Supervision of these measures will include audit firms providing regular management information on the audit practice to the FRC, who will then publish an annual assessment of whether firms are delivering these objectives and outcomes. The FRC will seek backstop powers to require audit firms to deliver these outcomes as part of the forthcoming legislation for the reform of audit.

There are a number of specific principles which cover:

  • Governance, including the purpose and composition of the Audit Board, which will be responsible for providing independent oversight of the audit practice.
  • The scope of the separate audit practice, including those services that should sit within the ring-fenced practice.
  • Financial matters – this includes the audit practice producing a separate profit and loss account. The FRC will also assess whether the overall distribution of profits to the partners in the audit practice and to those in the rest of the firm is consistent with their respective contributions to firm profits.
  • Remuneration of Partners – this should be designed to reward good audit quality, along with positive leadership and behaviours.
  • Transparency and accountability.

Timing and next steps

The FRC state that they are now asking the Big Four firms to agree to operational separation of their audit practices on the basis set out in the principles, and to provide a transition timetable to complete implementation by 30 June 2024 at the latest.
 
An implementation plan should be submitted to the FRC by 23 October 2020. The FRC will then agree a transition timetable with each firm.
 
Thereafter the FRC will publish annually an assessment of whether firms are delivering the objectives and outcomes of operational separation. Other accountancy firms engaged in auditing will need to pay close attention to the FRC’s requirements of the Big Four firms.

One of the most controversial of the CMA’s recommendations is proposed mandatory joint audits. In the update published on 1 May 2020 the FRC confirmed that it has developed its thinking on mandatory shared audits but has not said when it will be publishing its work on this issue. It is a complex area which raises a number of issues around roles, responsibilities and liability which will need to be carefully worked through if shared audits are made mandatory.

These changes sit alongside other proposed legislative and regulatory change for the audit profession, including the overhaul of the FRC itself and transformation into the Audit Reporting and Governance Authority (ARGA) and implementation of the recommendations of the Kingman review on the regulation of the audit industry. The Brydon review into the quality and effectiveness of audit also published its final report on 18 December 2019. As noted by the FRC, delivering many of the proposed changes will require legislation, the timing of which remains uncertain despite calls for speedy reform from many quarters.

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FRC principles for operational separation of audit practices

Objectives, outcomes and regulation