In the latest round of inspections of 2015/16, which reviewed 20 EY audits, only three were singled out as requiring a reasonable level of improvement, compared with 2014/15 inspection cycle when the Big Four firm was rapped over the quality of eight audits which fell below the regulator’s expectations of audit standard, including two which were rated as poor. This year, 17 of its audits were rated as good or limited improvements were required. However, there were still failings which reflect training issues on revenue recognition

The negative feedback in the last FRC inspection in 2014/15 forced EY to overhaul its audit quality programme and improve quality control procedures for audits. However, this year’s audit inspectors were critical of the lack of judgment shown by the firm over impairments and provisions and a failure to challenge client management teams about data and numbers. There are still issues over the audit of revenue and audit procedures, while attempts to tighten up partner compliance and independence still require work.

Revenue recognition reporting

The inspectors flagged concerns about the firm’s approach to revenue recognition and failures to perform sufficient audit work in this area to avoid material misstatement of revenue in the financial statements. The firm failed to implement robust testing of controls and there were questions over the adequacy of the substantive analytical review, which meant that in some cases ‘the differences between actual and expected amounts were not adequately investigated or corroborated’.

The AQI report found that ‘on one audit there was insufficient challenge of the entity’s forecast improvement in its profitability, which was the basis for not impairing its non-current assets. In addition, there was insufficient evidence that the audit team had adequately considered the potential problems that could have had an effect on the forecasts’.

The sample sizes used in testing were also frequently too small to provide adequate oversight of potential risk areas.

Interestingly, EY is reviewing the interaction between IT and audit teams, and is considering options to integrate the teams more closely to ensure that the IT audit professionals work more closely core audit teams.

Questioning management at client companies

A failure to question management’s judgment was a concern and could undermine the value and effectiveness of the audits as audit teams were failing to question the suppositions made by management, thus threatening independent scrutiny.

There were also issues around disclosures, whereby the auditors had not questioned the level of transparency or tested the management data to ensure that the assumptions were correct.

Responding to the criticism, EY said that it had beefed up training through the internal audit quality support team (AQST) – and was focusing on audit areas of significant risk. Going forward, the 2016 training programme will reinforce training around the application of professional scepticism to address failings in audit independence and levels of scrutiny.

Communication with Audit Committees

As audit committees gain more governance powers, EY is still failing to communicate sufficiently with their clients about key judgments and estimates. The inspectors flagged three audits where there was ‘insufficient evidence of reporting to Audit Committees of the audit findings in areas involving key judgments or estimates, including how the audit team had concluded that management’s key judgments and estimates were considered appropriate’.

This lack of communication with clients is mirrored across the firms and may reflect changes to the rules as a result of new FRC guidance on audit committees and the increasing impact of the pending EU Audit Regulations and Directive.

In a fairly guarded comment, the EY response said that it would ‘ask our teams to consider discussing with Audit Committees the form and content of our reporting as an input into decisions on the balance between our written and oral communication.’

Partner independence and conflicts of interest

The ongoing problem with monitoring and compliance of partner independence remains an issue for the firm, despite restructuring the independence team and giving it more resources over the last year.

FRC inspectors highlighted a number of shortcomings, particularly around the monitoring of holdings in prohibited financial interests which were not being reported in a timely way, while there was sporadic monitoring of partners that left the firm, who could easily face conflict issues, particularly when moving to private sector positions.

Despite assertions that this would be addressed after last year’s inspection, the report states: ‘Until recently, the firm did not have adequate procedures in place to monitor roles subsequently taken on by partners who leave the firm, such as joining audited entities.’

There are still delays in notifying audit partners and audit committees about independence breaches, although a new system has been implemented in 2016. There are also plans to tighten the mandatory training programme on independence issues to improve compliance standards. 

Hywel Ball, EY’s head of audit, UK & Ireland, said: ‘The results of the FRC’s inspection report reflect the significant level of investment EY has made to improve audit quality, particularly over the last two years.

‘We are really pleased by the progress we have made to date. Audit quality is key to promoting confidence in the capital markets and we are committed to continuous improvement and innovation.

‘Audit quality remains an ongoing focus and absolute priority for EY. We welcome the independent perspective of the FRC and continue to listen and act upon their feedback, in addition to conducting our own reviews of EY’s audit practice.’

EY audited 327 UK entities within the scope of independent inspection as at 31 December 2014. Of these entities, including 10 FTSE 100 companies and 38 FTSE 250 companies.

The FRC Ernst & Young LLP Audit Quality Inspection 2015/16 is available here