The Financial Reporting Council (FRC) reviewed selected aspects of 25 individual audits in 2015/16 focusing on tone at the top, independence and ethics, audit methodology, training and guidance, and internal audit quality monitoring.

In terms of overall audit quality and scrutiny, while no audits were singled out as poor, requiring significant improvement, of the 25 reviewed.

The majority (21) were ranked as good with limited improvements required while four audits were flagged as requiring further improvement. 

The FRC inspectors’ report stresses that PwC needs to ‘improve the consistency of the extent of challenge of management in relation to areas of judgment, in particular for impairment reviews and tax provisions’, and that it must make improvements to the audit of complex supplier arrangements, especially for major retailers, and needs to reduce the number of independence breaches.

There was criticism that in some cases the auditors had not taken into account the impact of cross-border tax arrangements. The report stated: ‘On two audits there was insufficient evidence supporting a number of long-standing tax provisions and the original basis for the provisions. On one of these audits, there was insufficient evidence that the audit team had challenged the judgments made for each exposure and jurisdiction.’  

There was also an increase in the number of instances of breaches of independence over the 12-month period with a failure to properly implement, monitor and comply with the firm’s independence policies and procedures.

The number of independence breaches was up year on year, with more instances of non-compliance with the FRC’s Ethical Standards in the year to 30 September 2015 than in the prior year.

Nearly all of these instances related to the holding of prohibited investments and the late approval of non-audit services, both problems highlighted in the last annual review, and not addressed.

Some of these holdings of prohibited investments had not been self-declared by the relevant partners and were identified through the firm’s independence testing, which covers the financial interests of approximately 10% of the partners each year, with additional testing of new partners. The lack of regular updating of the internal list of partner interests, the so-called CES, remains a problem for the firm. PwC stated that 25% of partners were subject to independence testing, which will be kept under review.

The contravention of tough new non-audit standard rules was also a measure of a lack of internal controls and the FRC recommended a tougher compliance system, recommending that ‘improvements should be made to ensure that non-audit services are not provided until the audit partner’s approval is obtained’.

The regulator also pulled up the firm over a number of instances where the audit team failed to communicate with client audit committees about ‘significant changes from the proposed audit approach’.

The surge in new audit clients has also created stresses with the FRC highlighting instances where communication with audit committees was sometimes of a limited nature.

The FRC inspectors stated that on one first year audit, ‘the audit team did not adequately explain to the Audit Committee the reasons for a change in the level of performance materiality set, compared with the lower level communicated at the time of the audit tender’.

The firm is going to update its audit committee reporting templates and is working with engagement leaders to stress the importance of regular and informed communications with the client’s audit committee.

Complex supplier arrangements

Following the reporting issues and misstatement in Tesco’s annual report two years ago, the FRC has taken a serious stance on the treatment of complex supplier arrangements, such as volume and other types of rebates, which can have a material impact on an entity's operating results and impact the financial statements.

PwC has increased its focus on supplier arrangements over the last 12 months with additional training and guidance on the topic for audit teams. However, there are still underlying problems and the FRC inspectors said there was a need for further improvement on certain audits, including the adequacy of audit procedures when analysing the total rebates: on one audit, for example, there was insufficient evidence that the audit procedures had adequately addressed the completeness of rebates and discounts which had been netted off revenue. Another problem around the year-end rebate debtor and creditor balances was also cited.

The report stated that ‘on one audit, while the testing of supplier income deals throughout the year included some items that were settled post year end, there was insufficient tracing of the year-end balances to the items tested. It was difficult to assess whether the level of testing of those balances was sufficient’.

In response to the criticism, PwC accepted that its guidance may have been too prescriptive and difficult to apply. ‘Our specific guidance on complex supply arrangements was issued in response to market focus in this area. It was prescriptive as to expected risk assessment and responsive procedures. Adoption by our audit teams was immediate and led to an increase in focus in this area,’ PwC stated.

‘Our root cause analysis identified that the guidance was not always easy to apply, given different client approaches and group organisational structures. We identified a need to add an additional step in our audit file to assist teams in appropriately tailoring those procedures for their specific engagement. We will monitor the application of the guidance through our internal quality monitoring programme during June – August 2016.’

In terms of dealing with criticisms in the last round of inspections, the Big Four firm has taken steps to address a number of the issues raised in the previous year’s inspection round, including enhancing quality and independence monitoring procedures, updating the firm’s audit manual and more staff training provision.

James Chalmers, head of assurance at PwC, said: ‘Audit quality is of paramount importance to the firm. We value the independent observations and recommendations provided by the FRC and are pleased it has recognised the steps we have taken in response to previous findings, reflecting the ongoing investment in our audit practice.

‘I believe the FRC's new style of report is a positive step in helping readers understand the key findings from the the inspections and the actions we are taking in response.’ 

PwC audited 540 UK entities as at 31 December 2014, including 35 FTSE 100 and 50 FTSE 250 companies.

The PwC LLP Audit Quality Inspection Report 2016 is available here