Clyde & Co's Accountants' Liability team consider some of the practical implications for auditors and how these might impact on later FRC Enforcement investigations.
Joint statement from regulators
In the context of the Covid-19 pandemic, the Financial Reporting Council (FRC) together with the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) last week issued a joint statement announcing a series of actions to ensure that information continues to flow to investors and to support the continued functioning of the UK’s capital markets.
Whilst recognising the possibility of a "sharp but large" reduction in business and commercial activity, the emphasis is on maintaining the flow of accurate information to investors and supporting the continued functioning of the UK's capital markets. Significantly, however, the FCA is allowing listed companies an extra two months to publish their audited annual financial statements (i.e. six months from the end of their financial year, rather than four), and it has indicated that this extension of time will be kept under review.
The joint statement was accompanied by an FRC Bulletin, giving guidance on important issues affecting the performance of an audit – in particular the gathering of audit evidence and communications with those charged with governance together with issues surrounding the assessment of going concern and internal controls.
Business as usual?
Clearly there are major issues for auditors to grapple with in a short timeframe and it remains to be seen how all this will be taken into account in the context of any future enforcement action with the FRC having emphasised in its earlier note of 16 March that it is "concerned that the current situation should not undermine the delivery of high-quality audits. Audits should continue to comply fully with required standards. In current circumstances, additional time may be required to complete audits and it is important that this is taken, even at the risk of delaying company reporting."
Whilst the two month extension for the publication of audited financial statements and the other guidelines provided by the FRC are of some assistance, auditors are clearly being required, to a large extent, to continue to perform their role effectively in extraordinary circumstances, where the restrictions on their ability to travel or be in the physical presence of key individuals and/or repositories of evidence at their audit clients (or even, in some cases, for their clients to be able access those repositories), will present unprecedented challenges for as long as these restrictions continue to be necessary.
Government and regulators in the UK and elsewhere evidently are reluctant to take the step of suspending markets and financial reporting for any sustained period while pandemic related restrictions continue. Companies are therefore required to report their financial position in the context of a level and extent of uncertainty for which there is no comparable precedent over the last seventy-five years, whilst at the same time subject to conditions which include an unusually severe level of share price volatility.
The decision to continue with financial reporting is one that upholds the interests of transparency and continuation of functioning markets. However, it brings with it further risk to companies. Indeed, it might be argued that the uncertainty created by financial reporting that attests to the existence and extent of future uncertainty and risk which is already obvious, and produces numbers of doubtful reliability that cannot be meaningfully verified, might be at least as damaging for both companies and the economy, if not more so. The FRC acknowledges that there will need to be many modified audit opinions and disclosures of material uncertainty, and there may be many situations in which auditors are prevented by circumstances from providing an unqualified audit opinion.
Specific challenges faced by auditors
- Auditors will be exposed to greater risk because of the difficulties of obtaining evidence, performing audit testing and review, and making judgments in uncharted waters. For example, in relation to markets that are no longer functioning because of Government restrictions (such as shop closures) and public attitudes and behaviours (such as domestic property markets), on what basis will auditors be able to assess inventory valuation, or the appropriate discount rate for an impairment review?
- It is likely that auditors will face considerable challenge from their clients in relation to any indication that they must qualify their opinion for lack of evidence or disagreements with directors on issues such material uncertainty.
- It is likely that auditing under current conditions will result in more extensive and rapid innovation and implementation in the field of technological developments relating to obtaining and evaluating audit evidence - but it is uncertain whether this can amount to the panacea which enables, as seems to be the hope, even a semblance of 'business as usual'.
- The FRC's Bulletin notes that particular challenges will surround group audit engagements and component auditing.Special arrangements may need to be made to allow remote access to audit papers where different firms are involved in group and component auditing, where previously it was possible to inspect documents at another firm's offices. Firms will need to consider any local legal restrictions on data protection before making information available in this way.
- Companies and auditors will need to resort, even more than before, to the increased use of ranges for judgments and the extended use of scenarios when forecasting. This will be a more complex exercise than in the past, and auditors will need to ensure that companies do not delay the process of formulating assumptions, and developing models and scenarios that the auditors consider appropriate for this purpose.
- Face to face discussions are often an important element of assessment of audit evidence (including the exercise of professional skepticism), partner reviews, reviews of component auditor work and quality control generally. Auditors should consider using audio-visual communication, rather than merely telephone calls, in place of meetings with management and audit committee. It will be more important than ever that all such discussions are well documented.
- The FRC rightly notes that there is a greater need for professional skepticism, as controls will be functioning less well and there will be a greater risk of fraud (not least because of limits on physical inspection). Yet auditors will be faced with greater difficulty in obtaining sufficient appropriate audit evidence.This dichotomy presents a significant challenge for auditors to address if they are successfully to mitigate the risks attaching to their engagements under current circumstances.
Whilst further practical guidance from the Regulator is welcome, it remains to be seen how effectively auditors will be able to meet the myriad of additional challenges thrown up by the Covid-19 pandemic – and to what extent the FRC will take account of this when considering future enforcement action.