Financial Reporting Review Panel Research Articles

Proactive Financial Reporting Enforcement: Audit Fees and Financial Reporting Quality Effects

ABSTRACTWe examine the costs and benefits of proactive financial reporting enforcement by the U.K. Financial Reporting Review Panel. Enforcement scrutiny is selective and varies by sector and over time, yet can be anticipated by auditors and companies. We find evidence that increased enforcement intensity leads to temporary increases in audit fees and more conservative accruals. However, cross-sectional analysis across market segments reveals that audit fees increase primarily in the less-regulated AIM segment, and especially those AIM companies with a higher likelihood of financial distress and less stringent governance. On the contrary, less reliable operating asset-related accruals are more conservative in the Main segment and, in particular, those Main companies with stronger incentives for higher financial reporting quality. Overall, our study indicates that financial reporting enforcement generates costs and benefits, but not always for the same companies.JEL Classifications: K42; M41; M42; M48.Data Availability: Data are available from the public sources cited in the text.

Proactive Financial Reporting Enforcement: Audit Fee and Financial Reporting Quality Effects

We examine the costs and benefits of proactive financial reporting enforcement by the UK Financial Reporting Review Panel. Enforcement scrutiny is selective and varies by sector and over time, yet can be anticipated by auditors and companies. We find evidence that increased enforcement intensity leads to temporary increases in audit fees and more conservative accruals. However cross-sectional analysis across market segments reveals that audit fees increase primarily in the less-regulated AIM segment, and especially those AIM companies with a higher likelihood of financial distress and less stringent governance. On the contrary, less reliable operating asset-related accruals are more conservative in the Main segment, and in particular those Main companies with stronger incentives for higher financial reporting quality. Overall, our study indicates that financial reporting enforcement generates costs and benefits, but not always for the same companies.

Book Reviews

Book Reviews

Achieving High Quality, Comparable Financial Reporting: A Review of Independent Enforcement Bodies in Australia and the United Kingdom

This article provides a review of the activities of two quite different types of national enforcement body, the U.K.'s Financial Reporting Review Panel (FRRP) and the Australian Securities and Investments Commission (ASIC). We present material (some not available elsewhere) about their activities over the period 1998–2004 and show that both types of body can fulfil an enforcement role, albeit subject to political forces. We also assess the relevance of the bodies’ past activities for comparable international enforcement following the adoption of International Financial Reporting Standards (IFRS) in 2005. A review of cases reveals that for both bodies approximately half were related to recognition and measurement issues, where interpretation can be crucial. Although there is potential for cross-country differences to arise, they may be mitigated by the participation of both bodies in international enforcement coordination activities. Past activities suggest that the scope of the bodies’ activities and the extent of comparability of enforcement decisions are likely to reflect political views held within the government, corporate sector and accounting profession.

Achieving High Quality, Comparable Financial Reporting: A Comparison of Independent Enforcement Bodies in Australia and the United Kingdom

The aim this study is to compare the activities of two significant examples of alternative enforcement models - the Financial Reporting Review Panel (FRRP) in the United Kingdom and the Australian Securities and Investment Commission (ASIC) in Australia over the period 1997-2004. The study was undertaken because of the important role enforcement bodies will have in promoting compliance with international accounting standards developed by the International Accounting Standards Board (IASB). There has been little evaluation of the effectiveness of alternative types of enforcement body, thus the results will be of interest to parties responsible for enforcement as well as for entities being regulated. We considered only ASIC's activities which were comparable to those of the FRRP and proposed that level of activity would represent the bodies' effectiveness. Using measures developed by Fearnley et al. (2000), we found ASIC reported more cases than the FRRP (41 compared to 31) and addressed significantly more cases related to recognition and measurement issues. The bodies were similar in the extent to which their decisions had a material impact on the financial results of companies investigated. The most commonly used remedial action was revision to accounts issued subsequently. However, ASIC was more likely to take matters to court. Press coverage of ASIC cases was 11.9 articles per case, compared to 2.2 for the FRRP. Our results show different types of enforcement body can achieve similar results. However, ASIC's proactive surveillance program allowed it to pursue more cases that addressed fundamental issues and to achieve more press coverage in the community.

Benchmarking Audit Committee Effectiveness in Financial Reporting

This paper examines the effectiveness of UK audit committees in their primary responsibility of overseeing financial reporting. A logit regression approach is used to benchmark corporate financial reporting quality against financial reporting standards in the period from 1991 to 2000. Using a sample of companies that have been subject to adverse rulings by the Financial Reporting Review Panel (FRRP), we test the impact of board and audit committee characteristics on the probability of compliance with financial reporting standards. Our results show that independent boards promote audit committee effectiveness in financial reporting and suggest that director share ownership and multiple directorships could undermine audit committee effectiveness in financial reporting. We also suggest that director financial literacy and an ‘active’ audit committee may contribute to audit committee effectiveness.

THE IMPACT OF THE FINANCIAL REPORTING REVIEW PANEL ON ASPECTS OF THE INDEPENDENCE OF AUDITORS AND THEIR ATTITUDES TO COMPLIANCE IN THE UK

The UK Financial Reporting Review Panel (FRRP) enforces the regulatory framework for larger companies and requires companies to restate non-compliant accounts. It is authorized to deal with directors but not auditors. Recent UK based research indicates a belief that the FRRP's activities have enhanced auditor independence and changed attitudes to accounting compliance. Defective accounts indicate a lack of audit quality as the auditor must have failed to detect and/or prevent the deficiency. By analysis of fifteen semi-structured interviews with finance directors and audit firm partners with experience of an FRRP inquiry, and by review of publicly available information, the impact of the FRRP on some aspects of audit quality is sought. The FRRP is found to have motivated auditors to improve accounting compliance by increasing the possibility of some errors being exposed. It is also found to have enhanced the independence of auditors at the pre-conventional level of ethical cognition as identified by Ponemon and Gabhart (1990), by changing the cost-benefit for auditors of permitting non-compliance. FRRP inquiries cause auditors to incur non-recoverable costs, can undermine the auditor–client relationship and increase the risk of client loss. Personal embarrassment, possible career damage and the risk of an ICAEW disciplinary inquiry arise for the audit partner. The FRRP is found to provide auditors with an additional negotiating tool in dealing with directors, thus making in easier for auditors at the conventional and post conventional level of ethical cognition to prevent non-compliance. Direct evidence is, therefore, found that the FRRP's activities have provided incentives for all auditors to focus more on accounting compliance (at least for items visible from an inspection of the accounts) and have provided incentives and mechanisms for auditors at lower levels of ethical cognition to be independent.

The characteristics of firms subject to adverse rulings by the Financial Reporting Review Panel

This study presents evidence on the characteristics of firms judged by the Financial Reporting Review Panel (FRRP) as having published defective financial statements. Relative to a pairwise-matched control sample, FRRP firms are associated with weak performance in the defect year. In contrast, their performance in the post-defect period is indistinguishable from that of the control sample, suggesting that rather than being perennial underachieves, FRRP firms are average performers suffering temporary performance difficulties. FRRP firms are also less likely to have a Big Five auditor. Weaker evidence is also presented that FRRP firms are less likely to have an audit committee and a high proportion of outside directors. In contrast, their remaining governance characteristics are largely indistinguishable from those of the control sample. Moreover, there is no evidence that public censure by the FRRP leads to a higher incidence of executive turnover in subsequent years.

We’re off to see the wizard

The Financial Reporting Review Panel (FRRP) was an innovation in the UK as it was responsible for the previously little considered issue of ensuring compliance with financial reporting regulations. This paper draws on institutional theory to compare the stated aims, objectives and operating procedures of the FRRP with the practical experiences of those who have had discussions with them, and evidence of the wider impact of their work. The aim is to provide a richer understanding of the way in which this relatively new institution achieves its objectives, and to determine whether it has engaged in “myth making” in order to establish and maintain its legitimacy. The original objectives of the FRRP are explored in this paper, as well as subsequent public pronouncements on its aims, procedures, and achievements. Discussions with key members of the FRRP have enabled further clarification of some of the issues. The perceptions of those with experience of dealing with the FRRP were gained by a series of semi‐structured interviews. Interviews were carried out with company directors and audit firm partners who had direct experience of the FRRP. The analysis draws out themes related to the investigation process and final outcomes of this process. The paper concludes that there is some evidence that the FRRP has engaged in “myth building”. For example, it was considered that cases the FRRP chose to pursue tended to involve rather less serious issues than their public statements might suggest. Also they have considerable operational discretion and this appears to be exercised in a rather unpredictable way without explanation. Overall, however, the evidence suggests that the FRRP is an effective regulator.

Problems and politics of regulatory fragmentation: The case of the Financial Reporting Review Panel and the Institute of Chartered Accountants in England and Wales

The UK regime for financial reporting and auditing was radically altered in 1990 and 1991 by two separate developments. When removing sole responsibility for setting accounting standards from the accounting profession, the opportunity was taken to establish a monitoring body, the Financial Reporting Review Panel (FRRP), to oversee compliance with company law and accounting standards, and with powers to apply to the courts for rectification. In addition, a new regulatory system for auditors was set up. This paper considers the problems arising between the regulatory responsibilities of the Institute of Chartered Accountants in England and Wales (ICAEW) and FRRP. In 50 cases (up to September 1999) FRRP found defects in accounts, 49 of which were audited by firms regulated by ICAEW, but no disciplinary action was taken by ICAEW until 1999. The way in which the new audit regulations were grafted onto the existing ICAEW disciplinary regime is considered, and the anomalies arising from that explored. The cases resulting in ICAEW's disciplinary action are compared with the other cases together with some evidence from finance directors and audit partners with experience of dealing both with FRRP and an ICAEW disciplinary investigation. The relevant theories relating to professional bodies and regulation are also reviewed. Finally, the authors review the problems identified in this study and make suggestions as to how they may be addressed.

An investigation into the stock market reaction to press notices issued by the Financial Reporting Review Panel

The Financial Reporting Review Panel (‘the Panel’) was set up in 1991 as part of the new regime under the Financial Reporting Council, with the objective of improving the quality of financial reporting in the UK. Arguably, the Panel was the most radical innovation since it was concerned with the previously not addressed issue of the enforcement of financial reporting regulations. However, it has no direct powers of enforcement and is funded at a level at which it can only react to complaints about company accounts rather than seek out problems. While the Panel has been granted powers to take companies to court with a view to compelling them to revise their accounts, these powers have not been exercised. Nevertheless, there is some evidence that its existence encourages companies to be more scrupulous about compliance with accounting standards and relevant company law before publishing their annual reports. Explanations for compliance include the possibility that adverse findings by the Panel result in economic damage or loss of reputation to the company or its management. This paper investigates a key aspect of possible economic damage: that press notices issued by the Panel about individual cases have an adverse effect on the share price of the company concerned. A share price event study was carried out on 33 companies that, since the inception of the Panel, had been the subject of press notices. We have found no evidence of an adverse share price reactions following the publication of press notices. Improvements in compliance may be attributable to other reasons, one possibility being the belief by management that an adverse finding will affect the share price.

Enforcing compliance with accounting standards: The role of the Financial Reporting Review Panel in the UK regulatory framework

A new regulatory regime for issuing, and enforcing compliance with, accounting standards has been established in the UK. It includes an enforcement body, the Financial Reporting Review Panel (FRRP), which is responsible for examining alleged departures from the Companies Act and accounting standards by companies. The FRRP has secured revisions in company accounts which were regarded as defective, and has issued press notices summarising the defects and the remedial action taken. The FRRP was intended to strengthen auditors in their negotiations with directors, but there are tensions in the relationship as the majority of companies receiving a press notice had unqualified audit reports. The FRRP has reported auditors to their professional body, but no action has been taken against any auditors to date.

Perceptions of auditor independence: U.K. evidence

The reality and perception of auditor independence is fundamental to public confidence in financial reporting. A new Independence Standards Board was set up in the U.S. in 1997 and the European Union (EU) is currently seeking to establish a common core of independence principles. The general setting within which audit decisions are made and independence perceptions are formed is evolving rapidly due to competitive and regulatory changes. Policy-makers must work continuously to evaluate the critical threat factors and develop appropriate independence principles. This paper explores the potential of recent regulatory reforms in the United Kingdom (U.K.), many of which are unique to that country, to strengthen the independence framework. Using a questionnaire instrument, U.K. interested parties’ perceptions of the influence on auditor independence of a large set of 45 economic and regulatory factors are elicited. Most factors have a significant impact on independence perceptions for all groups (finance directors, audit partners, and financial journalists). The principal threat factors relate to economic dependence and non-audit service provision, while the principal enhancement factors relate to regulatory changes introduced in the early 1990s (the existence of an audit committee, the risk of referral to the Financial Reporting Review Panel and the risk to the audit firm of loss of Registered Auditor status). Exploratory factor analysis reduces the factor set to a smaller number of uncorrelated underlying dimensions.