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Promoting Audit Quality: U.K. Financial Reporting Council Discussion Paper

By Mary Ellen Oliverio

FEBRUARY 2007 - In November 2006, the Financial Reporting Council (FRC), the United Kingdom’s independent regulator for corporate reporting and governance (www.frc.org.uk), issued a provocative discussion paper, Promoting Audit Quality. Audit quality is a hot topic among accounting practitioners and in regulatory circles in the United States and elsewhere. The FRC prepared this discussion paper in the context of the financial reporting framework in the United Kingdom and the Republic of Ireland. The FRC is soliciting the views of parties interested in the audit process with regard to three themes:
  • Identifying the relevant drivers of quality audits;
  • Identifying the threats to the drivers, and ascertaining whether there are threats that have not been identified; and
  • Suggesting additional action that could improve the “likelihood of audits being of a consistently high quality.”

The discussion paper was motivated by the FRC’s objective to promote and maintain users’ confidence in the audit process and in the resulting audit report. In order to do this, according to the paper’s introduction:

[T]he FRC believes that users of financial reports must be able to rely on an audit report giving a robust and objective opinion that the financial statements concerned …

  • [Show] a true and fair view;
  • Have been properly prepared in accordance with the applicable accounting framework; and
  • Have been prepared in accordance with the relevant legal requirements.

An Assessment of the Current Environment

The overall description of the current environment is especially valuable to U. S. auditors and others interested in the subject. It provides a thoughtful summary of the view of contemporary auditing from the United Kingdom. A statement in the introductory paragraph makes clear the impact of the recent U.S. auditing scandals:

Following the high profile collapses of Enron and WorldCom and the demise of Andersen, the quality of financial reporting and the effectiveness of the audit process have been the subject of unprecedented analysis, review and reform over recent years.

The FRC states explicitly the important role that financial reporting plays in effective operations of capital markets. It also states its belief that “the audit is fundamentally sound and appropriate to achieve its objective—namely a reliable and objective audit opinion.” The developments in the United Kingdom are outlined and reflect thoughtful consideration of U.S. auditing failures, especially during the past six years.

Drivers Identified

The discussion paper presents what the FRC considers the drivers of audit quality and related threats in each of four main areas. It then provides the thinking of the council to date. The following are brief summaries of the drivers and related threats.

The culture within an audit firm. The principal indicators identified include:

  • Whether the firm’s leadership effectively promotes the importance of auditors’ discharging their professional responsibilities;
  • Whether there is compliance with standards of ethics and professional conduct;
  • Whether the firm’s human resources initiatives promote personal characteristics such as integrity, objectivity, skepticism, and robustness;
    • and
  • Whether the firm avoids short-term decisions that have a negative effect on quality.

The principal threats identified include:

  • Leadership of the audit function has insufficient input into management decisions because of competing interests of other components of the practice; and
  • An overemphasis on winning audit engagements and on retaining clients.

The skills and personal qualities of audit partners and staff. The principal indicators of this driver include:

  • The skills base of partners and staff;
  • The training given to audit personnel; and
  • The approach to appraisal of partners and staff.

The threats identified include:

  • Failure to develop necessary personal characteristics through effective mentoring;
  • Failure to retain experienced and expert staff;
  • Allocating capable staff by client prestige rather than audit risk; and
  • Insufficient or ineffective training.

The effectiveness of the audit process. The principal drivers identified include:

  • Structure, experience, and knowledge of the audit team is appropriate for the engagement, and resources are sufficient for iissues that may arise;
  • High-quality technical support is provided to audit teams;
  • Audit methodology is structured to provide an appropriate framework and procedures that ensure compliance with standards, including requiring appropriate documentation and review; and
  • Objectives of ethical standards are achieved.

The threats identified include:

  • Increased use of computerized audit methodologies may shift focus away from evidence gathering, due to time spent coping with technology;
  • Overly prescriptive auditing standards, regulation, and audit methodology; and
  • “Client capture”—the relationship between the auditor and client is so close that objectivity is impaired.

The reliability and usefulness of audit reporting. The principal drivers identified are:

  • The form of the auditor’s report is highly codified and standardized; and
  • Good communication with audit committees is likely to contribute to high-quality outcomes.

The threats to confidence in audit reporting include:
  • Whether auditors are properly fulfilling their legal responsibilities to consider the adequacy of the client’s accounting records;
  • Whether auditors’ reports should be more informative about key audit issues; and
  • Whether the scope of the meaning of “true and fair view” was restricted with the introduction of International Financial Reporting Standards of the International Standards Board (IFRS; this is specific to U.K. requirements).

Outside Factors Affect Audit Quality

The final chapter of the discussion paper recognizes that external factors also impact the quality of audits. The paper includes brief discussions of: 1) the approach taken by management; 2) the contribution made by audit committees; 3) the role of shareholders and commentators; 4) the role of litigators; 5) the approach of regulators; and 6) the pressures caused by the accounting reporting regime.

The FRC Welcomes Comments

The discussion paper includes questions at the end of each topic, but the FRC states that “commentators should not feel that they are constrained by those questions or required to answer them.” Views of those stakeholders and other parties interested in the audit process are welcome.

As noted above, the discussion paper is provocative; it outlines critical aspects realistically and wisely; overall, it is an exceptionally impressive first approximation to the topic of determining audit quality. Nevertheless, the paper has many aspects for which comments are justified. For example, the nature of the evidence that is most likely to reflect the effectiveness of the specific drivers is yet to be identified. Under “The Culture within an Audit Firm,” the following driver is listed:

[W]hether the firm’s leadership effectively promotes the importance of discharging professional responsibilities as auditors.
.The question still to be answered in the guidance that is expected to enhance audit quality is this: What evidence provides valid, reliable information to give the person responsible for oversight confidence that the audit firm indeed promotes professional responsibilities as all members of the audit team perform their assigned tasks? An inquiry of the leadership of the audit or of the firm’s human resources executive is not sufficient for appropriate and sufficient evidence to satisfy that the driver is indeed reflected in the culture of the firm.

The discussion paper is available at www.frcpublications.com. Comments should reach the FRC by March 31, 2007, and should be addressed to:

JEC Grant
Financial Reporting Council
Fifth Floor, Aldwych House
71–91 Aldwych
London WC2B 4HN
U.K.

(or via e-mail to j.grant@frc-apb.org.uk)

Mary Ellen Oliverio, PhD, CPA, was formerly a professor of accounting at the Lubin School of Business, Pace University, New York, N.Y.