What do the FRC’s revised Ethical Standard and new ORITP Guidance mean for auditors?

Revised Ethical Standard

The FRC recently published its Revised Ethical Standard for auditors which is due to come into force on 15 December 2024. The main purpose of the revisions is to address concerns raised in the FRC’s recent consultation, and to refine and provide clarity on the existing Ethical Standard.

These changes come shortly after the FRC’s chief executive, Richard Moriarty’s, recent remarks on  importance of upholding the FRC’s strong regulatory reputation, whilst also ensuring not to place too heavy a burden on firms and individual auditors: ‘having a consequence free regulatory zone is not the answer to the attractiveness of the profession’. In the press summary that details the changes to the Revised Ethical Standard, the FRC further emphasised the necessary balance between stringent regulation and fairness: ‘High quality ethical standards for auditors enhance trust in the quality of financial information that drives investment in the UK. This is balanced with ensuring that any requirements are targeted and proportionate’.

Key changes to the Revised Ethical Standard include: 

IESBA Code of Ethics

The FRC has amended the Revised Ethical Standard to better align with recent revisions made to the international IESBA Code of Ethics. Changes include:

extension of the prohibitions to cover network firms; 

amendment of the language used in the public sector exemption to the loan staff prohibition (section 2.36); and

extension of the prohibition on corporate finance services to cover debt or other financial instruments (section 5.97). 

The FRC has also included additional wording to align with the IESBA’s proposed technology-related revisions to the code, set to also come into force on the 15 December 2024 (sections 5.53 – 5.54).

Restriction on fees for single controlling parties

To promote firm independence, and in response to issues identified through FRC audit inspection and enforcement cases, the FRC have introduced a restriction on fees derived from entities related by a single controlling party. 

While smaller firms raised concerns that withdrawing from engagements to align with this standard would substantially lessen their overall income, the FRC has acknowledged this concern and noted that it will continue to engage with respondents on this topic.

Other Entity of Public Interest vs Public Interest Entities 

Unanimous support was received for the removal of the other entity of public interest (“OEPI”), and its replacement with the revised public interest entity (“PIE”) definition.

However, while the FRC does have the power to amend or withdraw the category in the Ethical Standard, it does not have the statutory power to revise the definition of a PIE. 

As such, although unable to amend the definition at this stage, the FRC confirmed that it is highly likely to do so once a new statutory definition is confirmed. 

Notably, the FRC’s proposed changes to ethical breach reporting and the definition of an ‘inadvertent breach’ by firms did not make it into the Revised Ethical Standard. In particular, the FRC had proposed to insert the following paragraph into section 1.25: 

Whether a breach is inadvertent is a matter of professional judgement. However, a deliberate breach of this ethical standard by an individual or a firm cannot ever be considered to be inadvertent. The objective of a firm’s policies and procedures should be to prevent or detect breaches of this ethical standard. Therefore, if a breach of this ethical standard occurs because a firm’s policies and procedures were ineffective in meeting that objective, that breach is not considered to be inadvertent. 

Responses to the consultation ‘predominantly opposed to the changes that related to controls, and the expanded definition of an inadvertent breach’, arguing ethical quality controls are better dealt with in the Quality Management Standard (ISQM1). As such, the FRC removed this suggestion, as based on feedback the FRC considered ‘it would be likely to drive inconsistent reporting behaviours’ and ‘cause confusion and distract from the focus on professional ethics by practitioners’.

Objective, Reasonable and Informed Third Party test

To supplement the Revised Ethical Standard, the FRC also provided guidance on the Objective, Reasonable and Informed Third Party test (“ORITP”). Historically, it has been unclear how Firms should apply the ORITP test, which led to this issue being discussed as one of the first topics to be raised in the FRC Audit and Assurance Sandbox that was launched in December 2022. The sandbox enables firms to flag any concerns in a confidential manner across a broad range of areas, from ESG to competition. The focus in the sandbox was on how to  ‘identify better practice among current approaches and innovative ideas for how the test might be carried out or supported’.

As the FRC’s Revised Ethical Standard continues to include several requirements for firms to consider threats to independence from the perspective of the ORITP, the guidance offers suggestions on how to implement the ORITP in practice. The guidance published by the FRC provides a range of ways in which the ORITP perspective can be considered, and comments on the effectiveness and the pros and cons of each approach. 

Examples include firm-produced guidance, initiatives to train firm personnel and retrospective calibration or prospective consultation with an independent panel, although it is noted that none are consistently seen across the profession. The guidance prefaces that the examples given are not one-size-fits-all and vary depending on the balance necessary between accommodating specific scenarios, and strength of the measure from an ORITP perspective. The FRC recommends that firms implement a ‘strategic combination of measures is most likely to enhance the quality of ORITP judgments’.