Narrowly arriving in 2019, the Financial Reporting Council (FRC) has issued final versions of the amendments proposed earlier in the year to its Ethical Standard and a number of auditing standards (ISAs (UK)).
Luckily for audit firms, the implementation will not come with a “big bang” as had been proposed and feared. Instead, the changes to ISAs (UK) will go ahead as planned from 15 December 2019 and the revised Ethical Standard will be effective for periods beginning from 15 March 2020, except the special expansion of rules capping non-audit services to “other entities of public interest”, which allow a little longer, to 15 December 2020.
When the FRC last made wholesale changes to the International Standards on Auditing as they are applied in the UK (ISAs) back in 2016 it came with an undertaking to review them after three years to assess whether those changes had successfully addressed any shortcomings and had resulted in an effective framework for the conduct of audit work. Clearly at that time no one foresaw the dramatic changes that have rocked the auditing profession over the last three years following several high-profile corporate failures, and which have resulted in a series of high-profile and far-reaching reviews into how audit work is conducted and regulated. This includes the replacement of the FRC as the profession’s regulator, with the Audit, Reporting and Governance Authority (ARGA) set to take its place.
It has not been easy for the FRC to navigate all of the current debate on and investigation into audit, and it has explained that further changes may be needed in future when decisions are taken from the CMA and Kingman reviews and the newly-published Brydon report. However, the FRC has stated that urgent issues and weaknesses seen in its own reviews need to be addressed rapidly, not waiting for the outcome of other reviews.
In perhaps one of its final acts before it becomes the new ARGA, the FRC has issued these changes aiming to help to restore public confidence in audit. Some of the changes will only affect the audit of public interest entities (PIEs), although many will impact upon the audit of all entities and thus are of importance to all who carry out audit work.
The Ethical Standard
It will come as no surprise that the changes to the Ethical Standard are designed to address concerns regarding the independence of auditors and the elimination of any perceived conflicts of interest that may arise.
To help achieve this the ‘objective, reasonable and informed third party’ test, a core element of the Ethical Standard, has been redefined with a view to make it more effective. The test has been repurposed to provide greater focus on the perspective of stakeholders who are the ultimate beneficiaries of the audit process. As such when considering whether the overarching principles of the Ethical Standard have been met reference should be made to the perspective of a third party that is informed about the roles and responsibilities of an auditor, those charged with governance and the entity’s management, but is not themselves an audit practitioner. The viewpoint of an informed investor, shareholder or other public interest stakeholder is hoped will best support the effective evaluation required by the third-party test with the diversity of thought that this will bring. This will require auditors to have a greater understanding of an entity’s key stakeholders and their expectations as to how auditor independence should be ensured.
The role of the Ethics Partner has also been considered, and changes included to enhance the authority of the Ethics Partner. There is also a new requirement to report to the FRC (for PIEs) or to the Relevant Supervisory Body (for other entities) where an audit firm chooses to override the advice of the Ethics Partner.
The existing approach of having in place more stringent requirements for the audit of PIEs remains, but the Standard now acknowledges that these should be extended to other entities where there is significant public interest to stakeholders. This will be likely to include entities that fall within the inspection scope of the FRC’s Audit Quality Review process, for example private companies which have turnover in excess of £500 million, although there is no formal definition in the standard.
A common perception is that auditor independence is impaired when a range of additional non-audit services are also provided to an audit client. This is being addressed by a complete change of approach for the audit of PIEs and other entities of public interest, with the introduction of a new list of permitted services that can be provided to an audit client, all of which are closely related to the audit itself or are required by law or regulation. This move from a “forbidden list” to a “permitted list” is likely to significantly restrict the range of services auditors can provide to these types of clients. Further changes will also restrict all auditors from providing internal audit and recruitment services to their clients, and will rule out performing work under contingent fee arrangements. For some firms with client bases dominated by particular industries, this could be quite significant, for instance for those that specialise in audits of academies, where it is usual to offer external and internal audit services together.
The changes on non-audit services also become theoretically more onerous for some because the exemptions for ‘SME listed entities’ have now been removed. However, in practice these exemptions were rarely taken so the FRC does not expect this to have a significant impact, and the exemptions for small entities in Section 6 remain.
International Standards on Auditing (UK)
Although the changes affect a broad selection of the ISAs (UK), the main changes focus on four principal areas:
- Law & regulation – greater consideration of whether there are any indications of non-compliance with the legal and regulatory framework in which the audited entity operates will be required as part of the auditor’s risk assessment, and there is improved guidance on circumstances which may indicate that such non-compliance has taken place. The changes also emphasise the importance of qualitative factors when considering whether non-compliance is material and may require disclosure in the financial statements.
- Groups – as an area that has been repeatedly found to be poorly addressed in practice, it is perhaps no surprise that the guidance has been improved to clarify the level of work that is expected when considering the work performed by component auditors. Although there was already published guidance on this, in a Staff Guidance Note, moving it into the body of ISA 600 gives it extra prominence and emphasises how important it is to get this right. There is also guidance included for how the group auditor should respond if it is unable to gain access to the component auditor’s working papers.
- Reporting – the auditor’s report is to be enhanced to provide greater clarity on the audit’s capability for detecting irregularities, including fraud, in an effort to reduce the ‘expectation gap’ that currently exists regarding the auditor’s responsibilities in this area. The additional reporting requirements that exist for the audit of PIEs are to be extended so auditors must specify the level of materiality they have worked to and give additional information on the application of this materiality level and the significant judgements made by the auditor during the course of their work.
- Other information – enhancements to the auditor’s report are introduced that clearly present the auditor’s responsibilities for the statutory other information that is presented alongside the financial statements, such as the strategic and directors’ reports. More significant changes are also made for the audits of entities that report on how they have applied the UK Corporate Governance Code.
At this critical time for the audit profession it has never been more important to stay on top of the latest developments in order to ensure that the work you undertake remains compliant with the changing framework of standards and expectations. The changes will be reflected in the Mercia audit methodology and the General Practice Procedures Manual in 2020.
Also, our programme of webinars and audit update courses that are taking place at venues across the UK over coming months, includes:
- Online - Revisions to Audit Standards – Gearing up for the new requirements – 24 Jan 2020
- Online - Revisions to Audit Standards – ISA 570 Going Concern – 24 Jan 2020
- Online - Revisions to Audit Standards – Ethical Standard 2019 – 13 March 2020
- Online - Revisions to Audit Standards – Practical implementation of the changes – 30 September 2020
- Online - Revisions to Audit Standards – ISA 540 Accounting Estimates – Dates TBC
- Face to Face & Online - Audit update and current issues – Various dates & locations