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Part 4 - Auditor independence

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4.1 Background

Since 1996, the Government has been actively involved in the reform of the accounting and audit regulatory framework with a view to achieving quality disclosure to shareholders and other stakeholders. In addition to the overhaul of the accounting standard setting arrangements and the introduction of an effective continuous disclosure regime (which is discussed in Part 8), the Government has carefully examined issues relating to the independence of company auditors.

  • A Working Party of the Ministerial Council for Corporations (MINCO) produced a report in July 1997 entitled 'Review of Requirements for the Registration and Regulation of Company Auditors'. This report examined the legal framework for the registration, appointment, supervision and disciplining of company auditors in relation to their functions under the Corporations Act.
  • Work on the recommendations of the Working Party report proceeded in consultation with the States and the accounting profession. However, with a sharpening of focus on auditor independence issues in the light of the HIH collapse, the Government decided in July 2001 to engage Professor Ian Ramsay to undertake a comprehensive review of Australia's existing legislative and professional requirements on the independence of company auditors.
  • This work updated the Working Party report by taking account of new approaches to auditor independence adopted by the United States, the European Commission, and IFAC.

The Government released Professor Ramsay's report on the Independence of Australian Company Auditors (the Ramsay report) for public comment in October 2001 and sought public comments on the Ramsay recommendations by the end of March 2002.

The Government has considered the Ramsay report's recommendations in the light of comments provided by stakeholders and developments in Australia and overseas since the report's release. With the enactment in July 2002 of United States  legislation containing specific provisions on auditor independence, it is timely to determine Australia's approach to these issues.

While the proposals in the present paper constitute a Government response to the Ramsay report, final implementation of these proposals will need to take account of any relevant recommendations of the HIH Royal Commission.

4.2 The importance of auditor independence

Auditor independence is fundamental to the credibility and reliability of auditor's reports. The Australian Statement of Auditors Practice AUP 32 - Audit Independence (AUP 32) states that independence 'requires a freedom from bias, personal interest, prior commitment to an interest, or susceptibility to undue influence or pressure'.

Audited financial statements play a key role in relation to the efficiency of capital markets and the independent auditor constitutes the principal external check on the integrity of financial statements. The Ramsay report recognises the following four functions of an independent audit in relation to capital market efficiency:

  • adding value to financial statements by improving their reliability;
  • adding value to the capital markets by enhancing the credibility of financial statements;
  • enhancing the effectiveness of the capital markets in allocating valuable resources by improving the decisions of users of financial statements; and
  • assisting to lower the cost of capital to those using audited financial statements by reducing information risk.

A lack of auditor independence, or even an appearance of lack of auditor independence, can detract substantially from these outcomes.

The independent audit function is also a key element in the broader corporate governance landscape. President Bush's 10-Point Plan to improve corporate responsibility and protect shareholders recognised the importance of auditor independence:

Point 7 from President Bush's 10 Point Plan

'Investors should have complete confidence in the independence and integrity of companies' auditors.

Investors depend on the judgment, integrity and competence of independent auditors. While auditors cannot prevent intentional deceit, they are a critical external check on corporate management.'

4.3 Co-regulatory environment

The current regulatory environment in relation to the independence of auditors is co-regulatory:

  • the professional accounting bodies play a major role through their professional requirements and codes of ethics;
  • ASIC performs an essential enforcement role in ensuring that registered company auditors remain independent through compliance with the provisions of the Corporations Act which deal with the independence of auditors;
  • disciplinary matters concerning auditors, including the independence of auditors, is the responsibility of the CALDB.

One of the key objectives underlying the recommendations in the Ramsay report is to continue the current co-regulatory approach. The Government supports this objective.

4.4 Overseas developments

The globalisation of capital markets has created a policy environment that is conducive to harmonisation and uniformity in the areas of financial reporting and auditing. This includes the ethical requirements of the professional accounting bodies that govern the conduct of the work of the accounting profession, including as they relate to auditor independence.

The Ramsay recommendations on auditor independence have been significantly informed by recent international developments and the Government's response has also taken account of developments subsequently:

  • The release of proposals by the accounting profession's peak international body, IFAC to update its ethical requirements on audit independence.
    • In November 2001 (following release of the Ramsay report), IFAC adopted its new standard on audit independence.
    • Australia's two major professional accounting bodies, CPAA and the ICAA agreed in May 2002 to a new standard for audit independence which is fundamentally based on IFAC's new internationally harmonised standard.
  • The release by the European Commission of a consultative paper containing proposals designed to achieve greater uniformity in the requirements in force in the Member States of the European Community.
    • the European Commission published a Recommendation on auditor independence in May 2002. The Recommendation introduces a principles-based approach to auditor independence requiring the auditor to consider for each audit engagement independence threats and risks as well as the safeguards for mitigating those risks.
  • The United States SEC decision in November 2000 to remake its rules on audit independence to address issues associated with independence violations by auditors in the United States.
    • Since then the United States has enacted the Sarbanes-Oxley Act of 2002 which contains specific auditor independence requirements.

4.5 Core circumstances creating lack of independence

The Ramsay report identifies three key issues which need to be addressed when considering whether accounting firms are independent of their audit clients:

  • employment relationships;
  • financial relationships; and
  • the provision of non-audit services.

In developing a framework of reform proposals in relation to these key issues, the Ramsay report also recommended that the Corporations Act be amended to include a general statement requiring an auditor to be independent.

4.6 General statement of principle requiring independence

4.6.1 The Ramsay proposal

Background

While the Corporations Act currently contains several provisions dealing with the independence of auditors, it does not contain a general statement requiring an auditor to be independent. This can be contrasted with the positio
n in Canada and New Zealand.

  • Section 161 of the Canada Business Corporations Act contains a general statement that a person is disqualified from being an auditor of a corporation if the auditor is not independent of the corporation, any of its affiliates, or the directors or officers of any such corporation or its affiliates.
  • Section 204 of the New Zealand Companies Act states that an auditor must ensure, in carrying out the duties of an auditor, that his or her judgment is not impaired by reason of any relationship with or interest in the company or any of its subsidiaries.

The Ramsay report recommendations

The proposal in the Ramsay report contains three related recommendations.

  • The Corporations Act be amended to include a general statement of principle requiring an auditor to be independent.
  • The general statement would also provide that an auditor is not independent with respect to an audit client if the auditor is not, or a reasonable investor with full knowledge of all relevant facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the auditor's engagement. In determining whether an auditor is independent, the Ramsay report states that all relevant circumstances should be considered, including all relationships between the auditor and the audit client.
  • The auditor should be required to make an annual declaration, addressed to the board of directors, that the auditor has maintained its independence in accordance with the Corporations Act and the rules of the professional accounting bodies.

4.6.2 Stakeholder response

There was broad support from key stakeholders for all three of the recommendations.

  • The professional accounting bodies considered it essential that the general statement of principle be consistent with the language and spirit of the more extensive ethical rules of the accounting bodies.
  • Some stakeholders considered that any general statement should be included in the ethical rules of the accounting bodies because of concern that legislation could be too prescriptive.

4.6.3 Proposal

Proposal 2 - General statement of principle requiring independence

The Government will amend the Corporations Act to include a General Statement of Principle requiring the independence of auditors.

 

The general statement of principle will also establish a general standard of independence that an auditor is not independent with respect to an audit client if the auditor is not, or a reasonable person with full knowledge of all relevant facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the auditor's engagement. In determining whether an auditor is independent all relevant circumstances should be considered, including all relationships between the auditor and the audit client.

  • ASIC will be given the power to issue practice notes or guidelines, either generally or in specific circumstances, to assist with any issues of interpretation that may arise in relation to the application of the general standard to particular circumstances.

The general standard of auditor independence recommended in the Ramsay report is based on SEC Rule 210.2-01. In drafting the general standard, the Ramsay report has adopted a 'reasonable investor' test from the SEC rule. The Government considers that it would be desirable to adopt a 'reasonable person' test because the users of financial statements extend beyond investors. Furthermore, adoption of a 'reasonable person' test would bring the legislation into line with the language used in the new Statement F1 on Professional Independence which has been adopted in Australia by CPAA and ICAA.

Proposal 3 - Annual declaration by auditor

The Government will amend the law to require the auditor to make an annual declaration, addressed to the board of directors, that the auditor has maintained its independence in accordance with the Corporations Act and the rules of the professional accounting bodies.

 

4.7 Employment relationships

4.7.1 The Ramsay proposal

Background

Section 324 of the Corporations Act currently deals with employment relationships between auditors and clients.

The rationale for the imposition of restrictions on employment relationships between an accounting firm and an audit client is that such relationships can give the impression that an auditor is not independent of the client, whether or not that is the case. Where such relationships exist, there may a range of circumstances which, collectively or individually, make it difficult for the auditor to adopt an unbiased approach to the audit engagement, with the result that the audit client could receive a more favourable audit report than the facts or circumstances justify. The Ramsay report notes that in the English-speaking world at least, legislators have long been minded to include in corporate legislation provisions which have the objective of prohibiting or restricting employment relationships. More recently, professional accounting bodies have also addressed this issue in their ethical codes.

In framing reform proposals, the Ramsay report has taken into account the latest developments overseas. The Ramsay report notes that the IFAC independence standard, the European Commission proposals and the SEC rules all seek to safeguard independence by ensuring that:

  • partners or professional employees of an accounting firm are not employed by the audit client or serve as a director of the audit client;
  • where a former partner or professional employee of an accounting firm is employed in an accounting role or a financial reporting oversight role at an audit client, there are (with limited exceptions) no residual links with the accounting firm;
  • where a former officer, director or employee of an audit client becomes a member of an accounting firm, the person is not in a position to audit, or influence the audit, of financial statements concerning a period during which he or she was employed by, or associated with, the audit client; and
  • relatives of a member of an audit team are not directors of an audit client or employed by the audit client in a senior management position, in an accounting role, or a financial oversight role.

The Ramsay report recommendations

The Ramsay report recommended that subsections 324(1)(f) and 324(2)(g) and (h) of the Corporations Act should be replaced by new rules relating to employment relationships in the following areas:

  • Employment by client of current auditor/employee of auditor.
  • Employment by client of immediate family member of audit engagement team.
  • Employment by client of former auditor/employee of auditor.
  • Mandatory period of two years following resignation from an audit firm before a former partner of an audit firm who is directly involved in the audit of a client can become a director of the client.
  • Employment by audit firm of former employee of client.
  • Remuneration from audit firm.

The Ramsay report recommended that there should be protection for inadvertent breaches of the independence rules concerning employment relationships provided certain requirements are met.

The Ramsay report also recommended that the proposed rules would not apply if the audit client is a small proprietary company, as defined in section 45A of the Corporations Act.

4.7.2
Stakeholder response

The great majority of stakeholders supported the recommendations on employment relationships. The main concern raised by some stakeholders was that the recommendations should be implemented in the ethical rules of the accounting bodies rather than the Corporations Act.

4.7.3 Proposal

Since the Ramsay report was released, the European Commission has issued a Recommendation including a provision that a period of two years should have elapsed before a key audit partner can take up a key management position with the audit client. In its July 2002 report, the UK Co-ordinating Group on Audit and Accounting also favoured a two year cooling off period before an audit partner can join an audit client as an employee or director.

It would be appropriate for the Ramsay recommendation for a two year cooling off period to be extended to apply to senior management positions with the audit client as well as directorships.

Proposal 4 - Employment relationships

The Government will amend the law to strengthen restrictions on employment relationships between an auditor and the audit client.

  • This will include a mandatory period of two years following resignation from an audit firm before a former partner who was directly involved in the audit of a client can become a director of the client or take a position with the client involving responsibility for fundamental management decisions.

 

An overview of each of the proposed new requirements is set out below.

Employment by client of current auditor/employee of auditor

An auditor is not independent if a current partner or professional employee of the audit firm is:

  • an officer of the client;
  • a partner, employer or employee of an officer of the client; or
  • a partner or employee of an employee of an officer of the client.

Section 324 is currently limited to members of the firm. The proposal also applies to professional employees of the audit firm.

Employment by client of certain relatives of auditor

An auditor is not independent if an immediate family member of a member of the audit engagement team is:

  • a director of the client; or
  • an officer or employee of the client who is in a position to affect the subject matter of the audit engagement.

This proposal is drawn from the IFAC standard and the SEC rules which prohibit these employment relationships.

Employment by client of former auditor/employee of auditor

An auditor is not independent if a former partner or professional employee of an audit firm is:

  • a director of the client; or
  • an officer or employee of the client who is in a position to affect the subject matter of the audit engagement;

unless the individual:

  • does not influence the audit firm's operations or financial policies and does not participate or appear to participate in the audit firm's business or professional activities; and
  • has no capital balances in the audit firm; and has no financial arrangement with the audit firm other than one providing for regular payment of a fixed pre-determined dollar amount which is not dependent on the revenues, profits or earnings of the audit firm.

The proposal is drawn from the IFAC standard and the SEC rules which prohibit these employment relationships.

Retired audit partner joining audit client

An auditor is not independent if a former partner of an audit firm who was directly involved in the audit of a client becomes a director or senior manager of the client within a period of two years of resigning as partner of the audit firm.

  • If a former partner directly involved in the audit of the audit client becomes a director or senior manager of the audit client after the two year cooling off period, the Corporations Regulations will require that the audit client disclose this information in its annual report.

During the course of the Ramsay review, a significant number of stakeholders identified as a particular concern the issue of retired audit partners joining the boards of their audit clients. The proposal, which extends the Ramsay recommendation to include management positions with the audit client, is designed particularly to address threats to auditor independence when a former partner retains some financial arrangement with the audit firm or continues to exercise influence over the audit firm's operations or financial policies.

The proposal is restricted to a former partner of an audit firm directly involved in the audit of a client. In this way the proposal has attempted to achieve an appropriate balance between promoting auditor independence and not unduly impeding audit professionals joining companies and bringing with them valuable financial expertise.

Employment by audit firm of former employee of client

An auditor is not independent if a member of the audit engagement team has, during the period covered by the audit report, been:

  • an officer of the client; or
  • an employee of the client in a position to influence the subject matter of the audit engagement.

This proposal is drawn from the IFAC standard and the SEC rules which prohibit these employment relationships.

Remuneration from audit firm

An auditor is not independent if an officer of the client, or an employee of the client in a position to influence the subject matter of the audit engagement, receives any remuneration from the audit firm for acting as a consultant to it on accounting or auditing matters.

This proposal repeats the current paragraph 324(2)(h) of the Corporations Act but has been expanded to include employees of the client who are in a position to influence the subject matter of the audit engagement.

The ICAA, with the support of CPAA, has suggested that this restriction be extended to apply to all consultancy arrangements, not just those relating to accounting or auditing matters. The Government considers that there is merit in this proposal.

Inadvertent breaches

There should be protection for inadvertent breaches of the independence rules concerning employment relationships provided certain requirements are met.

The Government considers that there is a strong case in support of including these provisions in the Corporations Act rather than the ethical rules of the accounting bodies.

  • The Government agrees with the approach in the Ramsay report that the legislation should set the core requirements, and the ethical rules of the professional bodies would provide additional guidance for considering the threats to audit independence associated with employment relationships and the safeguards available for eliminating or minimising those threats. Exclusive reliance on the ethical rules of the professional accounting bodies would result in matters of public interest being regulated by a private contract between a professional body and its members.
  • There are benefits in terms of enforcement in having the core requirements set out in the Corporations Act. The proposed restrictions in relation to retired partners and former employees of the audit firm could not be enforced under the ethical rules if they were no longer members of the relevant professional body.
Small proprietary companies

As recommended in the Ramsay report the new rules will not apply if the audit client is a small proprietary company as defined in section 45A of the Corporations Act

4.8 Financial relationships

4.8.1 The Ramsay proposal

Background

The Ramsay review found that Australia's legislative and professional requirements in respect of financial relationships require significant updating to bring them into line with c
urrent and proposed overseas requirements. In particular, the Corporations Act contains no requirements in respect of investments in audit clients or about business relationships between auditors and their clients. The professional rules contain minimal requirements in respect of business relationships.

The Ramsay report proposes that a co-regulation model should continue to be used for ensuring financial relationships between an auditor and an audit client do not impair audit independence.

The Ramsay report recommendations

Section 324 of the Corporations Act currently deals with some aspects of financial relationships between auditors and clients. The Ramsay report recommends that paragraphs 324(1)(e) and 324(2)(f) of the Corporations Act should be replaced with the following rules.

As with the proposals on employment relationships, the Ramsay report recommends an exemption regime for inadvertent breaches of the rules if certain requirements are met.

The Ramsay report also emphasises that the financial relationships addressed in the proposed rules are not an exclusive indication of circumstances where an auditor may lack independence. The Ramsay report states that, as is currently the case, it is appropriate that the ethical statements of the professional accounting bodies contain additional guidance for auditors dealing with other circumstances in which an auditor may lack independence.

Investments in audit clients

An auditor is not independent if:

  • the audit firm, any member of the audit engagement team, or any of his or her immediate family has:
    • a direct financial investment in the client; or
    • a material indirect financial investment in the client;
  • the audit firm has a material financial interest in an entity that has a controlling interest in the client; or
  • any other client service personnel, or any of his or her immediate family has a direct financial interest or a material indirect financial interest in the client.
    • the term 'other client service personnel' is defined as 'partners and managerial employees who provide non-audit services to a client, except those whose time involvement is clearly insignificant'.

The recommendation is drawn from the IFAC independence standard which prohibits all these financial relationships. The Ramsay report notes that the SEC rules also prohibit these financial relationships, although the SEC rules are more prescriptive in a number of respects and include additional prohibitions.

Loans to and from audit clients

An auditor is not independent if:

  • subject to the exception contained in subsection 324(3) of the Corporations Act [which relates to certain principal place of residence housing loans to a natural person], a partner of the audit firm, or an entity which the partner controls, or a body corporate in which the partner has a substantial holding, owes more than $10,000 (or such other amount as may be prescribed by regulation) to the client; or
  • the audit firm, any member of the audit engagement team, or any of his or her immediate family:
    • accepts a loan from a client; or
    • makes a loan to a client; or
    • has a loan guaranteed by a client; or guarantees a client's loan;

unless the loan is made in the ordinary course of the client's business and the loan is made under normal lending procedures, terms and conditions.

The first recommendation repeats what is currently in paragraphs 324(1)(e) and (2)(f) of the Corporations Act. However, two changes have been made.

  • First, the amount of $5,000 currently in section 324 has been increased to $10,000, or such other amount as may be prescribed by regulation. This is consistent with a recommendation made in the report of the Audit Review Working Party.
  • Secondly, the prohibition currently in section 324 has been extended beyond partners of audit firms and bodies corporate in which partners have a substantial holding, to include entities which partners control. In order to prevent circumvention of the restriction, the Ramsay report did not consider that it would be appropriate to restrict the prohibition to bodies corporate.

The second recommendation is drawn from the IFAC independence standard. The recommendation does not go as far as the SEC rules which are more prescriptive and include additional prohibitions concerning loans. However, the recommendation does extend the IFAC standard by applying to the immediate family of members of the audit engagement team. The term 'immediate family' is defined as 'a spouse (or equivalent) or dependent'.

Business relationships

The Ramsay report recommended that the following rule should be included in the professional ethical rules of the professional accounting bodies. The Ramsay report noted that the Corporations Act currently does not deal with business relationships between auditors and clients.

An auditor is not independent if:

  • a member of the audit engagement team has a business relationship with the client or any of its officers which is not clearly insignificant to both the member of the audit engagement team, and also the client or the officer; or
  • the audit firm has a business relationship with the client or any of its officers which is not clearly insignificant to both the audit firm and also the client or the officer.

The proposed rule would provide that 'a business relationship' does not include professional services provided by the audit firm or member of the audit engagement team.

The proposed rule has been drawn from the IFAC independence standard.

4.8.2 Stakeholder response

Investments and loans

There was broad agreement among stakeholders that the financial relationships addressed by the Ramsay report should be prohibited.

  • Different views were expressed as to whether the restrictions should be included in the Corporations Act or the ethical rules of the professional accounting bodies. Those favouring inclusion in the ethical rules articulated their concerns by reference to the fact that the ethical rules would overlap with and extend beyond the Corporations Act provisions.
  • One stakeholder, while supporting the thrust of the proposals, was critical of the fact that the prohibition on investments in audit clients did not contain a similar monetary ceiling to that contained in the prohibition on loans to and from audit clients. However, the IFAC standard draws a distinction between investments and loans and considers that the type of investments covered in the restrictions create such a significant self-interest threat that no safeguard could reduce the threat to acceptable levels.

Business relationships

There was strong stakeholder support for the recommendations. Two qualifying comments are noted:

  • two stakeholders considered that the business relationship restrictions should be included in the Corporations Act rather than the ethical rules of the professional bodies; and
  • one stakeholder was critical of the fact that the prohibition contained a subjective test as to whether a particular business relationship was 'clearly not insignificant'.

4.8.3 Proposal

The Government agrees with the Ramsay report recommendations on investments and loans, including the continued location of these provisions in the Corporations Act (except that the Government does not favour an increase from $5,000 to $10,000 in the amount an audit partner can owe the audit client). These are core circumstances indicating lack of independence. Placing these provisions in the Corporations Act rather than the ethical rules reflects the public interest in auditor independence. The ethical rules serve their purpose in providing auditors with additional guidance in relation to the threats to independence that can arise from inappr
opriate financial relationships. There would also be benefits in terms of enforcement in having these provisions in the Corporations Act.

Proposal 5 - Financial relationships

The Government will amend the law to impose new restrictions on financial relationships. This will cover investments in audit clients and loans between an audit client, and the auditor or his immediate family.

 

The Government supports the Ramsay report position that the new rules in relation to business relationships should be dealt with in the professional ethical rules of the professional accounting bodies.

This approach will enable threats to independence from business relationships to be dealt with on a conceptual basis under the ethical rules. At the same time, the relationship would still need to be assessed objectively in accordance with the general standard set out in the statement on auditor independence in the Corporations Act.

4.9 Provision of non-audit services

4.9.1 The Ramsay proposal

Background

The Ramsay report defined the expression 'non-audit services', for the purposes of the report, to cover all services not coming within the scope of the audit contract that an audit firm provides to an audit client.

The methodology adopted in the Ramsay report was to examine each of the following issues before drawing together a package of proposals to deal with independence concerns arising from the provision of non-audit services to audit clients:

  • the Australian and overseas positions in relation to the regulation of the threats to independence arising from the provision of non-audit services to audit clients;
  • the issues underlying the debate whether audit firms should be prohibited from providing non-audit services to their audit clients; and
  • the options that could be adopted in Australia in order to establish the most appropriate regulatory model.
Australian position

The Corporations Act is silent on the issue of an audit firm providing non-audit services to its audit clients. The Australian accounting standard AASB 1034 Financial Report Presentation and Disclosures does, however, require disclosure of amounts paid or payable to the auditor for 'audit services' and to the auditor and any related entity for 'non-audit services.'

Since the release of the Ramsay report, there has been a significant development in relation to the Australian professional requirements about firms providing non-audit services to their audit clients. In May 2002, the ICAA and CPAA adopted a new standard for professional independence which is fundamentally based on the IFAC standard. While the new standard will only become mandatory after 31 December 2003, the two professional bodies have encouraged their members to apply the standard earlier.

The new Australian standard has adopted all the IFAC requirements in relation to the provision of non-audit services. The IFAC standard (which is now also the Australian position) has adopted a conceptual framework which establishes principles that the firm and the assurance team should use to: identify threats to independence; evaluate the significance of those threats; and identify and apply safeguards to eliminate the threats or reduce them to an acceptable level.

Overseas position
International Federation of Accountants

The IFAC standard identifies nine categories of non-audit services as having the potential to pose a threat to an auditor's independence. These are: preparing accounting records and financial statements; valuation services; internal audit services; IT systems services; temporary staff assignments; acting for or assisting an assurance client in the resolution of a dispute or litigation; legal services; recruiting senior management for an assurance client; and corporate finance and similar activities.

As the IFAC independence standard is the basis of the new Australian standard, it is instructive to consider the following table produced in the Ramsay report which sets out the nature of the threats to independence that may be caused by each of these services and the measures that should be adopted to safeguard independence.

Non-audit services identified by IFAC as posing a threat to independence

Non-audit service

Possible threats to independence

Measures to protect independence

Preparing accounting records and financial statements

A self-review threat may be created where a firm assists an audit client in matters such as preparing accounting records or financial statements and the statements are subsequently audited by the firm.

Services should not be provided to listed audit clients except in emergency situations.

Valuation services

A self-review threat may be created when a firm performs a valuation service that directly affects the subject matter of the assurance engagement.

Services should not be provided where they involve the valuation of matters that are material to the subject matter of the assurance engagement.

Internal audit services

A self-review threat may be created when a firm provides internal audit services to an audit client (see note a).

The audit client should be responsible for establishing, maintaining and monitoring the system of internal controls. An employee of the client should be responsible for internal audit activities, with the client approving the scope, risk and frequency of the internal audit work and which recommendations of the firm should be implemented.

IT systems services

A self-review threat may be created when a firm is involved in the design and implementation of financial information technology systems that are used to generate information forming part of a client's financial statements.

The audit client must be responsible for establishing and monitoring a system of internal controls. The client or one of its employees should have responsibility for all management decisions concerning the design and implementation of the system, for evaluating the adequacy and results of the design and implementation, and for the operation of the system and the data used or generated by it.

Temporary staff assignments

A self-review threat may be created when a firm lends staff to an audit client, especially when the individual is in a position to influence the preparation of the client's accounts or financial statements.

Assistance may be given provided the client is responsible for directing and supervising the activities of the firm's staff and the firm's staff will not be required to make management decisions, approve or sign agreements or similar documents, or exercise discretionary authority to commit the client.

Non-audit services identified by IFAC as posing a threat to independence (continued)

Non-audit service

Possible threats to independence

Measures to protect independence

Acting for or assisting an assurance client in the resolution of a dispute or litigation

An advocacy threat may be created when a firm acts for an audit client in the resolution of a dispute or litigation while a self-review threat may be created when the assignment includes the estimation of the possible outcome.

Except where the amounts involved are immaterial or the threat is insignificant, a firm should not provide such services to an audit client.

Legal services

Self-review and advocacy threats may be created by the provision of legal services to an audit client.

Whether the service should be provided will depend on a range of factors, including the nature of the service and whether there would be a material impact on the financial statements.

Recruiting senior management for an assurance client

Self-interest, familiarity and intimidation threats may be created by the recruitment of senior management for an audit client.

While the firm might advertise for and interview prospective staff and produce a list of potential candidates, the decision about who should be hired is one for the client to make.

Corporate finance and similar activities

Advocacy and self review threats may be created by the provision of corporate finance services, advice or assistance to an audit client.

In the case of some corporate finance services (eg promoting, dealing in, or underwriting an audit client's shares), the threat to independence is so great that no adequate safeguards are available. In other cases, adequate safeguards may be available.

(a) Under the IFAC proposals, internal audit services do not include operational internal services unrelated to the internal accounting controls, financial systems or financial statements.

Europe

The Ramsay report noted that the European Commission's existing requirements on audit independence did not specifically refer to the provision of non-audit services. Similarly, the UK Companies Act does not contain provisions dealing expressly with the provision of non-audit services.

The European Commission had, however, published a consultative paper in December 2000, Consultative Paper on Statutory Auditor's Independence in the EU: A Set of Fundamental Principles, which proposed that Member States significantly strengthen independence requirements concerning the provision of non-audit services.

After the release of the Ramsay report, the European Commission published a Recommendation on auditor independence in May 2002. The Recommendation adopts a principles based framework in relation to non-audit services, identifying safeguards to either eliminate or reduce threats to independence to acceptable levels.

United States of America

Paragraph c(4) of Part 210.2-01 of the SEC's rules provides that an accountant is not independent if, at any time during the audit and professional engagement period, the accountant provides services in nine specified areas. The SEC rules define the scope of the restrictions for each service and the extent of any permitted exceptions.

The SEC rules define the scope of the restrictions for each service and the extent of any permitted exceptions.

The Sarbanes-Oxley Act now prohibits the following eight specific categories of non-audit services being provided by an auditor to the audit client: internal audit; actuarial services; bookkeeping; financial information system design; valuation services; management functions (including human resources); investment advice; and legal services. The Act also prohibits any other service that the PCAOB determines, by regulation, is impermissible. The PCAOB may grant exemptions, on a case by case basis, from the list of prohibited services 'to the extent that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors'. Any exemption granted is subject to review by the SEC.

Common objectives of overseas requirements

The Ramsay report notes that the IFAC standard, the SEC Rules (since overtaken by the provisions of the Sarbanes-Oxley Act) and the European Commission proposals seek to safeguard independence by ensuring that auditors are independent in fact and appearance. The rules and proposals seek to achieve this by ensuring the auditor does not:

  • have a mutual or conflicting interest with the audit client;
  • audit his or her own work;
  • function as management of the audit client; or
  • act as an advocate for the audit client.
The debate whether non-audit services should be prohibited

The Ramsay report discusses the arguments supporting and opposing the provision of non-audit services in the context of the significant growth in these services over the past decade. The report cites statistics which show that for SEC audit clients in the United States, the ratio of accounting and auditing revenues to consulting revenues dropped from approximately 6 to 1 in 1990 to 1.5 to 1 in 1999.

In January 2002, ASIC announced the findings of a survey it had conducted on auditor independence with the Group of 100 Australian companies. The ASIC survey found that:

  • The provision of non-audit services by audit firms to their Australian clients is widespread, at least in respect of major corporates. Almost all respondents to the survey confirmed having retained their audit firms to provide other services, particularly taxation advice.
  • Audit firms are earning substantial fees for non-audit services. On average the non-audit fees accounted for nearly 50 per cent of total fees paid.
  • Processes for dealing with potential conflicts of interest require attention. ASIC concluded that most companies appeared to lack rigour in processes to manage conflicts.

Subsequent submissions have identified concerns about the imposition of blanket prohibitions on non-audit services. These include unintended consequences such as:

  • Increased audit costs - as costs cannot be spread across business lines;
  • Severe difficulty for major listed clients seeking competitive non-audit services, particularly in Australia with its high level of concentration in audit and non-audit services;
  • The possibility of audit staff switching from firm to firm as audit contracts are changed, ensuring the same auditors remain at the same clients;
  • The development of separate incorporated entities for non-audit services, with no real separation in substance;
  • The inclusion of some non-audit services in audit engagement contracts;
  • The dominance of form over substance on independence issues.

The following is a summary of the arguments presented in the Ramsay report opposing and supporting the provision of non-audit services.

Arguments opposing the provision of non-audit services by auditors to their clients
  • When an audit firm provides non-audit services to a client it is serving two different sets of clients: management in the case of non-audit services; and the audit committee, the shareholders and all those who rely on the audited financial statements in the case of the audit. In serving these different clients the audit firm is subject to conflicts of interest.
  • A rule prohibiting audit firms from providing non-audit services to their clients would be relat
    ively easy to administer and would not preclude an audit firm from providing non-audit services, as long as those services are not provided to audit clients.
  • Systems of compensation within audit firms may not give adequate weight to performing the audit function and may in fact adversely impact audit effectiveness. Success in marketing an audit firm's consulting services is often a significant factor in firms' compensation systems. The skills that make one successful in marketing non-audit services to management are not generally consistent with the professional demands on an auditor to be persistently sceptical, cautious and questioning in regard to management's financial representations, thereby creating a tension counter-productive to audit excellence.
Arguments supporting the provision of non-audit services by auditors to their clients
  • There is no solid evidence of any specific link between audit failures and the provision of non-audit services, and non-audit services have been provided by audit firms to their clients for many years. A ban should not be imposed in the absence of compelling evidence of a problem.
  • Many non-audit services are both in the public interest and beneficial to audit effectiveness. For example, 'a company may seek the assistance of its auditors to correct control weaknesses identified during the audit. The public interest is served by the controls (and the company's financial reporting process) having been strengthened through the auditors' knowledge of the company and its operations, and audit effectiveness is enhanced through the auditors' increased understanding of the company's systems'.
  • Companies that most need to improve their controls may decide not to do so because of the potential added costs and efforts of identifying and using firms other than their auditors.
  • It is not correct to assert that an audit firm has divided loyalties when it provides non-audit services to a client because it serves different clients (ie, management in the case of non-audit services and shareholders, the audit committee and those who rely on audited financial statements in the case of audits). To make this argument is to assert that the interests of management must necessarily be inimical to good financial reporting.
  • Audit firms increasingly need specialists such as information technology specialists to provide critical audit support. Attracting and retaining these specialists, and motivating them to provide direct audit support, may be hampered if they were to be prohibited from providing non-audit services to clients. These specialists generally are not accountants and their primary professional interest is not auditing. Yet they maintain and build their skills by providing non-audit services. Therefore, an unintended consequence of a prohibition on auditors providing non-audit services to their clients could be to reduce audit effectiveness.
Regulatory model options

The Ramsay report considered whether non-audit services should be dealt with exclusively in either the Corporations Act or the ethical rules or whether a co-regulatory model might be appropriate.

The report concluded that the arguments favoured retaining the professional ethical rules, updated to reflect the IFAC standard, as the basic guidance on maintaining audit independence when providing non-audit services to audit clients:

  • Exclusive reliance on the Corporations Act was considered inappropriate given the lack of precedent for this in Australia and elsewhere. More fundamentally, the Ramsay report concluded that this would not be necessary given that the review had not uncovered any evidence to suggest that there are systemic failures within the accounting profession in complying with the ethical rules for providing non-audit services to clients;
  • Furthermore, the Ramsay report also concluded that the Corporations Act was an inappropriate vehicle through which to deal with non-audit services because the rapid changes in this area made it impossible to draft a list of all circumstances which could arise to threaten the independence of an auditor; and
  • The Ramsay report did not consider that it would be appropriate to adopt the list of nine non-audit services identified in the SEC's rules because a number of the SEC's restrictions arose from intense debate and discussion and therefore represented compromises which, to an external observer, may lack principle. The Ramsay report concluded that it was inappropriate to rely on the types of political compromises it identified, typically reflecting circumstances in the United States, as precedents for Australia.

The Ramsay report recommendations

The Ramsay report recommended that the provision of non-audit services by audit firms to their clients be dealt with by the following package of proposals:

  • by revised and updated professional ethical rules which should reflect the IFAC independence standard;
    • the Australian professional accounting bodies adopted the IFAC professional independence standard in May 2002;
    • the categories of non-audit services identified in the IFAC standard as posing a potential threat to an auditor's independence and the measures that should be put in place to safeguard independence are explained above in section 4.9.1;
  • by mandatory disclosure of non-audit services and the fees paid for these services;
    • the Ramsay report recommended that the disclosure of non-audit services should be implemented by the following provisions which would form part of the Accounting Standards, or if they are not amended should form part of Chapter 2M (Financial Reports and Audit) of the Corporations Act:
      • the financial report for the year must disclose the dollar amount of all non-audit services provided by the audit firm to the client, divided by category of service, with appropriate discussion of those services;
      • the financial report for the year must disclose whether the audit committee of the board of directors, or if there is no such committee then the board of directors, has considered whether the provision of non-audit services is compatible with maintaining the auditor's independence.
  • by strengthening the role of audit committees (this topic is discussed in section 4.10); and
  • by establishing an AISB which would have, among its functions, the task of monitoring the adequacy of disclosure of non-audit services.

4.9.2 Stakeholder response

There is strong support from private sector stakeholders in relation to the overall package of measures proposed in the Ramsay report with the exception of the proposal to establish the AISB.

  • While there was considerable support for the need to improve the existing institutional arrangements in relation to auditor oversight, reservations were expressed about the desirability of establishing a new body.

The support was drawn from the professional accounting bodies, individual accounting firms, other professional representative bodies and from the corporate sector who are the main clients for non-audit services. The private sector view has been succinctly encapsulated in the comments received from the Group of 100 (of Australian companies):

  • 'We are concerned that the provision of non-audit services contributes to a perception that audit independence may be impaired. However, we are unsure that there is reliable evidence to suggest that the provision of non-audit services actually leads to the impairment of independence and a lack of objectivity in the external audit process'.
  • 'We believe companies should implement robust processes relating to the acquisition of non-audit and consulting services from their external audit firm. A total exclusion of non-audit services is inappropriate as often the external audit firm has the best experience or knowledge to perform certain tasks eg. audit services for due dil
    igence or acquisition. Certain activities may be excluded from a business practice perspective eg. internal audit and information systems services. In this regard a number of companies have indicated that they will discontinue these types of practices.'

Submissions have also suggested that it is not the presence of non-audit services themselves that is the threat to independence - it is the possibility of local offices being overly dependent on the fees they generate. Suggested solutions have included the disclosure of the percentage of local office revenues gained from a single client.

The Government recognises that publicly stating fee dependence levels may have detrimental effects on small and growing audit firms. This in turn would undermine the Government's policy of encouraging competition in the audit market. For this reason the Government believes fee dependence issues would be best dealt with under the independence oversight powers of the FRC.

4.9.3 Proposals

Proposal 6 - Application of Professional Statement F1

The Government supports the immediate application of Professional Statement F1 on Professional Independence, which forms part of the Joint Code of Professional Conduct of the ICAA and CPAA.

  • Statement F1 is based on the independence standard adopted by the International Federation of Accountants. It requires auditors to identify and evaluate threats to independence and apply safeguards to reduce any threats to an acceptable level.
  • Where the provision of non-audit services to an audit client poses a threat that cannot be reduced to an acceptable level, statement F1 prohibits the provision of that service.

 

Proposal 7 - Non-audit services

The Government will implement a series of measures to deal with non-audit services. It will:

  • amend the law to require mandatory disclosure in the annual report of fees paid for the categories of non-audit services provided;
  • amend the law to require a statement in the annual report of whether the audit committee is satisfied that the provision of non-audit services is compatible with auditor independence. This disclosure would include an explanation as to why the following non-audit services referred to in Professional Statement F1, if contracted, do not compromise audit independence:
    • preparing accounting records and financial statements of the audit client;
    • valuation services;
    • internal audit services;
    • IT systems services;
    • temporary staff assignments;
    • litigation support services;
    • legal services;
    • recruitment of senior management for the audit client; and
    • corporate finance and similar activities.

 

Rejection of blanket prohibition

The Government does not agree with the view that a blanket prohibition should be imposed on all non-audit services to audit clients. The Government agrees with the force of the argument in the Ramsay report that this would place Australia out of step with the position in every other developed capital market. Even the harder legislative stance that has been adopted in the new corporate governance legislation in the United States does not contemplate the imposition of a blanket prohibition in relation to all non-audit services. The UK Co-ordinating Group on Audit and Accounting Issues has stated in its Interim Report of July 2002 that it does not favour a blanket ban on the provision of non-audit services.

Principles based professional ethical rules

The Government agrees with the Ramsay report recommendation that the regulation of non-audit services provided by audit firms to their clients should be dealt with by the professional ethical rules of the Australian professional accounting bodies which were updated in May 2002 to reflect the IFAC independence standard.

The Government considers that the conceptual, principles based approach of the IFAC independence standard will achieve the most effective regulatory outcome. It is noted that under the IFAC standard a number of non-audit services are in fact prohibited because the identified threats to independence cannot be reduced by adequate safeguards to acceptable levels.

The European Commission's Recommendation has also concluded that the principles based approach has clear advantages over the prescriptive, rules based approach adopted in the United States:

  • 'A principles based approach to statutory auditors' independence is preferable to one based on detailed rules because it creates a robust structure within which statutory auditors have to justify their actions. It also provides the audit profession and its regulators with the flexibility to react promptly and effectively to new developments in business and in the audit environment. At the same time, it avoids the highly legalistic and rigid approach to what is and is not permitted which can arise in a rules based regime. A principles based approach can cater for the almost infinite variations in individual circumstances that arise in practice and in the different legal environments throughout the European Union. Consequently, a principles based approach will better serve the needs of European capital markets, as well as those of SMEs [Small and Medium Enterprises].'

The co-regulatory framework in relation to auditor independence under the CLERP 9 proposals is designed to achieve an effective enforcement regime in relation to non-audit services.

  • The professional accounting bodies will be expected to closely monitor compliance with their professional independence standards by their members and to take effective disciplinary action against members who fail to meet the requirements in the ethical rules which will include suspension or cancellation of membership. The FRC will be required to monitor the effectiveness of the accounting bodies' enforcement of their professional rules.
  • Section 1292 of the Companies Act will be amended to ensure that ASIC will be able make an application to the CALDB for the cancellation or suspension of registration of a registered company auditor who fails to comply with the general standard on independence which is to be included in the Corporations Act.
Audit committees

The Government agrees with the Ramsay report that effective audit committees can perform a very important role in ensuring that the auditor is independent of the company. It will be mandatory for the top 500 listed companies (that is, those that compose the All Ordinaries Index), to have audit committees. The Government's detailed proposals in relation to audit committees are addressed below in section 4.10.

Institutional arrangements for oversight of auditor independence

The Government agrees with the Ramsay report that an independent supervisory body is an essential instrument in addressing the challenge of implementing new auditor independence requirements in Australia.

The Government proposes that this role will be carried out by the FRC. The details of the FRC's oversight responsibilities are discussed in Part 2.

The FRC constitutes a key element of the overall regulatory framework that the Government proposes to introduce in order to deal with auditor independence in relation to the provision of non-audit services to audit clients.

Oversight of fee dependence

The Government agrees with stakeholder views that monitoring audit firm fee dependence has merit. The Government proposes that FRC should monitor fee dependence for all audit firms auditing listed companies.

4.10 Audit committees

4.10.1 The Ramsay proposal

Background

The Ramsay report
formed a strong conclusion that a 'well structured and well functioning' audit committee can play a very important role in ensuring that the auditor is independent of the company.

The role of the audit committee extends beyond the area of audit independence. The Audit Committees: Best Practice Guide (published by the Australian Accounting Research Foundation, the Australian Institute of Company Directors (AICD) and the Institute of Internal Auditors - Australia) states that 'the audit committee can play a key role in assisting the board of directors to fulfil its corporate governance and overseeing responsibilities in relation to an entity's financial reporting, internal control structure, risk management systems, and the internal and external audit functions'. One of the main objectives of an effective audit committee is to facilitate the maintenance of the independence of the external auditor.

The Ramsay report based its recommendations in relation to audit committees on an analysis it undertook of the requirements in Australia and overseas, as well as drawing on principles developed from international reports, best practice guides and standards. The accounting and corporate scandals which have occurred in the United States subsequent to the release of the Ramsay report, have provided a sharp focus on the key role that audit committees can play in relation to the independence of the external auditor and broader corporate governance issues. The Co-ordinating Group on Audit and Accounting Issues, in its Interim Report dated July 2002 to the UK Secretary of State for Trade and Industry, notes that 'a thread running through many of the commentaries post-Enron' is the strengthening of the membership and role of audit committees.

Australian position

The current Australian position can be summarised as follows:

  • The Corporations Act does not require Australian companies to establish audit committees.
  • The listing rules of the ASX also lack a mandatory requirement for companies listed on the Exchange to establish an audit committee. Rule 4.10.2 of the ASX's listing rules does, however, require a company to include in its annual report information whether the entity had an audit committee at the date of the directors' report and, if it did not, it must explain why.
  • In addition, rule 4.10.3 of the ASX's listing rules provides that the annual report is to contain a statement of the main corporate governance practices that the entity had in place during the reporting period. Among the matters that must be addressed is one requiring an outline of the procedures the entity had in place for the nomination of external auditors, and for reviewing the adequacy of existing external audit arrangements. Where these procedures involve an audit committee, directors are required to set out or summarise the committee's main responsibilities and rights and the names of committee members; and
    • the Ramsay report notes that, for those companies that have established an audit committee, guidance on the operation of the committee is provided in Audit Committees: Best Practice Guide.
United Kingdom

The Ramsay report notes the following:

  • There are no requirements in the UK Companies Act which require companies to establish an audit committee.
  • In relation to companies listed on the London Stock Exchange, the Listing Rules require listed companies incorporated in the UK to include in their annual reports a statement whether they have complied with the Principles of Good Governance and Code of Best Practice (the Combined Code) and to give reasons for any non-compliance. The Combined Code states that the board should establish an audit committee of at least three non-executive directors, the majority of whom should be independent.

On 27 February 2002, the Secretary of State for Trade and Industry established the Co-ordinating Group on Audit and Accounting Issues, (the Co-ordinating Group) following the collapse of Enron and other companies which had raised concerns over financial reporting and the role of auditors. The UK Government perceived a need to be clear that the regulatory regime in the UK, for financial reporting and audit, continues to be effective and provides appropriate underpinning for strong and efficient national and international capital markets.

The Co-ordinating Group provided an Interim Report to the Secretary of State in July 2002. The general tenor of the relevant part of the report is that the role of audit committees should be strengthened. In that context, the Co-ordinating Group states that 'in particular, the audit committee can act as a proxy for shareholders (who in theory appoint the auditors) and judge the threats to auditor independence and review quality'.

The Co-ordinating Group also considered the case for giving some form of statutory backing for audit committees, at least for some large companies. While the Co-ordinating Group cautioned that introducing the law into this aspect of corporate governance requires very careful thought in the UK, it nevertheless formally proposed in its Interim Report that 'the Government considers underpinning the role and responsibilities of audit committees in company law.'

European Commission

There is no legal requirement at present in any country within the EU for companies to have audit committees. One of the proposed post Enron policy actions of the European Commission is to examine the role of audit committees in European listed companies. The Irish Republic will be introducing legislative reforms that will require Boards of Directors to establish audit committees, each with a charter setting out a clear set of responsibilities.

United States

At the time when the Ramsay review was being undertaken, the principal requirements in relation to audit committees were contained in the listing rules of the New York Stock Exchange (NYSE). The Ramsay report notes that under the NYSE's rules, each company listed on the exchange must have a qualified audit committee. The requirements for a qualified audit committee include:

  • having a formal written charter that has been adopted and approved by the board of directors; and
  • having at least three independent directors, each of whom is financially literate and at least one of whom has accounting or financial management expertise.

The rules also place a number of restrictions on audit committee membership for the purpose of ensuring each member's independence.

Since the release of the Ramsay report, there have been a number of significant developments affecting the role of the audit committee in the post Enron environment:

  • President Bush's 10 Point Plan included measures to strengthen the role of audit committees:
    • SEC to establish guidelines for audit committees to prohibit the external auditor from providing other services to the audit client if audit independence would be compromised.
    • Audit committees would directly report their recommended choice of auditor to shareholders.
    • The SEC is developing proposals that would require all SEC registrants to have independent audit committees with sole responsibility for hiring, firing and retaining external auditors, and sole responsibility for approving non-audit services provided by the auditor.
  • The Sarbanes-Oxley Act which President Bush signed into law on 30 July 2002:
    • Vests the audit committee of an issuer of securities registered with the SEC with responsibility for the appointment, compensation and oversight of any registered public accounting firm employed to perform audit services.
    • Requires audit committee members to be a member of the board of directors of the issuer, and to be otherwise independent.
  • The NYSE Corporate Accountability and Listing Standards Committee submitted proposals for reform in June 2002 which, if implemented, would increase the authority and
    responsibilities of the audit committee, including granting it the sole authority to hire and fire independent auditors and to approve any significant non-audit relationship with the independent auditors.
Canada

The Ramsay report noted that Canada has a mandatory requirement for companies to establish audit committees under the Canada Business Corporations Act where securities have been issued to the public.

Effectiveness of audit committees

The Ramsay review undertook extensive analysis and research on the effectiveness of audit committees. The review concluded that having an audit committee per se is not enough; it is essential that the audit committee have the necessary attributes to render it an effective corporate governance mechanism. The Ramsay report drew the following conclusions:

  • An effective audit committee must not only exist and be independent, but must also be active.
  • There is a relationship between audit committee composition and effectiveness. In this context, it is important that audit committee members are independent in the sense that they have no relationship with the company that may interfere with the exercise of independent judgment.
  • Each member of the audit committee should be financially literate, or made financially literate within a reasonable time of appointment - this includes the ability to read and understand fundamental financial statements including a balance sheet, a profit and loss statement and a cash flow statement.

The Ramsay report recommendations

The Ramsay report recommended that qualified audit committees should be mandated for listed companies:

  • The ASX Listing Rules be amended to require all listed companies to have an audit committee. The new Listing Rule would be accompanied by an ASX Guidance Note. The Listing Rule and associated Guidance Note should govern the structure of this committee, and should reflect international best practice in audit committees as outlined in Appendix D to the report (the international best practice principles).
  • The Listing Rule should:
    • mandate the existence of a qualified audit committee;
    • specify the composition of the audit committee as contained in the international best practice principles; and
    • require the board of directors to adopt a written charter to govern the audit committee.
  • The Guidance Note should:
    • specify the general requirements, and duties and responsibilities, of a qualified audit committee as contained in the international best practice principles and
    • contain such other matters as are considered appropriate by ASX.

The Ramsay report also recommended that if the ASX does not amend its listing rules, the Corporations Act should be amended to reflect the recommendations regarding audit committees.

4.10.2 Stakeholder response

Overall, there was strong support for the Ramsay recommendations. However, the following two key stakeholder views are noted:

  • The ASX has decided to introduce a Listing Rule that will mandate audit committees for at least the top 500 listed companies (that is, those that compose the All Ordinaries Index), in accordance with a strong recommendation of the ASX Corporate Governance Council.
  • The AICD supports mandating audit committees for listed companies but considers that the international best practice principles contained in Appendix D to the Ramsay report should be contained in industry codes rather than the listing rules.

4.10.3 Proposal

The Government considers that, following international developments in response to the Enron collapse and general corporate governance concerns about the quality of financial reporting and the independence of the external auditor, strengthening the role of audit committees, particularly in relation to listed companies, is now recognised as a widely accepted principle of world's best practice corporate governance.

Proposal 8 -  Audit committees

It will be mandatory for the top 500 listed companies (that is those that compose the All Ordinaries Index), to have audit committees. The ASX has announced it will amend its rules to achieve this.

  • The Government supports the role of the ASX Corporate Governance Council in developing best practice standards for audit committees.

 

The best practice standards to be developed by the ASX Corporate Governance Council should include the following key issues:

  • Audit committees should have a formal written charter adopted and approved by the board of directors. The charter should stipulate matters including:
    • the structure of the audit committee;
    • the requirements for membership of the audit committee;
    • the nature and scope of the audit committee's duties; and
    • the processes to be used by the audit committee in discharging its duties.
  • The composition of audit committees should be addressed to ensure that the members are independent.
  • Members of audit committees should be financially literate and at least one member should have accounting or related financial expertise.
  • Audit committees should have a regular schedule of meetings with a system of reporting to the Board of Directors.
  • The broad duties and responsibilities of an audit committee should include the following:
    • The audit committee should review and assess the external reporting of the company.
    • The audit committee should review and monitor related party transactions and assess their propriety.
    • The audit committee should review and assess internal processes for determining, monitoring and assessing key risk areas.
    • The audit committee should review and assess key areas relating to the external audit of the company. In particular the audit committee should:
      • make recommendations to the board on the appointment, reappointment or replacement, remuneration, monitoring of the effectiveness , and independence of the external auditor;
      • review and assess non-audit service provision by the external auditor, with particular consideration given to the potential for the provision of these services to impair or appear to impair the external auditor's judgment or independence in respect of the company.
  • The audit committee should review and assess key areas relating to the internal audit of the company.

The Government notes that a significant proportion of companies listed on the ASX already have audit committees. The Government recognises that audit committees do involve higher costs for companies, particularly smaller companies. Where the appointment of an audit committee cannot be justified for a smaller company, as a matter of good governance, the directors of those companies should undertake the key functions of an audit committee.

4.11 Appointment and removal of auditors

4.11.1 The Ramsay proposal

Background

The Audit Review Working Party's report addressed a range of issues associated with the appointment, tenure, removal and resignation of company auditors. The Ramsay report considered that these issues and the Working Party's conclusions remained relevant.

Appointment

The options identified by the Working Party for appointing auditors include:

  • retaining the existing requirements with or without the provision of a period of fixed tenure for the appointment;
  • restricting voting at annual general meetings (AGMs) on resolutions to appoint auditors to those shareholders:
    • who are not directors; or
    • who have not exercised a right (whether written or otherwise), based on the size of their share holdings, to have a nominee app
      ointed to the board of directors;
  • having the auditor appointed according to existing requirements but on the recommendation of an audit committee or a committee of non-executive directors; and
  • having the auditor appointed by a completely independent body such as ASIC, the Court or an independently established tribunal.

The Ramsay report noted that Australia's regulations relating to audit appointment are broadly in line with those of other developed countries.

The Working Party considered that auditors of listed companies should be appointed on a recommendation of the audit committee or, where there is no audit committee, on a recommendation of an appropriate committee of non-executive directors. In the case of unlisted companies, the Working Party recommended that the auditor should be appointed on the recommendation of the audit committee where such a committee exists.

To facilitate the implementation of this proposal, the Working Party considered that either the ASX listing rules or the Corporations legislation should be amended to make it mandatory for listed companies to have an audit committee.

The Working Party was also of the view that changes to the auditors of a disclosing entity should be made a continuous disclosure matter.

Tenure

The Ramsay report noted that there are divergent views on whether company auditors should be appointed until 'death or removal or resignation' as provided for in section 327 of the Corporations Act, or for some fixed period.

Options available in respect of the tenure of auditors include:

  • retaining the existing requirements;
  • retaining existing requirements but with a fixed minimum term of appointment;
  • termination of the audit appointment after a specific period of time, with or without the opportunity to reappoint the existing auditor;
  • requiring, where the auditor is a firm, the rotation of the responsible partner after a specified period of time;
  • placing, in the case of a sole practitioner or a firm, a restriction on the period for which the sole practitioner or firm may hold office; and
  • requiring the appointment of a second or review partner within the auditor's firm or, in the case of a sole practitioner, from another firm.

Following consideration of these options, the Working Party concluded that there should be mandatory rotation of audit partners in accordance with the principles laid down in AUP 32 for all listed companies.

The Ramsay report endorsed the principle that there be mandatory rotation of audit partners. However, Ramsay considered that AUP 32 is not adequate in this respect. AUP 32 only requires 'the periodic rotation of audit staff between audit engagements'. Some firms may interpret this as only requiring rotation after many years. The Ramsay review was advised that under rules in the United States and the United Kingdom, audit partners are required to rotate after a period of 7 years. The Ramsay report considered that this is an appropriate precedent and therefore recommended that there be mandatory rotation of the audit partners responsible for the audit of listed companies and that the rotation is to occur after a maximum of 7 years.

An issue considered by the Audit Review Working Party, and an issue which also arose for consideration as part of the Ramsay review, was whether or not it is appropriate to mandate rotation of the audit firm, as an alternative to rotating the audit partner. The Audit Review Working Party noted in its Report (paragraph 7.26) that only in Spain and Italy is there a requirement to rotate the audit firm after a specified period of time (9 years). The Ramsay review investigated this issue and was advised that Spain has now withdrawn the requirement to rotate audit firms and that the requirement is therefore limited to Italy.

The Ramsay report did not believe it appropriate to mandate rotation of audit firms. The Audit Review Working Party, in also reaching this conclusion, stated that 'the anticipated cost, disruption and loss of experience to companies is considered unacceptably high, as is the unwarranted restriction on the freedom of companies to choose their own auditors' (paragraph 7.27).

Resignation and removal

The Working Party received submissions suggesting that consideration be given to circumstances when it may be appropriate for a change of auditors to take place other than at an AGM or without the requirement to obtain ASIC approval. The Ramsay report noted that the Working Party was concerned at the potential in these circumstances for the independence of the auditor to be compromised.

The Working Party considered that any proposal to remove the auditor from office should be the subject of a continuous disclosure notice to be filed with ASX, on the basis that it is 'material' information. The notice should also indicate reasons. Similarly any resignation by an auditor should be the subject of a continuous disclosure notice which contains a statement of the auditor's reasons for resigning.

Any appointment of a new auditor of a public company or disclosing entity must, at present, be approved by shareholders at the next AGM. The Working Party concluded that existing requirements established by the ASIC restricting voting on the change of auditor upon resignation largely to the AGM and to dates not near the financial year end should be retained. There should also be a requirement that any proposal for appointment of auditors should contain information on proposed fees.

The Ramsay report recommendations

The Ramsay report recommended that the following Audit Review Working Party recommendations (as amended by the Ramsay review) should be implemented:

  • The auditor of a listed company should be appointed and their remuneration determined on the recommendation of the company's audit committee. (Recommendation 7.2)
  • The auditor of a company which is not listed should be appointed and their remuneration determined on the recommendation of the company's audit committee where such a committee exists. (Recommendation 7.3)
  • There should be mandatory rotation of the audit partners responsible for the audit of listed companies. (Recommendation 7.7) The rotation is to occur after a maximum of 7 years but may occur sooner if considered appropriate by those involved in the audit. There is to be a period of at least 2 years before the partner can again be involved in the audit of the client.
  • The Corporations Act or the ASX Listing Rules (or the ASX Guidance Note relating to continuous disclosure) should be amended to provide that a proposed change to the auditor of a disclosing entity is a continuous disclosure matter. (Recommendation 7.14)
  • The Corporations Act should provide that any proposal for appointment of auditors of a disclosing entity must contain information on the proposed fees. (Recommendation 7.15)

4.11.2 Stakeholder response

There is broad support among stakeholders for the Ramsay recommendations.

4.11.3 Proposal

The Government notes that MINCO endorsed the recommendations of the Audit Review Working Party and noted that draft provisions to give effect to the broad thrust of the Working Party's recommendations would be prepared.

Proposal 9 - Appointment and removal of auditors

The Government will make audit partner rotation compulsory after five years.

  • The new requirement will apply to the lead engagement partner and the review partner. To maintain continuity of knowledge, the appointment of these partners could be staggered.

 

The Government supports the implementation of the other recommendations of the Audit Review Working Party and the Ramsay report in relation to the appointment and removal of auditors.

4.12 Attendance of auditor at AGM

4.12.1 The Ramsay proposal

Background

Section 249K of the Corporations Act provides that a company must give its auditor:

  • notice of a general meeting in the same way that a member of the company is entitled to receive notice; and
  • any other communications relating to the general meeting that a member of the company is entitled to receive.

Section 249V further provides that a company's auditor is entitled to attend any general meeting of the company and is entitled to be heard at the meeting on any part of the business of the meeting that concerns the auditor in their capacity as auditor.

Section 250T of the Corporations Act was introduced by the Company Law Review Act 1998 and deals with questions by members of auditors at the AGM of a public company. It provides that if the company's auditor or their representative is at the AGM, the chair of the AGM must allow a reasonable opportunity for members as a whole at the meeting to ask the auditor or their representative questions relevant to the conduct of the audit and the preparation and content of the auditor's report.

The Audit Review Working Party recommended that there should be a requirement in the law for an auditor to attend the AGM at which the audit report is tabled, either in person or by way of a representative, except in exceptional circumstances (Recommendation 7.16). The Working Party stated that this recommendation would appropriately complement what was then the draft provision to require the chairperson of the AGM to allow a reasonable opportunity for members to ask questions of the auditor. The Working Party further stated that it received submissions suggesting the role of the external auditor at a company's AGM should be strengthened as this is the only forum where the auditor and the persons to whom the auditor is accountable can meet on a face to face basis. The Working Party also noted that subsection 1289(1)(a) of the Corporations Act provides that an auditor has qualified privilege in respect of any statement that he or she makes, orally or in writing, in the course of duties as auditor.

The Ramsay report saw considerable merit in the views of the Working Party concerning attendance of the auditor at the AGM. It considered that the recommendation operates to both strengthen the role of the auditor and also strengthen the accountability of the auditor to shareholders. The Ramsay review noted that section 250T which requires the chair of an AGM to allow a reasonable opportunity for members to ask questions of the auditor applies only to AGMs of public companies.

The Ramsay report recommendation

The Ramsay report recommended that the Corporations Act be amended to require an auditor, or a representative of the auditor, to attend the AGM at which the auditor's report is tabled unless reasonable circumstances preclude the auditor's attendance. The report also recommended that this requirement for auditors to attend AGMs should apply only to AGMs of listed public companies. There are many small public companies (including many public companies limited by guarantee) where attendance by the company's auditor is not usually expected or required.

4.12.2 Stakeholder response

There was general agreement with the recommendation. Some stakeholders queried whether it was necessary to make a legislative change. The AICD considered that the proposal was appropriate but the obligation should not be extended further than the existing requirement in the Corporations Act to answer relevant questions.

4.12.3 Proposal

Proposal 10 -  Attendance of auditor at AGM

The Government will amend the law to require an auditor to attend the AGM of a listed company at which the audit report is tabled and to answer reasonable questions about the audit.

  • The Government will ensure shareholders are able to submit questions by e-mail to the listed company and that the questions will be posted on the company web site.

 

4.12.4 Recommendations of the Audit Review Working Party on auditor qualifications for registration

The Audit Review Working Party recommended changes to the educational and professional requirements to qualify for registration as a company auditor.

The Working Party identified three issues concerning qualifications for registration: educational qualifications, professional requirements, and the appropriate level of experience.

In relation to educational qualifications, the Working Party recommended that all applicants be required to have completed a specialist course equivalent to the auditing module currently provided by the ICAA's Professional Year program or CPAA's CPA program.

In relation to professional requirements, it was recommended that accountants who are not members of a professional accounting body be required to give an undertaking that they will abide by the code of ethics or other rules of one of the professional bodies on the same basis as members of that body.

In relation to the level of experience, the Working Party recommended that competency standards be used for determining whether an auditor has the necessary skills to be registered as a company auditor, rather than the current time-based criteria.

It was recommended in the Ramsay report that the recommendations of the Working Party be adopted in relation to auditor competency standards. Submissions received on the Ramsay recommendations have been widely supportive of this recommendation, which the Government supports.

Some concerns were raised that it may be inappropriate for auditors to be held to the standards of professional bodies of which they are not members. As a possible solution, it has been suggested that ASIC issue a policy statement on auditor independence requirements, perhaps based on that issued by IFAC.

Given the strong support evident in submissions, it is proposed that the recommendations of the Working Party concerning qualifications for registration be implemented, as recommended in the Ramsay report.

Proposal 11 - Qualifications for registration as a company auditor

Accountants seeking registration as company auditors will be required to meet agreed competency standards, to undertake to abide by an accepted code of professional ethics, and to complete a specialist auditing course prior to registration.