Principles for the operational separation of audit practice released: The FRC has released a set of 22 principles to guide the big four audit firms in separating their audit practices.
Objectives and desired outcomes of operational separation:
- The principles are underpinned by two objectives: 1) ensuring that the primary focus of audit practices is on delivery of high quality audits in the public interest; and 2) severing audit reliance on revenue from other parts of the firm to subsidise audit practice.
- The principles also identify a number of desired outcomes which broadly set the expectation that the culture, governance, remuneration and accountability frameworks and processes within audit practices operate to enable auditors' (including audit partners') primary focus to be on delivery of quality audits in the public interest.
- Going forward, the FRC intends to publish an annual assessment of the extent to which firms are delivering against these objectives/outcomes.
- In addition, the FRC says that it intends to 'seek backstop powers to require firms to deliver these outcomes as part of the forthcoming audit reform legislation.'
Timing: Firms are required to submit an implementation plan to the FRC by 23 October 2020. The deadline for separating their audit practices, in alignment with the principles, is 30 June 2024 'at the latest'.
Overview
The UK Financial Reporting Council (FRC) has released a set of 22 principles to guide the big four audit firms in separating their audit practices.
Announcing the release of the principles, FRC CEO, Sir Jon Thompson said,
'Operational separation of audit practices is one element of the FRC’s strategy to improve the quality and effectiveness of corporate reporting and audit in the United Kingdom following the Kingman, CMA and Brydon reviews. Today the FRC has delivered a major step in the reform of the audit sector by setting principles for operational separation of audit practices from the rest of the firm. The FRC remains fully committed to the broad suite of reform measures on corporate reporting and audit reform and will introduce further aspects of the reform package over time'.
Outcomes and Objectives of operational separation
The Principles document identifies both the objectives and desired outcomes of operational separation, and these underpin the 22 principles. Going forward, firms will be expected to demonstrate to the regulator how they are delivering against them.
Two Objectives
- 'Objective 1: Improve audit quality by ensuring that people in the audit practice are focused above all on delivery of high-quality audits in the public interest'.
- 'Objective 2: Improve audit market resilience by ensuring that no material, structural cross subsidy persists between the audit practice and the rest of the firm'.
Desired Outcomes
Broadly speaking, the 'desired outcomes' set the expectation that the culture, governance, remuneration and accountability frameworks and processes within audit practices operate to enable auditors' (including audit partners') primary focus to be on delivery of quality audits in the public interest.
Culture/Governance:
- 'Audit practice governance prioritises audit quality' and 'protects auditors from influences from the rest of the firm that could divert their focus away from audit quality'.
- 'The culture of the audit practice supports audit quality and the public interest by encouraging ethical behaviour, openness, teamwork, challenge and professional scepticism/judgement'.
- 'Auditors should act in the public interest and work for the benefit of shareholders of audited entities and wider society; they are not accountable to audited entities’ executive management and are not (nor viewed as or considered to be) consultants'.
Remuneration
- Profits distributed to audit partners 'should not persistently exceed' profits generated by the audit practice
- The primary consideration in setting individual audit partner remuneration is contribution to audit quality, 'taking account of the degree of difficulty and risk of the audits'.
Monitoring of performance
- 'Audit practice financial reporting is transparent to the regulator and public, allowing effective monitoring of audit practice performance and financial resilience'.
Principles
Governance: Principles 1-10 relate to the role, responsibilities and composition of the audit board and cover issues including (among other matters): a) the audit board's purpose; b) composition, c) minimum skills requirements (at least one member of the audit board should be a former auditor or 'consumer of audit services'); and d) oversight responsibilities (eg oversight of audit partner promotion and remuneration and oversight of audit CEO and audit strategy). Principle 10 requires states the Audit Board 'have the authority to commission reviews from Internal Audit to support their oversight role'.
Scope of the audit practice: Principles 11-14 concern the scope of the audit practice including: a) specifying the services that fall within the 'ring fence'; b) the circumstances in which speciliasts outside the audit team can provide support; and c) 'other ringfence matters' such as the requirement that audit partners/staff should spend 'the majority of their time on work in the audit practice' and the expectation that revenues from statutory audit work will make up the majority audit practices' revenue.
The financial relationship between the audit practice and the rest of the firm: Principles 15-17 outline expectations around the financial separation between the audit practice and the rest of the firm. Principle 17 sets out the FRC's expectation that audit practices should not be cross subsidised by other areas of the firm. The FRC states that this will be one measure of the extent to which firms are delivering against the objectives and outcomes.
Partner remuneration: Principle 18 states that remuneration policies/practices for audit partners should reward delivery of high quality audits and positive leadership and include mechanisms to reduce rewards in 'cases of poor audit quality'.
Transparency:
- Principle 19 requires firms to publish 'information about the governance of the audit practice and the terms on which transactions occur between the audit and non-audit business a the nature of these transactions'.
- Principle 20 requires firms to produce a separate profit and loss account for the audit practice, assured by the firm's auditors, for submission to the FRC annually. The FRC expects firms to submit this information 'no later than four months after the financial year end' during the implementation period. After this period has ended, firms will be expected to publish the audit practices' profit and loss account in their Transparency Reports.
Accountability: Principle 21 requires firms to appoint either a single member of the senior management team (or a small group) to be responsible and individually accountable for 'ensuring the outcomes and principles for operational separation are delivered, embedded and monitored'.
Transitional arrangements: Principle 22 sets out: a) the timeline for firms to provide the FRC with their implementation plan (23 October 2020) and the deadline for full implementation of the principles (30 June 2024); and b) outlines expectations around reporting/publishing profit and loss accounts. The FRC says that the profit and loss account for the audit practice 'may be done on a best efforts basis'. Firms will also not be required to publish the profit and loss account while they are executing their agreed transition plans (ie there is no requirement to publish the profit and loss account until after 30 June 2024).
Implementation timeline
The regulator expects firms to submit an implementation plan, in line with the principles, by 23 October 2020. Once firms and the FRC have reached agreement on the plan, firms have until 30 June 2024 'at the latest' to fully implement them.
Next steps
- Regular reporting to the regulator: Going forward, firms are expected to demonstrate to the FRC how they are delivering against objectives and outcomes of operational separation identified in the Principles document, with the FRC publishing annual assessments.
- Additional powers? In addition, the FRC says that it intends to 'seek backstop powers to require firms to deliver these outcomes as part of the forthcoming audit reform legislation'.
