Comments from ACCA to the Financial Services Authority & Financial Reporting Council (FRC), September 2010.
Question 1
In addition to the matters set out in this paper, are there any other matters you would like to raise concerning the auditor's contribution to prudential regulation?
ACCA welcomes the opportunity to respond to the discussion paper Enhancing the auditor's contribution to prudential regulation issued by the Financial Services Authority (FSA) and Financial Reporting Council (FRC). We have structured our comments as answers to the questions set out in the discussion paper.
It is a matter of great concern that the discussion paper raises concerns about the exercise of professional scepticism, stating that auditors showed a 'worrying lack of scepticism' in some of their audits of financial institutions, and that they had focused too much on gathering and accepting evidence to support the assertions of institutions. These concerns are reiterated in the audit inspection reports on the Big Four audit firms published by the Professional Oversight Board in September 2010, which concluded that there was a lack of 'sufficient professional scepticism in relation to key audit judgements'.
While ACCA has no evidence itself that professional scepticism has not been applied appropriately in the audit of regulated firms, we believe that auditors and the audit profession need to take the conclusions of the above report very seriously and consider remedial steps as a matter of urgency.
In our answers to several other questions we provide views on the interactions between auditors and regulators. As the discussion paper itself states 'The purpose of this paper is to stimulate debate on how the FSA can best use audit and auditors to meet its statutory objectives.' The objectives of the FSA are not identical with those of auditors. The primary objective of auditors is to report about whether the regulated firm's financial statements as a whole are free from material misstatement, whether due to fraud or error. Thus, regulator and auditors have different viewpoints and can on occasion validly disagree.
Even where the actions of auditors are determined by a legal duty to report to the regulator (also where the work of the auditors is in a different role - such as reporting on client assets) the objectives remain different and it is important, therefore, that the regulator not only understands the danger of an 'expectation gap' but communicates with firms and other stakeholders the position that auditors are not an extension of the regulator.
Question 2
Given that professional scepticism on the part of firms' auditors is especially important in their audit of key areas of judgement in relation to accounting estimates and related disclosures, how could the requirement for professional scepticism and its application in practice be enhanced in these areas?
The work of auditors is underpinned by their understanding of auditing and quality control standards and professional ethics. Professional scepticism is part of the training of auditors and is given due prominence in International Education Standard 8 Competence Requirements for Audit Professionals which requires an advanced level of professional scepticism to be demonstrated in an audit environment. This provides a high baseline but clearly one that the discussion paper seeks to challenge.
The role of the FSA is important because sharing with auditors both relevant general industry information and any matters specific to the regulated firm in question will inform and enhance the auditor's professional scepticism.
The FRC, through the Auditing Practices Board, should consider whether professional scepticism could be enhanced through appropriate updating of Practice Note 21 The audit of investment businesses in the United Kingdom (revised).
In re-emphasising the importance of professional scepticism the discussion paper itself promotes its renewed and heightened exercise. We believe that auditors and the audit profession need to take criticisms very seriously and consider remedial steps as a matter of urgency. A key factor in regulated industries is that auditors should be well versed in applicable laws and regulations and in industry-specific accounting treatments. Such knowledge and experience should be maintained and enhanced and there should be sufficient involvement of experienced auditors to develop the professional scepticism of junior team members.
Question 3
Do you agree that management and auditors should pay particular attention to the provision of disclosures about management's key judgements, especially in cases where other specific disclosures required by the accounting standards may not fully inform users about the economic substance of a transaction, or about a firm's financial position and performance more generally?
The discussion paper highlights areas where there is a 'possible need for disclosures that go beyond those specifically required'. The point is made that for larger and more complex financial institutions, it may be necessary to go beyond the specific detailed requirements of standards: this is indeed recognised in IFRS (paragraph 17(c) of IAS 1 Presentation of Financial Statements). The point is well made, as are the concerns expressed in relation to, for example, fair value estimates and impairment provisions. The paper benefits from having a later vantage point than was available to auditors, and indeed regulators, at the beginning of the economic crisis. It is constructive to use that knowledge to inform future improvement in regulated firms and prudential regulation and we welcome in general the constructive initiatives addressed in the remainder of the discussion paper.
Question 4
Do you agree with our proposal to enter into dialogue with firms' audit committees and auditors as set out above? If not, why not?
Enhanced communication between the FSA and audit committees is beneficial but we do not believe that there is merit in the FSA formally or informally communicating information designed to assist the firm discharge its responsibility to ensure the appointed auditor has the required skill, resources, experience and independence to perform such a role (paragraph 4.20).
The responsibility is placed on the firm, not just the audit committee, and is normally regarded as discharged if the firm takes reasonable steps to ascertain that the conditions are satisfied. The existing rules advise the firm to seek confirmation of such matters from the auditor concerned as appropriate, but do not promote the concept that the FSA can be approached for similar confirmation.
We see considerable difficulty in the FSA communicating what might be regarded as partial information in circumstances where auditors may disagree with a matter but have no opportunity to comment. Were a matter to be so serious that it would be expected to influence the view of the firm concerning the suitability of its auditor, we anticipate that the FSA would wish to communicate its findings to the FRC, which is the appropriate body to deal with such matters.
Question 5
Do you consider that it would be appropriate to widen the scope of the FRC's independent monitoring arrangements? If so, what additional work do you believe should be covered by these arrangements?
The scope of the Audit Inspection Unit's (AIU) independent monitoring arrangements and its powers to take follow up action independent of the Recognised Supervisory Bodies in response to their findings have been determined primarily by an assessment of the extent to which they are in the public interest. Such an assessment is not fixed but will vary over time as circumstances change. The difficulty of reassessing the AIU's scope and powers is currently compounded by the impact of the economic circumstances following the credit crisis and the current and planned changes to the FSA supervisory regime. We would suggest that a long-term view is necessarily the best way to approach an assessment of the need for change. We note that there will be a separate consultation on auditors' reporting on client assets but, of the areas mentioned in paragraph 4.33, we consider that, for auditors of major entities, reporting on client assets is a matter that should be closely considered for AIU involvement.
Question 6
Do you believe that the FRC's powers should be improved in scope and clarity, and its resources increased, to conduct investigations in a short timeframe in relation to areas of concern?
We would be concerned if the FRC felt that it was unable to take timely action on significant concerns over audit work identified by the FSA. However, we are unable to suggest an answer to this question as the FRC has not provided data on the number and nature of such non-routine investigations, nor on circumstances where the existing powers or resources have hampered such action. We suggest that these factors should be dealt with together with other factors that impact the FRC's remit and operating resources, in the FRC annual Plan and Budget.
Question 7
Do you think the FSA should seek an enhanced range of enforcement tools in relation to audit firms as described above? If so, do you think that there should be powers to take enforcement action against individuals within an audit firm as well as the audit firm as a whole? If not, why not?
As set out in paragraph 4.35, the FSA can refer complaints to an appropriate body or use its own power to disqualify an auditor. The latter may be regarded as a 'nuclear option' the exercise of which could be very difficult to justify for the reasons referred to in paragraph 4.36. As a consequence, the range of enforcement options set out in paragraph 4.37 could provide alternatives in appropriate circumstances.
The discussion paper does not provide evidence, however, that the existing regime has been incapable of providing the right level of response to regulatory concern in any given case. Moreover, the FSA does not currently have in place itself the mechanisms possessed by the FRC's Accountancy and Actuarial Discipline Board and the auditor's professional bodies to ensure that matters are pursued and resolved in an appropriate fashion. These factors persuade us currently to prefer the maintenance of the status quo.
Question 8
How can the FSA's more intensive engagement with firms' accounting, and the audit thereof, be most effective?
We believe that it is vital for the FSA to build relationships with auditors that promote collaboration rather than separate working. Mutual trust and understanding are important drivers of effective communication which is key to the achievement of each party's objectives.
The discussion paper identifies a need to engage at an earlier stage and we would support that intention.
The paper also highlights the role of the audit committee and goes as far as suggesting trilaterals for high impact firms, between the FSA, auditors and firms' audit committees. We believe that an expansion of the FSA's engagement in this way should be beneficial, in part because the ethos of working with the FSA would energise audit committees to be more robust in their work on behalf of shareholders.
Question 9
Are you aware of any significant barriers to mutual information sharing between auditors and the FSA, and, if so, what should be done to remove them?
Initiatives as described in the discussion paper should do much to increase information sharing and we see no particular barriers to that other than the additional costs, which may not be significant.
Question 10
In what ways should the use of s.166 SPRs be developed so that they are of greatest benefit in terms of the FSA's statutory objectives?
The discussion paper questions the existing regime and suggests possible change but does not report any instances of actual failure. It is particularly important, therefore, that the 'lessons learned' review is used as a means of developing concrete evidence-based proposals. Increasing direct commissioning of external reports should not be seen as an automatic solution to perceived issues over the scope of work or the objectivity of reporting.
Question 11
Would some form of external assurance on regulatory returns be helpful in ensuring that data in returns is complete and accurate? If so, why, and would greater use of s.166 RARs be preferable to introducing an audit requirement for all returns?
Auditor involvement in regulatory reporting should be beneficial to the completeness and accuracy of returns but there would be an attendant cost. Any changes to the regime must be justified by risk assessment and must be proportionate. Complex businesses, such as banks, may hold substantial client money and/or customer assets and even pose risks to the stability of the UK's financial systems. This contrasts strongly with the position of small regulated firms, with little or no client money and/or customer assets. We welcome, therefore, the assurance in paragraph 6.20 of the discussion paper that, should the FSA decide to take this further, it will consult and conduct a full cost benefit analysis of any proposals. This should also allow scrutiny of the possible impact of the expansion of the use of s.166 Return Assurance Reports as set out in the discussion paper.
Question 12
Do you believe there could be benefit in auditors providing additional direct reports to the FSA? If so, what should these reports cover? What do you consider would be the additional costs of such reporting?
The responsibility for the provision of additional information to the regulator should generally lie with the regulated firm. A similar approach to that through which the FSA has access to auditor reports to those charged with governance would be appropriate where the matter is core to the conduct of the audit. Other reports, such as set out in paragraph 6.29 of the discussion paper, should be made by management with auditor involvement to the extent that the FSA requires assurance.
Question 13
Would audit increase the decision-usefulness of Pillar 3 disclosures made by BIPRU firms? Would the benefits justify the costs?
While, theoretically, audit would increase the decision-usefulness of Pillar 3 disclosures of BIPRU firms, the absolute need for audit depends on the use made of the disclosures: in other words, audit is indicated only if the demand is there at the level of necessary cost. In general, we would caution against introducing an EU member state option, which would amount to 'gold plating' of the Capital Requirements Directive.
Question 14
Are the different approaches to audit of Pillar 3 information between BIPRU firms and insurers justified, or should there be a common approach?
We do not believe that a common approach is indicated as the need for audited information is fundamentally affected by the type of regulated firm.
Question 15
To what extent do you believe external audit of information linked to the regulatory capital numbers in the annual report, which is not covered by accounting standards, should be audited, and why? What do you consider would be the additional costs of such reporting?
It is important to establish whether the existing regime is unsatisfactory as a whole to users before proposing change in relation only to auditing. We find the argument in paragraph 1.18 of the discussion paper persuasive in relation to this question: ". . . as well as increasing the costs of the audit, unless coupled with more specific disclosure requirements, this could create incentives for firms to publish less information on capital adequacy or to publish information in different places, which would not lead to increased benefits for market participants."