ASIC Annual Forum

Why are we here, talking about the quality of audits? No one in this room today would be unfamiliar with the effects of the Global Financial Crisis over 2008-2009. Internationally, the GFC led to the failure of a number of entities, putting significant pressure on financial report preparers and auditors to signal weaknesses to the market more effectively, to help prevent future crises.

Reviewing the audit, however, is not a simple task. Audit is part of an integrated financial reporting supply chain that includes managers, directors, accountants and regulators, domestically and internationally.  A broad range of stakeholders has to be considered and the needs of often conflicting perspectives have to be balanced, and it is this input that the Australian Financial Reporting Council, or FRC, is well equipped to provide. As Chairman of the FRC, I have a strong personal interest in ensuring that these perspectives have the room to be heard.

So, today, I plan to give you a better understanding of the FRC's role in relation to audit quality. After briefly explaining what the FRC does, I will explain, in more detail, the focus for much of the FRC's attention in relation to audit quality, including:

  • improving communication through the development of a definition of audit quality;
  • considering the impact of the release of final audit proposals in Europe; and
  • describing how the FRC contributes to international processes on audit quality more broadly.

The FRC oversees the effectiveness of the financial reporting framework in Australia. It regularly considers issues related to financial reporting including audit quality and standard‑setting, with a view to developing strategic advice to the Minister on these issues.  In short, the FRC is the key external advisor to the Australian Government on the financial reporting system.

The FRC brings together key financial reporting stakeholders to ensure the existing financial reporting system works well and to provide strategic advice to the Minister on the operation of the system.

The core strength of the FRC lies in its diverse membership. Members are selected from key stakeholder groups and are a source of experience and knowledge, unparalleled in its breadth and relevance to the issues being considered here today.

Audit quality is one of the FRC's main focus areas. It is tasked, by law, to "give strategic policy advice and reports to the Minister and professional accounting bodies in relation to the quality of audits conducted by Australian auditors". As Chairman of the FRC, I receive strong support in this role from the FRC Audit Quality Committee. The Committee currently comprises representatives from the Auditing and Assurance Standards Board (AUASB), AICD, the professional accounting bodies, G100, ASIC and APRA, providing the FRC with broad expertise specific to audit quality.

In 2012, the FRC committed to developing a definition of 'audit quality' to specify the objective of audit, be consistent with audit quality measurement practice and to better facilitate conversations about these issues.

It submitted a definition to the International Auditing and Assurance Standards Board (IAASB) in May 2013 which is the basis for the definition used by ASIC in Information Sheet 196 on "Audit Quality: The role of directors and audit committees", which was issued last week. It says that:

"audit quality concerns matters that contribute to the likelihood of the auditor achieving the fundamental objective of obtaining reasonable assurance that the financial report as a whole is free of material misstatement, and that the auditor ensures any deficiencies detected are addressed or communicated through the audit report".

The definition proposed by the FRC was also considered by the IAASB in developing their Framework for Audit Quality, released in February this year. While the IAASB, based on its consultation, could not agree a definition of audit quality that could be used internationally it did state that:

"The objective of an audit of financial statements is for the auditor to form an opinion on the financial statements based on having obtained sufficient appropriate audit evidence about whether the financial statements are free from material misstatements and to report in accordance with the auditor's findings".

Note the importance of the financial report being free of "material misstatement". The IAASB Framework also recognised that essential to a quality audit are not only highly ethical and skilled auditors, but also strong interaction of stakeholders, namely the participants in the financial reporting supply chain, with those auditors.

The main international regulatory developments in audit are currently coming from Europe.

The European Union (EU) emerged from the GFC bearing the scars of significant corporate and banking failures. It subsequently committed to pursuing reforms to prevent such failures in future. Audit was singled out as part of this process due to an arguably unrealistic community expectation that auditors provide a warning to stakeholders about a company's viability.

In December 2013, the European Community (EC), the executive body of the EU, announced that a political agreement had been reached between the European Parliament and member states on proposed audit reforms, following several years of consultation and negotiation.

Some of the reforms in this political agreement included:

  • A mandatory audit firm rotation period of 10 years for public interest entities, with the possibility of extending this by up to 14 years if the firm undertakes a joint audit, or the audit is put out to tender.
  • A limit on fees chargeable for non‑audit services and tax advice of 70% of audit fees.
  • imposing a blacklist on certain types of advisory services, paralleling the restrictions placed on consulting work by auditors in the United States under the Sarbanes‑Oxley Act and
  • The coordination of auditor supervision in the EU under the Committee for European Audit Oversight.

The political agreement is subject to technical finalisation and formal approval. Plus, to become a Directive for member states to implement, it must be ratified by the council of national governments and the full European Parliament. With the elections in the European Parliament scheduled for May of this year, we anticipate that these reforms will be finalised in the first half of 2014.

I will be interested to see how the European reforms, if passed, impact on audit quality in Europe.   There are a range of views as to the effectiveness of the policies proposed as a means to improving audit quality, especially mandatory audit firm rotation. Audit quality may benefit from increased auditor independence following audit firm rotation; however audit quality may also suffer following the loss of corporate knowledge.

Such diversity in views is reflected in legislative change in the US, where the question of audit firm rotation has recently been examined. Last year, the US Congress came to the view that mandatory audit firm rotation should not be pursued at this time, passing legislation preventing the US audit regulator from imposing auditor terms limits.

In Australia, the law currently requires audit partners to rotate, and firms that undertake audits of significant entities to produce transparency reports providing information on the audit firm's governance and review processes, revenue, remuneration policy and other such key information. It also allows ASIC to publish audit deficiency reports where ASIC believes an audit firm has not taken appropriate remedial action to remedy a failure to comply with relevant auditing standards, codes of conduct, or requirements under the Corporations Act 2001, as well as communicate directly with an audited body.

These requirements are designed to promote good governance practices, including scepticism, and balance the tension between auditor independence and having the corporate knowledge to perform an effective audit. It remains a matter for Government whether the regulation of audits needs to be further reformed in light of overseas developments. At this time, such reforms also need to be considered in the context of the Government's deregulatory agenda, which requires a strong case to be made before imposing an additional regulatory burden on Australian businesses.

Other international processes are currently underway to improve audit quality.

The FRC takes its contribution to such processes very seriously. We have a strong relationship with international standard-setters and regulators, who carefully consider the input provided by the FRC when consulting internationally before revising standards and regulation with the aim of improving audit quality. I should note here that the Chairman of the AUASB is a member of the IAASB and on their audit quality committee as well as an FRC Member and on our FRC audit quality committee, which assists us in exerting positive influence at the international level.

The FRC has provided valuable input, for example, at all stages of the consultation undertaken by the IAASB, on the project to revise Auditor Reporting. As the auditor's primary means of communication, the Auditor's Report is of critical importance to stakeholders.

In September 2012 the FRC conducted a survey with Australian Shareholder Association members. When asked whether the auditor's report  provided sufficient information to them about what the auditor is required to do, 65% of those who responded to the survey said  NO.

Furthermore only 52% said they understood the concept of going concern in the auditor's report. The least understood concept was emphasis of matter at 13%. Over 75% said it would be of value to relocate the auditor's opinion to the front of the audit report.  They also said that, if the auditor's report provided additional commentary, the following 3 areas would be of most value to them:

  • Matters of audit significance, including areas of significant auditor judgement
  • Significant or unusual transactions and
  • Difficult or contentious matters noted during the audit

Finally 87% said an explicit statement as to whether any material uncertainties have been identified in relation to going concern should be included in the auditor's report.

We included this survey with our submission to the IAASB in October 2012.

In the course of the IAASB Auditor Reporting project, rather than focusing solely on audit or financial reporting, the FRC sought to highlight the importance of using the Auditor's Report to better inform stakeholders about company viability and the Going Concern assumption and uncertainty about going concern. We also raised a concern about major differences between book values and market values and suggested it for review.  Since then:

  • the IAASB has released proposed amendments to expand audit communication to stakeholders, with a focus on key audit matters, the audit opinion and going concern and
  • ASIC has suggested that directors and audit committees should consider whether the auditor has "exhibited sufficient professional scepticism in challenging, rather than rationalising, estimates and accounting policy choices (e.g. complex or subjective asset valuations, including cases where the reported net assets exceed the market capitalisation of the company".

As you would note by now, the FRC can provide a unique perspective by identifying relationships between issues in the audit space.

Sometimes the FRC works with associated groups interested in improving audit quality. A paper prepared by the Australian Public Policy Committee (APPC) for the FRC, for example, considered the audit expectation gap and noted it broadly refers to the difference between  what the public and other financial statement users perceive auditors' responsibilities to be and what an auditor's actual responsibilities entail. They noted that auditors' responsibilities in relation to the detection of fraud and in relation to the going concern concept are two areas commonly associated with the existence of an expectations gap. The APPC considered that bridging the expectations gap requires acknowledgment that the task is a shared responsibility on the part of auditors, those charged with governance, regulators, standard setters and legislators

The FRC will continue to monitor audit quality in Australia, especially examining any evidence of declining audit quality and understanding why that deterioration has occurred. In so doing, the FRC can provide strategic advice to Government to respond with measures to improve the confidence of investors in financial reports.

In closing I would like to refer back to the theme of this panel, Assuring the quality of audits – what is the solution?

In my view the solution involves us all working closely together to ensure our financial reporting system works well and to suggest improvements where they are needed.