PRA statement on the evaluation of the Written Auditor reporting policy

Executive summary

This statement sets out the conclusions of the Prudential Regulation Authority’s (PRA) evaluation of the Written Auditor Reporting policy (‘the policy’), to assess how it is delivering against its original objectives. It also sets out how the PRA intends to continue to refine its approach to the policy to make it a more efficient and effective supervisory tool.

The evaluation findings confirm that the policy has met its objective of improving the quality, focus and discipline of the auditor-supervisor dialogue. The policy has helped the PRA to identify and address emerging concerns more effectively and so has supported the PRA’s statutory objectives regarding safety and soundness. Cost estimates obtained by the PRA have been within or below the range we envisaged at the inception of the policy.

We have identified some improvements we plan to make to enhance the PRA’s approach to the policy to make it more proportionate to risks to our objectives and to respond to feedback we received as part of the evaluation. These improvements do not require amendments to the corresponding rules or supervisory statement as the existing policy allows for flexibility in how it is operated by the PRA.

More detail about the policy, the evaluation work and findings, and the planned enhancements to how the policy is implemented by the PRA, are set out below.

Background

Supervisory statement (SS)1/16 – Written reports by external auditors to the PRA sets out the PRA’s expectation of auditors in relation to the requirement to provide written reports to the PRA concerning the audit of major banks and building societies as laid out in Chapter 8 of the Auditors Part of the PRA Rulebook.

Overall, the purpose of the policy is to improve the quality, focus and discipline of the auditor-supervisor dialogue, so as to identify and address emerging concerns more effectively and to support the PRA’s statutory objectives regarding safety and soundness.

The policy involves the PRA asking questions each year of auditors of the largest UK banks and building societies to which the auditors respond via a private report at the end of their audit. The policy applies to a UK-headquartered bank/building society that is not a subsidiary of a non-UK undertaking and has a balance sheet total greater than £50 billion. At present, there are nine firms in scope of the policy.

The PRA introduced the policy for the audits of financial reporting periods ending on or after 1 November 2016, with the first auditor reports received in April 2017. Since April 2019, the PRA has published thematic findings from the review of the auditors’ written reports annually via a series of Dear chief financial officer (‘DCFO’) letters.

1: Evaluation work and evidence

To support the evaluation, the PRA took into account evidence and feedback from a variety of sources gathered between 2021 and 2023. This included:

• surveys and structured interviews with firms in scope, their audit committee chairs, and their auditors covering the costs/benefits of the policy and the impact on the quality of the audit;
• surveys and structured interviews with PRA supervisors on how the policy had been employed and its effects on the quality, focus and discipline of the auditor supervisor dialogue;
• regulatory data and published financial statements to assess the potential impact of using different thresholds to set the scope of the policy and to assess cost as a proportion of the audit fee; and
• engagement with the PRA specialists that use auditors’ responses to understand how the policy had supported cross firm and thematic analysis on emerging risks, the findings from that work and how these have advanced the PRA’s statutory objectives.

The PRA used this information to consider whether the policy has achieved the objectives that were originally intended in line with the expected costs, what improvements can be made to make the policy a more efficient and effective supervisory tool, and whether the scope of the policy captures the appropriate firms.

2: Key evaluation findings

The key findings of the evaluation are outlined below, along with proposed follow-up actions by the PRA (see key finding 3).

The evaluation has concluded that the policy has supported the PRA’s safety and soundness objective in three ways:

• Helping to enhance the auditor-supervisor dialogue. The auditors’ reports provided the PRA with in-depth and comparable cross-firm information to enable effective analysis of emerging risks. Supervisors noted that written auditor reporting has aided the dialogue with external auditors by providing a structure for more focussed and informed discussions at bilateral meetings.
• Promoting audit quality. The questions provided auditors insights into areas of regulatory concern, and so supported auditors in considering the PRA’s safety and soundness objective in their work. Auditors generally noted that the policy has aided the auditor-supervisor dialogue, including through allowing them to gain deeper insight into the PRA’s areas of focus and on emerging issues.
• Supporting the PRA in promoting high quality and consistent accounting in areas that could impact a firm’s safety and soundness. PRA specialists noted the policy had provided a deeper understanding and greater clarity on accounting and auditing matters and allowed for more effective use of the auditors’ work to identify and address prudential risks. This has enabled the PRA to provide firm specific and thematic feedback to promote high-quality and consistent accounting practices in areas that impact our prudential objectives, such as IFRS 9.

Specific examples of how the policy has helped further the PRA’s objectives since its introduction include the following:

• Promoting high quality and consistent accounting, including for expected credit losses (ECL) under IFRS 9: The PRA regards the effective implementation of ECL to be important in ensuring the safety and soundness of PRA-authorised firms. Since 2018, written auditor reporting has been used to monitor how ECL is being implemented. In 2019, the PRA set out views on practices that would contribute to a high-quality and consistent implementation.

The PRA has subsequently used written auditor reporting to monitor the extent to which firms have adopted these high-quality practices and has observed significant progress. This has included improvements in model risk management, the approaches to capture the impact of economic uncertainty on forward looking scenarios and credit losses, and identification of significant increases in credit risk.

The PRA’s ongoing monitoring of ECL practices has enabled the PRA to publish annual feedback via DCFO letters to encourage firms to continue to identify improvements that can be made to ensure changes in credit risk are recognised in a timely way. Understanding of the range of practice helps identify outliers for closer investigation as part of regular close and continuous engagement with firms and auditors.

This work has also supported the PRA in working with preparers, users, and other regulators to develop enhanced market disclosures to promote greater transparency around ECL, and has furthered the PRA’s understanding of the interaction between IFRS 9 and the prudential framework.

• Supporting the PRA taking swift action in response to accounting challenges raised by the Covid-19 pandemic and as economic conditions have evolved: The knowledge and insights gained from written auditor reporting about how ECL is being implemented, and the challenges faced by firms and auditors, were important in enabling the PRA to respond quickly to events such as Covid-19. This included publishing Dear CEO (DCEO) and DCFO letters during 2020 to promote consistent and robust application of ECL during the pandemic and as economic conditions have evolved. This guidance was widely used and welcomed by firms and auditors.
• Helping the PRA to assess risks related to market changes, including global benchmark reform: The policy was used between 2019 and 2021 to help the PRA understand firms’ preparedness to transition from LIBOR to robust alternative reference rates, as well as to understand the potential implications for financial reporting and, as a consequence, regulatory capital. This analysis helped the PRA to identify and assess risks to an orderly transition. The PRA published thematic findings in 2020 and 2021 DCFO letters to help firms and the wider market to monitor and assess possible accounting or audit risks.
• Supporting robust planning and early action on accounting for climate risks by firms: In 2022, the PRA used written auditor reports to assess the robustness of firms’ financial reporting risk assessments and the extent to which firms consider climate risk in their accounting valuations. This has supported the PRA in monitoring early progress to incorporate climate risk into firms’ overarching governance frameworks, and to factor climate risks into financial reporting, as part of assessing how firms are managing the financial risks associated with climate change, against the PRA’s expectations as set out in SS3/19 – Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. The auditors’ reports have enabled the PRA to set out views on elements that contribute to planning for the development of capabilities to capture the impact of climate risks on balance sheets over time, for example through a DCEO and DCFO letter in 2022. In turn, this has informed the PRA’s latest thinking on climate-related risks and regulatory capital frameworks and is being used to support international engagement through the Basel Committee on Banking Supervision.
• Supporting deep dives on thematic issues by PRA specialists to inform policy analysis, including the treatment of software assets: In 2019, the PRA used written auditor reporting to explore the accounting treatment of investment in technology, partly in response to concerns that some changes to the regulatory treatment of intangible assets at that time may create incentives for firms to delay when technology spend is recognised for capital purposes. This analysis helped to inform the PRA’s position on the prudential treatment of software assets published in 2021.

As part of the policy evaluation, the PRA considered whether the existing scope of the policy captures the appropriate firms, including whether the metrics, thresholds or other scope requirements should be amended. The evaluation concluded that the scope of the policy, being based on balance sheet size and limited to the largest UK-headquartered banks and building societies, is appropriate given considerations of proportionality and risks posed to financial stability. In particular, the PRA concluded that raising the threshold to reduce the number of firms in scope would risk excluding firms that are important for financial stability, and that it would be disproportionate to the PRA’s objectives to lower the thresholds and widen the scope of the policy.

The PRA has also considered the impact of the policy on its secondary objective to facilitate effective competition as well as its new secondary objective to facilitate, subject to alignment with international standards, the international competitiveness and growth of the UK economy. The PRA believes that promoting high-quality and consistent accounting and high-quality audits fosters a level playing field for competition. The PRA also found the policy is likely to promote confidence in high-quality implementation of accounting standards, which in turn promotes confidence in UK firms’ capital adequacy and competitiveness. By continuing to publish findings and setting out views on high-quality accounting practices, the PRA provides transparency to firms and auditors that are not in scope of the policy of how accounting standards are being implemented in practice, which may not otherwise be available.

All cost estimates provided to the PRA during the evaluation were within or below the estimated range of 5–15% of the audit fee envisaged in the initial consultation for the policy which formed part of the PRA’s original cost-benefit analysis. Cost estimates were below this range for the largest firms but tended to be towards the higher end of this range for the simpler and less systemic firms. Feedback received indicated that key drivers for costs include the number and depth of the questions asked, the level of detail in auditors’ responses, and whether the questions are similar year on year. The policy allows flexibility for the PRA to vary these drivers between years and across firms to help ensure that costs do not become disproportionate.

The evaluation work has identified the following key improvements that we intend to implement to make the PRA’s use of the policy more proportionate to the risk to PRA objectives and to respond to feedback received.

• We will aim to continue to ask a low number of questions in future years: Since implementation, the PRA has reduced the number of questions asked of the auditors as it has gained more experience of which questions have resulted in the most valuable responses to the PRA. The number of questions we have asked each year is set out in the Chart below and shows that most questions relate to credit risk.

We have sought to focus questions on areas where we regard effective application of accounting standards to be important in ensuring the safety and soundness of PRA-authorised firms. We have found responses particularly valuable where they have helped us to understand the auditors’ assessment of the quality and consistency of firms’ processes.

Since 2015, on average, we have asked nine questions a year, although not all questions were asked of all firms. For example, a question about fair value has not been included for firms that do not have large derivative exposures. In future, we intend to continue to ask fewer questions compared to the earlier years of the policy. For example, in 2023 we are asking 3 questions across credit risk and climate.

Consistent with the expectations set out in SS1/16, in a year of major change, the number or extensiveness of questions is likely to rise on a temporary basis. We plan to continue to monitor the number of questions asked as well as the length of auditors’ responses.

• We will aim to ask fewer questions for those firms in scope who are smaller and less complex, relative to the largest and more complex firms: Cost estimates provided to the PRA show that the costs of written auditor reporting have been within or below the range we initially estimated for all firms, as noted above. However, costs have tended to be towards the higher end of this range for the smaller firms in scope. The PRA has asked the auditors of these firms fewer questions on average since the policy was introduced.

To the extent possible, the PRA will aim to keep the overall expected burden represented by the questions stable from year to year. We will continue to monitor the number of questions we ask across firms, and actively consider asking fewer questions of firms that pose fewer risks to the PRA’s objectives. This may mean asking no questions for some firms in some years.

• We will also aim to clarify guidance to auditors about what we are looking for in a good response to support shorter, more focused responses from auditors: PRA specialists have noted that in some instances responses included more detail in some areas than we had anticipated and where the link to the supervisory concern was unclear.

The PRA has provided guidance for auditors when setting the questions that has been shared with the auditors annually as well as through other engagement. This has included making clear what expectations the PRA has as to the way questions should be answered. In doing so, we have made clear that the PRA is not expecting the auditors to carry out any procedures that go beyond the scope of the statutory audit.

We plan to explore with auditors how we can improve our existing guidance, and the feedback we provide from our analysis of the responses, to improve the focus of future responses towards areas that are of most value for the PRA and in a way that is as efficient as possible for auditors to produce and for the PRA to analyse.

• We will set clear goals for questions that are repeated to help auditors understand our focus and limit duplication in responses: Some feedback received through the evaluation prompted the PRA to clarify why we have asked similar questions year on year and to consider if there would be benefit from questions being more varied.

The PRA considers that repeating questions has enabled it to track progress over time where we have given feedback to encourage firms to identify improvements that can be made to the quality of firms’ practices. We have sought to focus responses on understanding significant changes made to firms’ processes, how effectively processes have operated in the period, and firms’ plans to develop capabilities to support timely recognition of changes in risk over time.

We believe repeating questions remains appropriate to help us to monitor improvements firms have made where we have set out our concerns over the quality of practice in areas that impact safety and soundness.

However, we will look to improve our guidance for auditors when repeating questions. For past questions, we have set out the supervisory concern that has prompted us to ask the question. When repeating questions, we have encouraged auditors to limit duplication of material used in prior year responses to focus on changes in the period. The supervisory concerns have tended to be high-level and similar year on year, and so it may not be clear how our focus has shifted.

In the future, we will consider including a goal for each question. This will help guide the analysis we do, the feedback we provide, and determine if similar questions will be repeated in future years. We would expect to update the goal to explain the reasons for any follow up questions and to explain how we are narrowing our focus. We would also expect to discuss the goal with auditors when agreeing the questions asked.

Next steps

The PRA has today published thematic feedback from the 2022/23 round of written auditor reporting and questions relating to written auditor reporting for 2023/24 will also shortly be shared with auditors. The questions for the 2023/24 round of written auditor reporting take account of the feedback received through the evaluation process. In our implementation of the policy, we will be guided by the findings of the evaluation as set out above. For example, we will continue to improve the way that the policy is implemented over time to be more proportionate to the risks to our objectives and, where relevant, we will also look to improve our guidance for auditors.