Misconduct: The Financial Reporting Council's View

Nicola Sharp of Rahman Ravelli explains the significance of a Financial Reporting Council (FRC) Tribunal decision regarding misconduct.

While much happened in the accounting world in 2019, an FRC Tribunal decision relating to auditing may arguably have the largest legal effect on the profession.

The decision was one of a number of developments arising from the FRC’s review of an audit by Baker Tilly into the Tanfield Group – a review that led to the accountancy firm being reprimanded and fined £750,000. Two partners were also reprimanded, with one fined £30,000 and the other £35,000. But the significance of the FRC action in this case is due to it clarifying which features constitute misconduct and which constitute negligence.

An unqualified audit report for the Tanfield Group from Baker Tilly for the year ending 31 December 2007 led to the FRC beginning investigations in 2009; prompted by the goodwill value apportioned to the acquisition of a separate company and some other issues. FRC Tribunal hearings in 2017 and 2018 held that the auditors had failed to identify discrepancies in most of the significant items on the Tanfield Group’s balance sheet. The Tribunal had to consider whether these failings could be considered to be misconduct – or negligence.

What is the definition of misconduct?

The FRC’s rules and procedures define misconduct as an act or omission (or a series of acts or omissions) by a member or a member firm in the course of their professional activities which falls significantly short of the standards reasonably to be expected or has brought or is likely to bring discredit to the profession.

Baker Tilly applied for judicial review to the Court of Appeal, challenging the FRC’s decision to pursue a formal complaint against the firm. The appeal was dismissed, bringing to an end a lengthy legal saga. While the appeal was lost, it did provide clarity regarding the FRC’s stance in such cases.

The FRC had considered the distinction between a finding of negligence and one of misconduct as regards whether the auditors should have signed off a clean audit report on the Tanfield Group. In the judicial review, Baker Tilly questioned whether the FRC should have proceeded to a formal complaint: the firm believed the alleged misconduct was actually conduct described in the FRC guidance as a non-trivial failure and, therefore, did not meet the threshold of misconduct for the purposes of the FRC's accountancy disciplinary arrangements. But at the FRC Tribunal, the Executive Counsel submitted that negligence was not misconduct but conduct which fell short of gross incompetence could amount to misconduct.

The Bolitho Test

Both parties referred to the Bolitho Test that arose from Bolitho v City and Hackney Health Authority (1996): whether a "responsible" or "reasonable" body of professional opinion could do as the accountant did. Baker Tilly argued that it was possible to have different interpretations regarding the meaning of the relevant professional standards and that a number of professional views could satisfy the Bolitho Test.

But the FRC decided that "it is not bound to unquestionably accept the evidence of an expert as to what reasonably competent auditors would do in any given circumstances". The FRC did not accept that another way of testing the position was to ask whether the shortcomings were so serious that they would undermine public confidence in the accountancy profession. The FRC stated that this "adds a gloss" on the wording of the relevant rules that refer to conduct that "is likely to bring discredit to the Member or the Member Firm or to the accountancy profession" as a separate basis for a finding of misconduct.

The Two-Step Approach

The Tribunal considered that two steps were involved in the approach to determining misconduct:

• Step One: Consider the position of each respondent in respect of each allegation. Ask whether the conduct relied upon justifies a "falling short" criticism. This requires consideration of whether no reasonable or responsible body of opinion could support the conduct. If the answer to that question is no then that is the end of the matter.
• Step Two: To the extent that the Tribunal considers that one or more criticisms of falling short are established, for each allegation the Tribunal has to consider whether the conduct is not merely serious but sufficiently serious to cross the threshold into significance so as to justify a finding of misconduct.

The FRC's decision shows that the judgement about whether the actions of an individual amount to misconduct is at the regulator’s discretion: any opinions expressed by experts in accountancy when regulatory hearings are contested will not be decisive. The two-step test may be of use, however, to accountants defending themselves against regulatory actions where their conduct may be sub-standard but not sufficiently serious to be said to amount to misconduct.

Just over a year ago, the independent review of the FRC led by Sir John Kingman was fiercely critical of it. The review recommended that the FRC be replaced with a new body, the Audit Reporting and Governance Authority (ARGA). This recommendation was accepted by the UK government. The Business Secretary at the time, Greg Clark, said the government recognised the need for a new independent statutory regulator with stronger powers.

The FRC has since re-emphasised its commitment to addressing deficiencies in audit and reporting quality through its supervisory and enforcement roles. It remains to be seen whether its Tribunal decision prompted by the Tanfield Group audit leads to it taking a tougher line.

This article was also featured on Lexology.com.