The FRC focuses on mid-tier firms with a new annual report and increased support measures

The Financial Reporting Council (FRC) has published, for the first time since it became the UK Competent Authority for statutory audit in the UK, a separate audit quality inspection and supervision report for Tier 2 and Tier 3 audit firms, along with plans to establish greater support for these smaller firms.

The seven largest audit firms which sit at Tier 1 of the FRC’s tiered system will be very familiar with the FRC’s annual publication of their audit quality inspections and supervision. However, the FRC has not until now published similar reports for the smaller firms it regulates, in respect of the Public Interest Entity (PIE) audits they perform.

Before we delve into why these changes are happening, what they entail, and the implications they will have, a brief note about which firms will be impacted may be helpful. Last year, the FRC introduced a tiered system for firms it regulates, which is based on the number of PIE audits a firm conducts and other risk factors. The system is essentially risk-based to enable the FRC to vary the intensity of its inspection and supervision work at each tier proportionate to the risk to the public interest.

The FRC’s approach to audit supervision is thus more intensive in respect of the Tier 1 firms, being those firms conducting a significant majority of PIE audits, approximately 87% of the PIE audit market. However, audit quality inspections and supervision of the smaller firms falling within Tiers 2 and 3 is still a key regulatory activity for the FRC and, as we shall see, the latest developments indicate a shift in the FRC’s focus towards ensuring audit quality is achieved across the board.

A new annual report for Tier 2 and Tier 3 firms

The FRC has strengthened its supervision of Tier 2 and Tier 3 firms over the past couple of years in response to the government’s proposed changes to audit and corporate governance, and ahead of its transition to the Audit, Reporting and Governance Authority (ARGA). Although currently, there are 22 firms that make up the Tier 2 and Tier 3 firms, which collectively only conduct 13% of audits in FRC scope, both the number of firms that will fall within these tiers and the percentage of audits they perform that will be in FRC scope, is set to rise owing to the anticipated expansion of the PIE definition.

Against this backdrop, the introduction of a new annual report of audit quality inspections and supervision for Tier 2 and Tier 3 firms is not wholly surprising. However, it represents a new development in how the FRC presents its aggregated findings and recommendations in respect of these firms and is significant in the sense that it signifies the FRC’s greater focus on audit quality beyond those firms within Tier 1.

While the existence of these reports is new, the FRC’s inspection of Tier 2 and Tier 3 firms is not. Over the last 5 years, the FRC has inspected an increasing number of these smaller firms. Since 2016/17, the FRC has carried out 31 firm inspections, 51 individual PIE audit inspections, and 27 inspections of firms’ quality control procedures, across several firms belonging to Tiers 2 and 3. The change now affecting these firms centres on how findings from their inspections will be published. Whereas previously, findings were included in the FRC’s annual Developments in Audit publication, the FRC has for the first time, and with the intention to continue to do so, published a separate report for its inspections and supervision of Tier 2 and Tier 3 audit firms.

Importantly, although the equivalent annual audit quality and supervision reports for Tier 1 firms are very detailed with the FRC publishing an individual report for each of the 7 large firms, this will not be the case for Tier 2 and Tier 3 firms. As these firms conduct only a small number of audits which fall within FRC scope, publishing firm-specific inspection data would risk identifying specific audits. As such, the annual report for these firms will only identify the firms that were in Tier 2 and Tier 3 for the corresponding annual period, and which of these firms were inspected. The information will otherwise be aggregated and anonymised.

Key findings from the 2021/22 annual report

Exceptionally, the FRC’s inaugural report of audit quality inspection and supervision for Tier 2 and Tier 3 firms covers the period from 2016/17 to 2021/2022, since the FRC became the UK Competent Authority. Over this period, the FRC inspected 51 audits at Tier and Tier 3 firms and assessed 36% of these as requiring no more than limited improvements. When compared to its inspections of Tier 1 firms over the same period, in which it found 73% required no more than limited improvement, the FRC concludes the position to be “clearly unacceptable”.

The report goes on to state that 33% of the 51 individual audits were assessed as requiring improvements and 31% were assessed as requiring significant improvements. Areas in which poor quality were noted related to the audit of judgements and estimates, revenue and inventory, going concern, financial statements and journal entries.

The FRC’s inspections of quality control procedures at Tier 2 and Tier 3 firms between the period 2016/17 and 2021/22 also suggest weaknesses in audit methodology, compliance with ethical requirements, acceptance and continuance, human resources (recruitment, performance management, and reward processes), and internal quality monitoring (IQM).

For ease of reference, we have captured in tabular form the FRC’s key findings and observations of good practice arising from its inspection of individual audit quality and quality control procedures. Please click here to download a copy of this table.

A new approach to supervising Tier 2 and Tier 3 firms

Along with a new annual report, the FRC commenced a new “forward-looking supervisory approach” for Tier 2 and Tier 3 audit firms last year, with a stated purpose of “holding firms to account through the assessment of key quality drivers, setting actions to drive improvements, monitoring progress and providing a challenge to the firm’s leadership”.

In line with its tiered system of supervisory activity, the FRC’s focus will vary depending on whether the firm falls within Tier 2 or Tier 3. For the former, the focus is directed on assessing and challenging a firm’s audit quality improvement plan, its progress in addressing the action plans arising from external inspections and internal quality monitoring activities, and the firm’s root cause analysis (RCA) processes. For Tier 3 firms, the primary focus for the FRC will be on how a firm is addressing action plans arising from external and internal monitoring.

This year, the FRC started to issue all Tier 2 and Tier 3 firms with an Annual Supervisor Letter (ASL) setting out specific priority areas for improvement and issues for the firm to address over the coming year. While these ASLs are communicated privately to the firm, the annual report sums up themes arising. This year’s report sets out specific priority areas including improvements to audit methodology, ethical procedures, people-related processes, IQM and RCA procedures.

Other action areas include being adequately prepared for registrations with the FRC as PIE audit firms (the deadline for which was 5 December 2022), being on track to implement ISQM1 as the new international standard on quality management as of 15 December 2022, and demonstrating an appropriate focus on audit culture that supports audit teams challenging management during the conduct of audits.

On the horizon: greater support for Tier 2 and Tier 3 firms

We have long-maintained a strong view towards the FRC ensuring it balances its regulatory enforcement of smaller audit firms with adequate and meaningful support to help these firms develop better audit practices.

In an open letter to the Financial Times in April this year, we highlighted our concerns about the potential adverse consequences the proposed reforms to the audit sector may have on mid-tier firms, which would be exacerbated without additional support measures being implemented by the FRC. We are therefore pleased to read the FRC’s announcement, released alongside its new annual report on audit quality inspection and supervision of Tier 2 and Tier 3 firms, suggesting such support measures are on the horizon.

While there is no set date for when these measures will be introduced, here is what we know so far:

• The FRC will be extending the scope of supervision activities including launching a new initiative called the “Audit Firm Scalebox”.
• The Scalebox will comprise bespoke measures to help smaller firms take on PIE audits and those scaling up the number or complexity of PIEs they audit.
• This will include helping new PIE audit firms better understand the expectations the FRC will have on them, and helping firms develop robust quality control systems as they grow.
• The Scalebox will be run by a dedicated team at the FRC to provide smaller firms with direct and immediate access to the regulator.

We will, as ever, be keeping a close eye on developments as they arise in this space. In the meantime, we remain hopeful that these developments hold long-awaited promise for greater support and engagement between the FRC and the Tier 2 and Tier 3 audit firms.

Further information

If you have any questions or concerns about the content covered in this blog, please contact Julie Matheson or any member of the Regulatory team.

About the Author

Julie Matheson is a partner in the Regulatory Team. Her expertise lies in advising professionals and professional services firms, particularly in the accountancy, audit and built environment sectors, on regulatory compliance, investigations and enforcement proceedings.