Revisions to the FRC's Ethical Standard have introduced some additional prohibitions for all auditors, writes James Ferris.
The FRC’s Ethical Standard (ES) sets fundamental principles, supporting ethical provisions, and general requirements for the conduct of audits and other public interest assurance engagements. In 2016 the ES was revised to implement more robust requirements for the auditors of Public Interest Entities (PIEs) as a result of the 2016 EU Audit Regulation, and to merge the previously separate ethical rules for auditors and reporting accountants. The 2019 version of the standard is a product of our post implementation review (PIR) of the 2016 changes.
The context for our 2018/19 review was one of significantly increased public and political concern about audit, and increased scrutiny of the non-audit related fees auditors earn from the companies they audit. During the course of our review several firms made voluntary public commitments to the BEIS Select Committee to limit the provision of non-audit services other than those that were ‘essential’ to the FTSE 350 companies they audit in order to address perceptions of conflicts of interest. Responses to our consultations and wider stakeholder outreach in 2018 and 2019 were generally supportive of further restricting the types of non-audit services which external auditors can provide, alongside the existing fee cap for PIE auditors. Given the experience of corporate and audit failures outside the world of PIEs, there was also strong support for stronger independence rules for the auditors of other types of entity, which although not PIEs themselves, are of significant public interest.
As a result, our revision of the Ethical Standard focussed on:
Enhancing the role and status of Ethics Partners within the firms, as well as the requirement to report to the FRC where there have been ethical breaches
Strengthening the Objective, Reasonable and Informed Third Party (ORTIP) test, where auditors are required to consider possible external perception of threats to independence
For PIE auditors, moving from a list of prohibited non-audit services to a more narrowly defined list of permissible services that are audit related or required by law and regulation
The development of a new defined term of Other Entity of Public Interest (OEPI) to be applied to entities which do not meet the PIE definition, but where the level of public interest is heightened. Auditors of those entities will only be able to provide non-audit services from the permitted services list
Introducing additional prohibitions applying to non-audit services to all audited entities. These were informed, in part, by stricter rules introduced into the IESBA Code (for example in respect of recruitment services and playing a ‘management role’ in an entity).
Our final overarching aim was to try to simplify the text, remove some perceived ambiguities and make the standard easier to use – at least relative to the complexity of the underlying subject matter.
The measures to enhance the role and status of Ethics Partners are central to our overall objective, which is to encourage the firms to deal with ethical matters in a more holistic way, and to provide a focal point for the practical application of the ethical principles. It is the day-to-day application of principles by those firms that is critical to the achievement of ethical outcomes in the public interest. Since it would be impossible to anticipate every possible set of circumstances, and therefore to write an Ethical Standard with a complete set of ‘rules’ covering every possible situation, a deep commitment to and understanding of the fundamental principles of Integrity, Objectivity and Independence is of paramount importance.
This is underpinned by changes to the ORTIP test which previously required practitioners to take account of the perspective of an ‘objective, reasonable and informed third party’, and whether such a person would probably conclude that, were a course of action be taken, that would compromise the ethical outcomes required by the standard. We strengthened the focus of this test on key stakeholders who are not practitioners, with reference to s172 of the Companies Act and the stakeholders to whom company directors have specific obligations. We have also extended the use of the ORITP text to a broader range of scenarios.
The more narrowly drawn list of permissible services which can be provided by PIE auditors means that those auditors will only be allowed to provide services which an objective, reasonable and informed third party would consider appropriate and related to their role as auditor, or where there is a legal or regulatory requirement. No other services can be provided. The permissible services list also applies to our new category of OEPIs, although the 70% fee cap does not. OEPIs are entities where we believe there is a legitimate wider public interest, and where a more stringent set of auditor independence rules should apply. As a proportionate regulator we have defined OEPIs as larger AIM listed companies, large pension schemes and large private companies, as well as Lloyd’s Syndicates. Whilst we do not doubt that there will be challenges associated with this change, we believe the objective of enhancing confidence in auditor independence for these larger entities is paramount. In order to allow audit firms and audited entities time to prepare we delayed the effective date for OEPIs to periods commencing on or after 15 December 2020. The 10 year tendering or 20 year rotation requirements do not however apply to OEPI auditors.
Finally, we introduced some additional prohibitions for all auditors. These were areas of the previous version of the Ethical Standard where we felt that more robust rules were appropriate. These included the use of contingent fees for non-audit services – where the service provider effectively has an interest in the successful outcome of the transaction on which they are reporting. In respect of recruitment services, we felt that the old rules which allowed some short-term junior staff secondments from audit firms to audited entities – was no longer defensible and should be simplified to an outright ban. Similarly, we do not feel it is appropriate that an external auditor should simultaneously provide internal audit services to an entity and have introduced an absolute ban.
The majority of the new requirements have now been in force since March 2020. This has, of course, coincided with the COVID-19 pandemic. We have been very mindful of the significant challenges facing the UK economy, and have been flexible and responsive with the guidance we have produced on the new non-audit services rules. We made it clear, for example, that where auditors were helping companies with applications for government support schemes that we considered those as part of the list of permissible services.
More generally, we welcome the positive and constructive engagement we have had with audit firms, including regular discussions with Ethics Partners. We are always open to dialogue with any stakeholders to help them understand our ethical requirements better and how they may be affected by them.
We also constantly monitor the impact our Ethical Standard has on auditors and the entities they audit, as well as on wider perceptions of and confidence in the profession. Looking forward, we will also need to consider the impact of the government’s proposals for audit reform in response to the three independent reviews. In the meantime, we believe that our revised Ethical Standard provides an enhanced set of ethical principles and requirements.
James Ferris is Acting Head of UK Auditing Standards at the FRC. He joined the FRC as a Project Director in 2015, and has been involved in a variety of projects relevant to UK auditing and assurance standards including, most recently, revisions to the Standards for Investment Reporting and the FRC’s Ethical Standard. Immediately prior to joining the FRC James was a Financial Audit Director at the National Audit Office, where he also trained as a chartered accountant.
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