‘De-risking’ and financial exclusion
The Financial Reporting Council (the ‘FRC’) has published its Annual Enforcement Review 2021 (the ‘review’). We highlight the key trends in relation to the Enforcement Division’s activities during the past year, observations in relation to the FRC’s adoption of constructive engagement as a means of early resolution of matters, trends regarding sanctions imposed by the FRC, and priority areas of concern identified by the FRC, which are likely to impact its enforcement work over the coming year.
The review reports a significant growth (44%) in headcount in the FRC’s Enforcement Division from 36 at March 2020 to 52 at March 2021. This growth is also set to continue over the coming year, with plans to increase headcount by further 38% by March 2022.
Specifically, this year, the number of lawyers employed by the Enforcement Division rose by 33%, from 15 last year to 20 this year, and 40% more forensic accountants joined the team, from 15 last year to 21 this year.
With a larger headcount, we expected an increase in activities undertaken, and the review suggests this to be case. There were 8% more cases opened this year (95 this year compared to 88 last year).
The review also reports an increase in on-going cases as at 31 March 2021, from 42 last year to 49 this year, representing a 14% increase. However fewer cases were referred to the Conduct Committee, 14 this year compared to 18 last year, representing a 29% decrease. This might be explained by the significant increase in cases that were resolved early by way of ‘constructive engagement’, which we consider in more detail in the section below.
The review reports that a greater proportion of cases (almost half of new cases) were resolved through the FRC’s Constructive Engagement process, with 48 cases being resolved through this process compared to 31 last year. This represents a 45% increase in these cases compared to the previous year. In addition, the review reports a quicker resolution of these cases, with the average time taken to conclude cases through Constructive Engagement coming in at just under 5 months this year as opposed to just under 7 months last year. It’s also notable that in last year’s FRC Annual Enforcement Review 2020, a 58% increase in cases being dealt with through Constructive Engagement was reported compared to the previous year. The latest review therefore suggests a continuing upward trend in the FRC’s focus on early engagement and resolution.
The Constructive Engagement process is discretionary. It involves the FRC entering into dialogue with a firm or auditor to seek to secure remedial action to improve audit standards, without going through the full enforcement process (which often leads to significant costs awards and significant sanctions). While its suitability in any case will be determined by the FRC Case Examiner taking account of a range of factors, cases that were determined suitable for Constructive Engagement involved errors in financial statements which appeared unlikely to have had a real impact on an entity’s stakeholders, such as investors, or where potential breaches of auditing standards had been identified through AQR inspections, and timely remedial action by the audit firm could be achieved via intervention through Constructive Engagement.
Among the most common root causes identified in cases resolved through Constructive Engagement, there was a moderate increase in cases involving insufficient audit testing (from 22 last year, to 24 this year). This observation is unsurprising, factoring in the overall increase in cases being dealt with through this early engagement process. However, the number of cases where a lack of professional scepticism was identified as a common underlying issue disproportionately increased from 7 last year to 21 cases this year. This represents a 200% increase in these cases, which is likely to have contributed to the FRC’s identification of ‘failure to exercise professional scepticism’ as a recurring theme in this year’s annual report.
Over the past couple of years, we have seen a greater focus on the FRC trying to resolve issues by way of Constructive Engagement. The review statistics support our expectations in this regard, and we hope the upward trend we are seeing in more cases being considered under this process will continue following the FRC’s transformation into ARGA.
Where the FRC decided that a firmer approach was required to address potential breaches identified, it is interesting to note that the number of investigations that resulted in a financial sanction being imposed on an audit firm or auditor was down by 27% from last year. Conversely, only a slight increase from last year (3%) may be observed in the number of investigations resulting in a non-financial sanction.
Non-financial sanctions are often bespoke, and aim to address underlying causes of the breaches or misconduct investigated and seek to improve audit quality. Types of non-financial sanctions have included remedial actions such as the imposition of additional requirements on audit firms, reprimands in the form of conditions imposed on firms and individuals, and in one case this year, exclusion of an individual from the profession.
Looking at previous years, a greater percentage is generally observed in the imposition of non-financial sanctions as opposed to financial ones. For example, in 2018/19, non-financial sanctions made up 58% of FRC imposed sanctions during that period, while in 2019/20, they comprised 71%. This year, 2020/21, the percentage gap has increased a little further, with non-financial sanctions making up 78% of all sanctions imposed. However, it is only in rare cases that the FRC will only impose non-financial sanctions, and what is more likely is that a mixture of financial and non-financial sanctions will be imposed.
Of final note, while the amount of pre-discount financial sanctions imposed in 2020/21 was more or less consistent compared to last year, the amount of post-discount fines have increased by about 45%, meaning that smaller or fewer discounts were given by the FRC during this latest period. In accordance with the FRC Sanctions Policy and Guidance, discounts may be given to reflect levels of mitigation, co-operation, timing of admissions, and settlement with firms. Seeking advice early on in an FRC investigation may therefore help to increase the chances of these mitigating factors having relevance if and when a financial sanction is being considered by the FRC.
At the conclusion of its review, the FRC identifies several themes which it considers will continue to bring significant changes to its regulatory landscape over the coming year. Looking to the future, on-going risks and uncertainty arising from Covid-19, Brexit, and climate change are highlighted as issues which companies will continue to face.
To combat these increased risks and uncertainty, the review re-states the importance of audit firms and auditors carrying out appropriate risk assessments, which it notes will be of particular pertinence owing to entities having to quickly adapt to Covid-19, Brexit, and climate change, which may potentially result in a weakening of their financial controls.
Audit firms and auditors are also advised to be alert to their assessment of going concern, viability, and related disclosures, particularly in response to the increased uncertainties facing entities. Linked to this, the review suggests the requirement to make, and assess for reasonableness, judgements and accounting estimates is likely to increase, with current levels of uncertainty meaning that significant additional disclosure is likely to be required.
Finally, the current environment, the review suggests, is likely to trigger increased risk of fraud, arising from economic pressure on management and employees. Auditors and firms are therefore advised to respond to these risks and adapt their audit procedures. The need for auditors to maintain professional scepticism throughout the audit process is again emphasised.
The FRC’s latest Annual Enforcement Review highlights a number of interesting trends. The increase in cases opened by the FRC’s Enforcement Division this year in some ways reflects its significant expansion in headcount, and with future plans to expand the team further by March 2022, we expect an upward trend in new cases being opened by the FRC over the coming year. The growth of the Division might also suggest it is preparing for its transformation to ARGA, and the potential enlargement of the Public Interest Entities (PIE) market, which is expected following the recent BEIS white paper consultation on audit reform. Those reforms are likely to result in an increased number of audit firms entering ARGA’s remit of oversight regulation for audit quality. With this in mind, the continued increase in the number of cases being resolved through the Constructive Engagement process is welcome news, and will offer comfort to new firms entering the PIE market, as well as to those firms who are already operating within it.
Not only will the Division (under the structure of ARGA) be overseeing and regulating audit firms, the reforms also envisage the regulatory scrutiny of company directors. Currently, the FRC has no direct power against company directors, unless in those limited circumstances where the director is also a chartered accountant. The proposals include a new power to be given to the FRC’s successor ARGA, to take enforcement action against directors who are not chartered accountants where they may have breached their duties relating to corporate reporting and audit. Regulatory oversight of this new group of individuals will no doubt call for greater internal resources than the FRC has previously had.
Another piece of welcome news is the trend observed in relation to the proportion of non-financial sanctions imposed by the FRC. This year’s review suggests an increase in the FRC’s focus on utilising non-financial sanctions as a means of encouraging audit improvement. In serious cases, the FRC has demonstrated it will continue to impose significant fines where necessary to protect the public interest; however, the positive trend in the FRC imposing non-financial sanctions to improve audit quality, coupled with its use of Constructive Engagement in a greater number of cases, will be reassuring to many new and existing mid-tier firms operating within the PIE market. An intention to engage with firms and assist them with audit quality improvement would indeed fit with the FRC’s overall message since the Constructive Engagement process was first introduced in 2016.
If the PIE market expands as is anticipated by the BEIS reforms, we hope that the FRC (and its successor, ARGA) continues this trend of increasing its use of Constructive Engagement. There is some nervousness from firms which are auditors of companies which may be caught be the PIE net if the BEIS reforms are implemented. On behalf of those firms, it is hoped that positive engagement with the regulator will continue, as opposed to the number of enforcement cases increasing disproportionately on the extension of the PIE market.
If you have any questions or concerns about the content covered in this blog, please contact a member of the Regulatory team.
Julie Matheson is a partner in the Regulatory Team. Her expertise lies in advising professionals and professional services firms, particularly in the accountancy and built environment sector, on regulatory compliance, investigations and enforcement proceedings.
Lucinda Soon is a professional support lawyer in the Regulatory team, and is responsible for knowledge management and practice development.
Her work focuses on leveraging the team’s collective knowledge and expertise, ensuring that know-how and current and emerging regulatory developments are identified, evaluated, synthesised, and shared. She is particularly experienced in the adoption of technology to aid the delivery of these outcomes.
Professional Support Lawyer
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