British Report Finds Flaws In Big Four Auditing Practices

A study released last week by the British government identified problems with certain audits conducted by the Big Four accounting firms of companies in the United Kingdom.

One of the areas criticized was “insufficient documentation” of auditing practices, making it difficult to access the effectiveness of judgments.

The report by the Professional Oversight Board for Accountancy applauded the high standards of the accounting giants “elsewhere in their audit work” but said that in some specific instances proper procedures were not followed. The POBA did not identify which companies were involved in the audits that were found to be lacking.

Bourn

“We found that each of the Big Four firms of auditors have the necessary infrastructure in place, and commitment, to complete good quality audits,” said POBA Chairman Sir John Bourn. “However, where the firms do not follow their own procedures they expose themselves to the risk that future audit opinions may not be appropriate.” In announcing the report, POBA said that its new audit inspection unit is in the process of making “a number of recommendations to each of the firms in their private reports as to the actions it believes are appropriate to address the issues arising from its work.”

Bourn encouraged the Big Four to heed those recommendations when they are made. “We trust that all the firms will rise to the challenges which our work presents to them and expect the firms to implement our recommendations on a timely basis,” he said. Bourn also noted that the POBA would monitor compliance with those recommendations next year. “We will review the extent to which they have done so during our 2005-06 inspections and report on this in our next public report in a year’s time,” Bourn said.

Insufficient Audit Documentation

The POBA was established in 2004 by Britain’s Financial Reporting Council in the wake of Enron and other corporate scandals. It is similar to the Public Company Accounting Oversight Board in the United States, which released a comparable report last August critical of some of the Big Four practices in the U.S.

From June 2004 to March 2005, the POBA’s audit inspection unit—known as the “AIU”—conducted on-site inspections with respect to 27 audits of some of the largest companies in the U.K. “An important aspect of our work is assessing the appropriateness of the key audit judgments exercised in forming the audit opinion and challenging those judgments where appropriate,” said the report. “The appropriateness of the key audit judgments is central to the quality of an individual audit engagement. We therefore regard critical assessment of those judgments as an essential part of an effective audit quality inspection.”

Key audit judgments “exercised in relation to financial reporting issues appeared, in the great majority of cases, to be both appropriate and soundly based,” the AIU said.

However, citing insufficient documentation, the AIU notes that “it was often necessary to form a view as to the appropriateness of such judgments on the basis of oral explanations provided.”

The AIU “identified a need to improve the quality of audit documentation across all firms, in respect of many of the audit engagements we reviewed. This was also an issue that the firms themselves had recognized as needing to be addressed following previous internal and external reviews. … It was apparent that actions previously taken to improve the position (such as issuing reminders to audit staff of the need to document properly all work undertaken) had not been effective.”

Insufficient audit documentation “both reduces the effectiveness of firms’ own quality control processes and makes it more difficult to adopt a monitoring approach focusing on key audit judgments (rather than an approach characterized by some as ‘box ticking’),” according to the AIU.

Perhaps not coincidentally, inspection reports issued by the PCAOB last August also cited problems with documentation at the Big Four.

Private Recommendations

The AIU identified “no systemic weaknesses in the overall policies, procedures and systems of quality control operated by the firms and [indicated] that, when properly applied, those procedures and systems should provide reasonable assurance that appropriate audit opinions are issued by the firms.”

However, the AIU found “certain areas in which it considers that improvements to these policies, procedures and systems, and/or the application thereof, should be made, either to achieve compliance with relevant standards or to enhance audit quality.”

The AIU referred two of the 27 cases reviewed to the FRC’s Financial Reporting Review Panel as a result of “sufficient doubt as to whether the accounting treatment adopted and/or disclosures provided complied with U.K. GAAP.” The issues in question did not affect reported profits in the case of either company, neither of which was identified.

Recommendations to the Big Four for improvement will be made privately, the AIU said. “Our private reports include prioritized recommendations to the firms concerned together with responses and an action plan from the firms,” the report notes. “We prioritize the issues and our recommendations to the firms on the basis of our assessment of their actual or potential impact on audit quality (as opposed to solely on the basis of their implications for the firm's compliance with the existing regulatory framework).”