Audit quality is in the spotlight again with the UK’s Financial Reporting Council (FRC) zeroing in on Ernst & Young’s (EY) audit of the Thomas Cook Group (TC Group) in 2017 and 2018.

At the heart of the matter was the failure by the firm’s audit team and statutory auditor to exercise adequate professional scepticism in connection with goodwill and the ability of the firm to continue as a going concern.

According to the FRC, the EY breaches of key audit requirements included:

• a failure to obtain sufficient evidence to support and adequately corroborate key management assumptions and estimates;
• a lack of professional scepticism in connection with the sufficiency and adequateness of the evidence obtained;
• inadequate disclosure in relation to goodwill;
• a failure to prepare sufficient audit documentation; and
• a failure to adequately consider a risk to EY’s independence during the FY18 audit.

Goodwill impairment

TC Group’s goodwill balance was primarily the result of past mergers and acquisitions. In FY17 it amounted to £2.6 billion ($3.4 billion) and represented approximately 40% of the firm’s total assets. The EY team identified it as an area of higher risk and planned both its audits accordingly, zeroing on discount rates, cashflow forecasts and the reasonableness of headroom calculations.

The TC Group, at the time of the two audits, was operating in a sector that was “facing significant and/or unusual challenges” including Brexit, increased competition and changes in consumer preferences.

In this context, in order to employ “appropriate professional scepticism,” the FRC says the EY team should have:

• planned a more detailed review of the achievability of the TC Group’s business plan;
• completed in-depth testing of the underlying cash flow calculations;
• focused more closely on the TC Group’s revenue growth assumptions and cost savings calculations;
• evaluated tax rates, discount rates and compliance with the specific requirements of IAS36; and
• conducted further sensitivity testing.

Instead the management assumptions were “accepted without adequate challenge” and insufficient audit evidence was obtained to corroborate key assumptions made by the TC Group.

Going concern

The deteriorating condition of the TC Group in 2018 resulted in questions around the ability of the firm to continue as a going concern to be upgraded to a significant risk.

Had the possibility of uncertainty around this been material it would need to be disclosed in the financial statements. The FRC says the EY audit team should have established this by performing “detailed audit procedures in relation to management’s forecast trading results, and forecast liquidity.” The assumptions underlying the forecasts should be been verified and challenged with the EY team:

• requiring management to prepare an update base case reflecting actual FY18 results rather than historical data;
• modelling a downside scenario representing a decline in performance compared to FY18;
• challenging management on lower performance levels and performing further modelling based on these;
• re-examining the performance of the TC Group as a whole rather than reusing work carried out in the Goodwill context;
• carrying out detailed testing comparing actual vs budgeted results;
• gaining a better understanding of the assumptions underlying the sensitivities selected by management in order to ensure that they truthfully reflected the exposure of the business to downside risk;
• challenging the cashflow benefits as modelled; and
• validating and challenging management on shock scenario selected by management.

Auditor independence

This breach stemmed from a longstanding and close business relationship between the EY restructuring partner who joined the audit team in 2018 and the TC Group’s CFO.

Because the restructuring partner role was one that “exerted direct influence over the FY18 Audit” a robust assessment of any risk to the audit firm’s independence should have been made and should have included:

• meetings with the restructuring partner;
• consultation with the engagement quality control review partner; and
• a written record evaluating the potential risk to independence.

Although there is no suggestion that “the breaches were intentional, dishonest, deliberate or reckless”, Claudia Mortimore, FRC deputy executive counsel, called the breaches “significant” with those in 2018 being “particularly serious” given the “heightened risks surrounding the audit work.”

Critically, the breaches resulted in both audits failing in their principal objective of “obtaining reasonable assurance that the financial statements were free from material misstatement.”

As well as receiving a severe reprimand, EY will pay fine of £4,875,000 ($6,302,300). The statutory auditor, who has also been reprimanded, will pay a fine of £105,000 ($135,700). Both fines represent a discount of 25% on the initial fines imposed in recognition of cooperation and admissions by both firm and auditor.