UPDATE 1-UK accounting watchdog warns over bank audits
* Bank loan-loss provisioning an accounting concern
* Watchdog says broader review must bring improvements
* FRC to consult on new transparency rule
* Big Four accountants say they working to improve audits (Adds reaction from Big Four accounting firms)
By Huw Jones
LONDON, May 28 (Reuters) - Accountants who check the books of Britain's banks must sharpen their act or could be ordered to take corrective measures, the sector's watchdog said in a report showing how a core lesson from the financial crisis has yet to be applied.
The Financial Reporting Council (FRC) said in its annual audit quality inspections report that there was a significant improvement in audits of listed companies in general, but the banking sector continued to lag.
"The overall grading of bank and building society audits is, and continues to be, generally below those of other types of entity," the FRC said.
The inspections during 2013 and 2014 covered audits for the year that ended December 2012. They included the books of five banks and five building societies, all unnamed and none were "good" - the top grading - while 56 percent needed improvements.
In particular there was no significant improvement in how accountants check the way banks set aside capital to cover souring loans, known as loan-loss provisioning.
Too low levels of capital forced taxpayers to shore up lenders during the 2007-09 financial crisis. It also prompted policymakers to ask auditors why they gave banks a clean bill of health just months before they had to be rescued.
"Weaknesses in the testing of loan impairment models and related assumptions were key issues," the FRC said in the report.
"Insufficient challenge of management or the failure to obtain further evidence to support provisioning judgements were common themes in the issues identified."
Britain's big banks are all audited by one of the "Big Four" accounting firms, KPMG, Deloitte, PricewaterhouseCoopers (PwC) and EY.
"The FRC's report provides a balanced view of the focus and results of its inspection, and we agree with its overall conclusions and findings," Deloitte said.
Auditors will have to work hard to continuously improve, EY said. PwC said it has put in place a comprehensive action plan to embrace recommendations in the watchdog's report.
KPMG said the review showed that most of its audits were either good or required only limited improvements and that it will redouble efforts to ensure that no audit requires substantial improvement.
Britain's competition watchdog and the European Union are bringing in rules forcing companies to change accountants more frequently to avoid cozy relationships and failure by accountants to question what they are told by customers.
Barclays is changing its auditor PwC for the first time in 120 years. Lloyds and Royal Bank of Scotland may follow suit but given the complexity of lenders, the switching will almost certainly be between the Big Four.
Paul George, the FRC's executive director for conduct, is looking for a "step change" in audit quality at banks when the FRC publishes the results of a separate broad review of bank book-keeping in the autumn.
"If we do not see the level of progress that we expect then clearly enforcement would be something we would need to consider," George told Reuters.
The FRC announced the separate review of 13 banking audits in December in a bid to focus the minds of auditors as they checked banks' financial statements for 2013.
It came after routine inspections by the FRC were not providing "sufficient incentives" for accountants to improve their work at banks.
"The headline message is that the firms took our concerns in December 2013 very seriously and have sought to take actions to address those points but it is too early to assess whether those actions have been effective," George said.
The FRC does not name the banks and other firms whose accounts it reviews annually but this could change.
Britain's competition watchdog has recommended that audit committees at companies say if the FRC has inspected the accounts and what the outcome is.
George said the FRC supports transparency and will launch a public consultation later this year on how audit committees might report to shareholders on accounting concerns. (Editing by Susan Fenton)