FRC Annual Enforcement Review 2021: The Main Points

On 29 July 2021 the FRC released its 2021 Annual Enforcement Review (the “Review”) summarising the FRC's enforcement work over the past year. In this bulletin we summarise and provide our comments on the Review.

Key themes

As with last year, the failure of auditors to exercise professional scepticism (ISA 200) remains one of the key "live issues" in the regulation of the profession.  But the Review also focuses on issues in connection with auditors’ preparation of audit documentation (ISA 230).  The FRC underscores the importance of this standard and emphasises that breaches of ISA 230 may result in "significant sanctions".

Other key themes in the Review shine a spotlight on those who prepare and approve the companies’ financial reporting which is the subject of the auditor’s work.  The issues highlighted are:

1. The fraudulent use of company funds: the most serious cases involve accountants who have committed fraud.  The drivers do not always appear to be financial.  In some cases accountants have ostensibly been motivated by a desire to improve the appearance of the company’s financial health.
    
2. Misleading financial reporting: examples include:
   1. the fabrication of revenue streams;
   2. wrongly recognising revenue;
   3. recognising revenue too early;
   4. the inappropriate capitalisation of costs;
   5. failures to account appropriately for bad debts; and
   6. the inappropriate categorisation of liabilities such that financial statements were misleading as to the true level of the company’s financing requirements.
       
3. Goodwill in companies' assets: incorrect, and sometimes reckless, goodwill assessments. Examples include the unjustified inclusion of goodwill on the company’s balance sheet in circumstances where the business was loss-making with net liabilities, as well as inaccurate assessments of future cash flows or erroneous discount rates.
    
4. Misleading the auditors: management failing to provide relevant material to the Audit Committee and the auditors, or demonstrating an excessive degree of optimism which in turn appears to have compromised the objectivity of the accountants and/or auditors.

Constructive Engagement

However, the stand out theme in the Review is not enforcement but the successful championing of the Constructive Engagement process as an alternative to full enforcement action.  48 cases have been resolved through Constructive Engagement over the past year.  That is an increase of 45% on the previous year.  The typical timeframe to resolve cases using the Constructive Engagement mechanism has also reduced from just under seven months to just under five months.  As one would expect, the biggest users of the process are the biggest firms: 34 of the 48 cases involved the "Big Four", and 43 included the seven largest firms. Bespoke remedial actions were agreed with firms in 81% of cases that went through Constructive Engagement.  Those remedial actions are often similar in effect to types of non-financial sanctions often agreed at the end of enforcement action.

The year in numbers

In time-honoured fashion the Review contains a considerable number of statistics about the cases which the Enforcement Division has seen over the past year:

• There are 49 current investigations.
• 16 new investigations have been opened over the past year.
• 9 cases have concluded: 3 have been closed with no further action, 6 have settled, and 1 has been decided by a Tribunal.
• There has been a 44% growth in the enforcement division as headcount has increased from 36 to 52.
• There are 12 ongoing investigations into accountants, and in a number of those cases the FRC has already sanctioned the auditors or the audit investigations are on-going.
• 6 cases in relation to audit matters resulted in sanctions being imposed on audit firms and audit partners.
• The FRC has imposed financial sanctions of £16.7 million (before settlement discounts).
• The level of total discounts and reductions ranged from 20% to 44%.
• The FRC also handed out 28 non-financial sanctions.

This year finally saw the conclusion of some major cases on which the Enforcement Division has been working for the past few years.  Those included Autonomy, which saw the highest financial sanction to date in any FRC matter.  The financial sanctions in that case – £15 million for the audit firm, £500,000 for one audit partner and £250,000 to another – made up the lion’s share of the total financial sanctions imposed.

Although the number of concluded cases decreased by four versus 2020, the number of non-financial sanctions imposed increased, which may demonstrate the increased use of non-financial sanctions to attack the root causes of breaches and/or misconduct.  

It should also be noted that fewer investigations were resolved this year, which the FRC say partly reflects "slower progress" than they should have liked where cases were concluded by settlement.

"Looking to the future"

In addition to the normal retrospective of the FRC’s annual enforcement reviews, this year’s Review looks ahead to the risks and uncertainties of Covid-19, Brexit and climate change that are yet to be felt in full.  Some of the key areas that the FRC has flagged for audit firms and auditors are:

• The importance of carrying out appropriate risk assessments, given the risk of weakened financial controls.
• The assessment of going concern and related disclosures because of increased uncertainties.
• The likely increase in the need to make judgement and accounting estimates.
• The increased risk of fraud as a result of the economic pressure that companies face.

Comment

The increased focus on Constructive Engagement should be seen as positive, and firms no doubt welcome a swifter and more contained process in return for making sensible concessions and improvements to their processes.  At the moment there appears to be some consensus regarding the "benefit of regulatory cooperation, including where those subject to investigation proactively identify and remediate issues, and self-report or make full and frank early admissions".  It will be interesting to see how far firms will be willing to take this in the coming year(s).

Other aspects of the Review seem quite transparently to mesh with the wider reform agenda ushered in by the publication of the BEIS white paper: Restoring Trust in Audit and Corporate Governance (the “White Paper”) in March 2021¹. One obvious example is the emphasis on issues around preparing and approving companies’ financial reporting, which clearly has one eye on the FRC’s Future of Corporate Reporting Project, and the sustained political and parliamentary focus on the role of audit and the need for audit reform more generally.

Likewise, the growth in the FRC’s headcount is part of its preparations to morph into ARGA (at some point).  We expect to continue seeing the upward trend in more investigations being opened as the Enforcement Division expands.  Then one has in addition the challenges and risks presented by Covid-19, Brexit and climate change, and the issues for accountants and auditors which are likely to result.  There can be little doubt that the FRC/ARGA will be busy in the coming years – particularly if, as proposed, it obtains powers to investigate and sanction directors of Public Interest Entities in relation to corporate reporting / audit related responsibilities.

All in all, we expect all the same key metrics to have increased again by this time next year.

1. Audit purpose, scope, liability and engagement with shareholders 
2. Privilege reform in regulatory investigations
3. New corporate reporting – brave new world?
4. Competition, choice and resilience in the audit market
5. Redressing the balance between auditors and directors (Chapters 2 and 5 of the White Paper)
6. A strengthened regulator (Chapter 10 of the White Paper)
7. Supervision of audit quality and additional changes in the regulator’s responsibilities (Chapters 9 and 11 of the White Paper)