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"Further improvement" of bank and building society audits needed, says watchdog

The quality of the auditing of banks' loan loss provisions is generally improving, but further improvements are needed to ensure consistency, according to the Financial Reporting Council (FRC).

Publishing the results of its year-long review of bank and building society audits (18-page / 1.3MB PDF), the watchdog called on auditors working with financial firms to "apply an appropriate degree of challenge and professional scepticism" during the audit process, rather than merely seeking to corroborate the views of the firm's managers. Of the 13 firms whose audits it reviewed as part of the process, one required improvement and two required "significant" improvement, it said.

"There is no room for complacency and we expect all audit firms to achieve consistently high quality," said Paul George, executive director of conduct at the FRC.

"I am pleased to note the improvements achieved by many audit teams outlined in this report. This reflects investment in sector specific procedures and focus by the firms in addressing concerns previously highlighted by the FRC," he said.

The FRC did not name the three firms whose audits required improvements or their auditors. However, it said that the two audits that required the biggest improvements were of the UK subsidiaries of international banks. It said that it would carry out "follow-up work" on audits were significant improvements were needed as part of its 2015 inspection cycle.

The review, which was announced in December last year, was intended to address concerns about the quality of bank and building society auditing, particularly in relation to loan loss provisions and their related IT controls. The FRC said that it was concerned that banks were failing to consistently measure and report loan loss provisions: a term that refers to the amount set aside by the firm to cover potential bad loans.

In its report, the FRC said that it had found improvements in the quality of firms' audits of these provisions, particularly at those firms where it had previously identified significant issues. It said that it was clear that those firms with "sufficient banking sector experience and access to up-to-date specialist knowledge in IT and other relevant areas, such as real estate valuation" were able to audit loan loss provisions to a good standard. Concerns remained about the effectiveness of audit testing in the "majority" of cases, although the impact of these issues generally did not affect the quality of the audit overall.

Among its recommendations to firms and their auditors, the FRC said that a "proactive" approach to monitoring and enhancing bank audit quality was needed, as well as "reactive" action to address regulatory concerns. It said that partners and staff involved in the audit process should receive mandatory sector training, and called for more non-IT specialists to be "fast-tracked" into the audit team.

A new international accounting standard, International Financial Reporting Standard (IFRS) 9, will affect the way that banks must account for losses in their annual accounts once it comes fully into force on 1 January 2018. The previous 'incurred loss' model will be replaced by an 'expected loss' model, meaning that banks will be required to account for expected losses at an earlier stage rather than waiting until these losses have actually occurred before accounting for them.

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