The business press has recently been full of stories about audit quality, and the need to ensure that both audit and auditors are fit for purpose. The topic has generated a number of formal reviews, and suggestions for how audit could be improved. At a high level, the following ideas have been mooted:
- simplification of accounting standards,
- reducing concentration of audit firms in some areas,
- separation of consultancy work from audits,
- clarifying the purpose and scope of audit in the modern marketplace,
- more external quality review, and
- a need for firms to focus more on “thoroughness, trust and integrity”
Meanwhile the charity regulators have themselves put pressure on auditors and examiners to be more proactive in meeting their reporting obligations. In early 2018 the Charity Commission specifically criticised firms for not reporting fast enough on modifications to audit reports, and this criticism was then endorsed by the Financial Reporting Council.
Trustees therefore should take note that audit quality is an important issue. Various stakeholders put different degrees of reliance on the fact that a set of accounts has been audited, although few probably give more than a cursory glance to the report itself. The same broad principles apply to independent examination, although there is considerably more room for judgement in applying them.
Many of the bullet points set out above are “macro” issues. The complexities of the Sorp are sometimes cited as an impediment to clear reporting, for instance, and different charities have different approaches to separating advisory work from audit. For each charity, however, the challenge for the trustee is how to assess audit quality, not just on the macro scale set out above, but individually, firm by firm, partner by partner.
Sector based surveys are a useful source of information if read in conjunction with other data, but they only provide part of the picture. Surveys are inevitably influenced, to some extent, by popularity rather than technical assessments, and sometimes volume can be seen as a proxy for quality. Therefore, whilst sector based survey data is informative, trustees can – perhaps should - look for additional, objective data.
In the UK this will primarily come from two sources: the auditors’ own regulators and reviewers, and the firms’ own quality reports. The external reviewers for larger firms comprise: the AQR (the Financial Reporting Council’s Audit Quality Review team), QAD (the ICAEW Quality Assurance Department) and the PCAOB (Public Company Accounting Oversight Board who oversee the audits of US firms). For charities, the AQR and QAD reviews will usually be the most relevant.
The FRC is officially designated the Competent Authority for audit regulation in the UK by Regulation. The Audit Quality Review (AQR) team, within the FRC, monitors the quality of the audit work and audit firms in the UK that audit Public Interest Entities (PIEs) and certain other entities. These no longer include large charities, but nonetheless the findings provide insight into firm’s wider audit quality issues.
The frequency of AQR inspections varies, with larger firms inspected annually while other firms are generally inspected once every three years. An inspection covers a sample of audits and firm-wide procedures.
Reviews of individual audits focus on the appropriateness of key audit judgments made in reaching the audit opinion and the sufficiency and appropriateness of the audit evidence obtained. Reviews of firm-wide procedures are wide-ranging in nature and include an assessment of how the culture within firms impacts on audit quality.
Inspections also monitor compliance with ‘Relevant Requirements’ as defined in the 2016 Regulations. Relevant Requirements include, for example, the Auditing Standards, Ethical Standards and Quality Control Standards for auditors.
The AQR identifies areas where improvements are required to safeguard or enhance audit quality and/or comply with regulatory requirements. They agree an action plan with each firm inspected to achieve the improvements needed, and then monitor the progress made by the firm in addressing the findings.
Each year the AQR publishes a number of individual firm and thematic inspection reports, which summarise the results of their inspection activities. At present 11 firms have individual reports published, with a concentration on the Big 4 and BDO. Since early 2017, thematic reports, which cover varying numbers of firms, have addressed data analytics, audit quality control, audit culture and materiality. The AQR also issue confidential reports on individual audits reviewed to the relevant audit firms and Audit Committee Chairs – in the past charity audit committee chairs received such reports.
In addition, In England and Wales, QAD conduct monitoring visits to all firms registered for audit with the ICAEW, with a comparable regime in Scotland with ICAS. The firms covered by AQR are therefore reviewed by two different quality reviewers. QAD review and assess firms’ procedures, processes and controls to ensure audits comply with professional standards and meet the requirements of the audit regulations. QAD reviews also include independent examinations.
QAD use a risk-based approach to select firms for visits, but visit all firms at least every six years. Reports are issued directly to individual firms, and in some circumstances, matters may be reported to the Audit Registration Committee (ARC). That Committee reviews the QAD reports, the responses to those reports, and decides if any regulatory action is needed.
All of the above reports and reviews provide rich information for trustees, treasurers and audit committee chairs to explore either in their annual review of the audit process, or during a tender process. Even if a report is not in the public domain, the auditor can be asked about it.
Apart from these external sources, many firms also publish their own annual “transparency reports”: these are a mandatory requirement for auditors of UK companies with securities admitted to trading on a UK regulated market. In practice about 30 firms produce such reports, but they vary in content and style considerably, depending mainly on the size of the firm and its involvement in the relevant markets. The reports are not formally verified by a regulator, but their contents are checked for consistency with findings from the AQR, ICAEW or ICAS as appropriate.
Whilst the content of such reports is defined by regulation, most will be more comprehensive. By way of example, here are the contents of a recent BDO report, which runs to 55 pages, including appendices:
- Introduction from the Managing Partner
- Report from the Chairman of the Public Interest Committee
- Governance Structure
- Firm Strategy, Culture and KPIs
- Ethics and Independence
- Internal Quality Control Systems
- Audit Quality Indicators
- Top Risks
- Legal Structure and Ownership
The point of these reports is to shed light on how the audit firms operate, and they are therefore useful to trustees interacting with audit firms, especially as the report specifically covers the findings from the reviews discussed above.
A third source of data available to trustees is to see what happens when charities change their auditors. This data is not so readily available, and so we conducted our own review. We looked at all the changes of auditor reported in Caritas Data Top 3000 charities, concentrating on the top 500 over the last five years. Having identified these, we then looked to see how many new appointments lead to adjustments to the previous year’s accounts – indicating either an error in the past or a poor accounting policy choice. We took such issues at face value, with two exceptions. Firstly, the period covered included the FRS 102 transition year. We reviewed the transition note to identify changes that were presented as transition adjustments but were in fact prior period adjustments and included those in our data. Secondly, we applied the definition of prior period adjustment as dictated by the contemporary accounting standards. Put simply, before FRS 102 an error needed to be fundamental, afterwards it needs only to be material.
The overall results were surprising: There were 111 auditor changes in the top 500 charities over 5 years. Of those 111, a staggering 27 resulted in prior year adjustments – just a smidgeon shy of 25%. That implies that one in four sets of accounts in the charity sector have some sort of material defect, and that auditors are not picking them up, or not being robust enough with audit committees.
There are two interesting distributions to consider. Whether there is any pattern in which firms have their accounts restated, and the nature of the restatements.
Despite the volume of adjustments, it is difficult to draw conclusions based on such small individual samples. For instance, as a group, the Big 4 lost 32 audits, which is clearly disproportionate to the distribution but perhaps reflects the growing recognition that charities are not the natural market for these firms. Net gains in this period reflected this too, with HaysMacintyre and BDO reporting net gains of 8 and 9 respectively. This all indicates that the numbers are too small to base robust conclusions on.
The list of firms that were newly appointed to 5 or more charities in this period were:
- Grant Thornton
- Kingston Smith
- Sayer Vincent
This indicates the range of firms that the sector is appointing. Of that list, Sayer Vincent and BDO had no prior year adjustments reported on subsequent accounts.
The nature of the restatements is again very spread, and the number of issues does not equate to the number of accounts restated. Some have multiple issues, and sometimes the explanation is not very clear. However, on a broad and rather subjective analysis, the issues seem to be as follows:
|Staff cost reclassification
|Grant expenditure recognition
|Investment valuation basis
There may be two conclusions to be drawn. Firstly the distribution of problems may suggest that financial reporting quality, and audit, need a general improvement. Secondly, about half the issues are charity sector specific, with a concentration on income. This underlines firstly the need for charity expertise on audit teams, and secondly the correctness of income recognition representing a presumed risk on audit plans.
Audit quality in the sector can be perceived to be a subjective matter, based on opinions and “soft” measurements. The regulators and the firms themselves provide more objective data, and even harder evidence is available by looking at the actual history of accounts reporting.