FRC publishes principles for operational separation of the audit practices of the Big Four firms

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By James E Barbour, Director, Policy Leadership

7 July 2020

The FRC has announced its principles for operational separation of the audit practices of the Big Four firms

The stated objectives are to:

• 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; and
• improve audit market resilience by ensuring that no material, structural cross subsidy persists between the audit practice and the rest of the firm.

The FRCs desired outcomes are that:

• 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 total amount of profits distributed to the partners in the audit practice should not persistently exceed the contribution to profits of the audit practice.
• Individual audit partner renumeration is determined above all by contribution to audit quality, taking account of the degree of difficulty and risk of the audits.
• Audit practice financial reporting is transparent to the regulator and public, allowing effective monitoring of audit practice performance and financial resilience.
• 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.

From a regulatory perspective the FRC highlights:

• Firms will need to demonstrate to the FRC that they are delivering these outcomes, consistent with these principles.
• Firms should provide regular management information for the audit practice to FRC, including financial statements, audit quality indicators and other information which indicates whether these outcomes are being delivered.
• FRC will publish annually an assessment of whether firms are delivering these objectives and outcomes.
• FRC will seek backstop powers to require firms to deliver these outcomes as part of the forthcoming audit reform legislation.

Principles

These cover governance, scope of the audit practice, financial matters, remuneration of partners, transparency, accountability and transitional provisions. Various matters are covered within the FRC document under these respective principles, including:

• The composition and purpose of the Audit Board.
• Scope of the audit practice (services that can be provided).
• Transactions between the audit practice and the rest of the firm should be conducted and priced on an “arms-length” basis.
• Remuneration policies and practices for audit partners should be designed to reward good audit practice-related behaviours.
• Firms are to produce annually a separate profit and loss account for the audit practice that is to be assured by the firm’s auditors. After an agreed transition period, firms should publish this profit and loss account in their Transparency Reports.

The FRC states that the Big Four firms should provide a transition timetable to ensure that each of these principles is implemented as soon as practicable and that they are implemented in full by 30 June 2024 at the latest. The firms are to submit their transitional plans to the FRC by 23 October 2020.