1. Systems and processes of Australian auditors
Subparagraph 225(2B)(a)(i) of the ASIC Act requires the FRC to monitor and assess the nature and overall adequacy of the systems and processes used by Australian auditors to ensure compliance with auditor independence requirements.
In 2005-06, the FRC performed this function by gathering information from ASIC under the terms of its MOU with that body and through meetings with the four largest accounting firms.
Report from ASIC
The MOU that the FRC has entered into with ASIC provides for periodic consultations and information sharing between the two bodies to assist in undertaking their respective responsibilities under the law.
ASIC’s second report to the FRC on the audit inspection programme describes ASIC’s inspection process together with observations and findings in relation to independence systems and audit quality for the Big Four firms and selected offices of six other firms.5 ASIC’s report focuses on improvements since its first (2004-05) inspections, where relevant, together with weaknesses identified, rather than areas of strength requiring no action.
The review undertaken by ASIC has therefore constituted a key source of information for the FRC with respect to its responsibilities in this area during 2005-06.
In its report to the FRC, ASIC noted that:
- the firms have generally responded positively to the new Australian legislative requirements for auditor independence and audit quality; and
- its observations and findings vary considerably between the Big Four firms and the other firms, as the challenges faced by these respective firms and the resources available to them are significantly different.
ASIC’s report contained the following comments concerning independence at the Big Four firms:
- all the firms have the resources and capability to undertake audits of the largest listed entities and the necessary resources to implement effective systems in response to changes to the regulatory framework;
- ASIC recognises that the firms have had limited time since the completion of the first year inspections to implement all of its observations and findings; and
- ASIC went on to comment that, while the necessary improvements could be characterised as further enhancements to an already fundamentally sound process, there is a need for further improvement in the quality of audit work being done on the financial statements of listed entities in Australia, with areas requiring continued emphasis from the leadership of the Big Four firms including:
- compliance with their independence policies; and
- documentation and approval of non-audit services.
The other firms, which were included in ASIC’s audit inspection programme for the first time in 2005-06, were subject to a more comprehensive inspection than that received by the Big Four firms during their first inspection in 2004-05, which was focussed just on auditor independence. ASIC has noted that its observations and findings vary considerably between the firms. It acknowledges that there are significant differences in the other firms’ size, structural complexity, extent of centralized resources and international reach. Accordingly, it states that its observations for the firms visited may not be indicative of this group of firms as a whole, or of other member firms of the associations to which they belong.
While ASIC was encouraged by the policies and systems developed by these firms in some areas of independence, it was concerned that its inspections identified that:
- four firms need to further develop independence policies and systems to ensure they fully comply with the requirements of CLERP 9;
- five firms do not have adequate documentation supporting decisions to provide non-audit services to audit clients;
- in all firms, partner performance reviews are either not conducted or not documented, and/or the remuneration of audit partners is linked purely to financial results without explicitly considering audit independence and audit quality; and
- two firms have conducted very limited testing of compliance with audit independence policies and systems and four have not commenced any testing programme.
ASIC also noted that most of its observations and findings in respect of the other firms are consistent with recent reviews conducted by other international regulators of non-Big Four firms within their own jurisdiction.
ASIC has noted that with respect to the Big Four firms, only limited progress has been made in testing compliance with the firms’ own independence policies and systems and, in the case of the other firms, four have not commenced any testing programme. In the case of the Big Four firms, two firm’s testing programmes identified breaches of the Corporations Act, but the firms concerned asserted that these were addressed promptly in accordance with the requirements of that Act.
The FRC acknowledges that, in certain instances, the firms’ policies could be more stringent than the requirements of the Act and therefore breaches of the firms’ policies do not necessarily equate to breaches of the Act, but also supports the observation by ASIC that failure to comply with the firm’s own policies may increase the risk of breaches of the Corporations Act.
Other observations made in the ASIC report note that the provision of non-audit services are one of the main threats to auditor independence.
The FRC notes that the Treasury comparative review, which is referred to in a later section of this report, indicates that Australia, unlike the US, has not prohibited actuarial services, although APRA precludes auditors of banks and insurance companies from providing such services to the banks or insurance companies that they are auditing. The FRC has also noted from the Treasury comparative review that in Canada and the UK actuarial services may only be provided on condition that specified requirements are satisfied.
The FRC further notes that the Treasury comparative review identified that the UK considers that the provision of certain tax services poses potential threats to independence.
Because of the importance of perceptions on auditor independence, in addition to the quantum of work involved in the provision of these non-audit services, the FRC intends to do further research and analysis in this area as part of its 2006-07 work programme.
Issues raised by accounting firms
Big Four response to ASIC’s report
The major firms were generally pleased with ASIC’s findings and accepting of the observations and findings in relation to auditor independence. The FRC is encouraged by ASIC’s conclusions that improvements have been made since the first report and that the firms have a strong commitment to independence and quality demonstrated by their leadership.
As noted previously, the detail of the report does refer to two firms internal testing which encountered breaches of the independence rules. The report makes a number of observations and findings regarding processes and procedures which should be improved at one or more of the firms. In terms of the FRC’s goal of aiming for continuous improvement it is recommended that the firms involved consider implementing the improvements.
All of the firms raised the issue of the substantial additional cash and non-cash costs which they have incurred as part of their processes to implement the requirements of CLERP 9. Examples were given of the dedicated teams of partners and staff now in place whose sole purpose is to monitor the new corporate governance requirements. Additional costs of between $5 million to $10 million were mentioned as being incurred by each of the firms for 2005-06. The FRC acknowledges that firms have faced higher costs, but rather than they being attributable to CLERP 9 reforms only, they result from the cumulative impact of several concurrent changes and, in the case of some firms, from international requirements such as the US PCAOB requirements for the audits of US Securities and Exchange Commission (SEC) registrants.
The FRC acknowledges that 2005-06 has been a watershed year for the profession with the major firms being subject to reviews by ASIC/ICAA/FRC Quality Control Consultants and starting to gear up for the AQRB in 2006-07. The FRC recommends that the ICAA, as the professional body whose members do most audits of listed entities and who completed in 2005-06 triennial reviews of the Big Four firms, assists in planning for the 2006-07 year by arranging a roundtable of interested parties to streamline the processes dealing with the quality reviews by the firms, including the AQRB, and ASIC. It is the FRC’s view that any inspections needed for monitoring compliance with the requirements of the US Public Company Accounting Oversight Board (PCAOB) should be considered in the context of their intended collaboration with ASIC’s inspections.
Response of other accounting firms
A meeting between the FRC and the accounting firms other than the Big Four firms was arranged by the ICAA to discuss ASIC’s findings in relation to these firms. The meeting only dealt with the ASIC comments relevant to the FRC’s auditor independence responsibilities in relation to CLERP 9. The comments in relation to audit methodologies and audit standards are outside the scope of this report.
The firms have noted that ASIC appears to apply a uniform model behind a number of its observations and findings as to how some of the firms could improve their processes and procedures in relation to audit independence. The firms at the meeting commented that to implement some of ASIC’s observations and findings would lead, in the case of some firms, to high levels of documentation and add to the costs of the assignment with no benefit to the recipients of the assignment.
Within the group of firms outside the Big Four there are significant differences in each of the firm’s size, structural complexity, extent of international reach and centralised resources. The FRC wishes to see a strong and varied profession made up of different types of firms best geared to servicing the wide array of users. Since this is the first year of review of the firms other than the Big Four, the FRC recommends that for 2006-07, the ICAA takes a lead position in assisting the implementation of ASIC’s observations and findings. The FRC understands that ASIC is willing to continue to work with individual firms, each of the three professional bodies, and through working committees to assist all firms understand how ASIC’s observations and findings should lead to improved audit quality.
The ICAA may also choose to develop training programmes, with input from ASIC, aimed at the other accounting firms in relation to the CLERP 9 requirements and documentation.
5 Collectively the Big Four firms (PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloittes) audit 53 per cent of the listed entities in Australia, and approximately 88 per cent by composition and 96 per cent by market capitalisation of the 300 largest entities listed on the Australian Stock Exchange (S&P/ASX 300). In contrast, the other firms inspected by ASIC (BDO Sydney, Horwath Sydney Partnership, PKF Sydney, Grant Thornton Western Australian Partnership, Pitcher Partners Melbourne and RSM Bird Cameron and RSM Bird Cameron Partners) audit approximately 2 per cent by composition and 0.2 per cent by market capitalisation of the S&P/ASX 300.