- This report outlines the work undertaken by the Financial Reporting Council (FRC) during 2006-07 in the performance of its auditor independence functions. The report also sets out the findings of the FRC as a result of that work and, where appropriate, the action taken by the FRC in respect of those findings.
- During the year the FRC addressed each of the core issues that, together, make up its auditor independence functions.
- The overall conclusion reached by the FRC as a result of its 2006-07 work on auditor independence is that the independence framework continues to operate effectively. No systemic issues were identified as a result of the work undertaken by the various parties. This outcome is consistent with the conclusions reached by the FRC in both 2004-05 and 2005-06.
Systems and processes of Australian auditors
- Since 1 July 2004, when the FRC first became responsible for monitoring auditor independence requirements, audit firms have made significant progress in the adoption and refinement of the systems and processes they use to ensure compliance with auditor independence requirements. The annual audit inspection programmes undertaken by the Australian Securities and Investments Commission (ASIC) initially focused on the major audit firms, with inspections in subsequent years reviewing the firms covered in the previous year and being progressively extended to cover other significant firms that conduct audits of publicly listed entities.
- In 2006-07, the FRC undertook its work on monitoring the systems and processes used by audit firms to ensure compliance with auditor independence requirements by gathering information from ASIC, reviewing reports published by the Audit Quality Review Board (AQRB) and The Institute of Chartered Accountants in Australia (ICAA) and through meetings with the four largest audit firms (the ‘Big Four’) and two other firms. In reaching the overall conclusion referred to above, the FRC noted:
- ASIC’s 2006-07 audit inspection programme covered nine firms in the group immediately below the Big Four firms, with five of these firms being reviewed for the first time. ASIC’s report indicated that the four firms being reviewed for the second time made significant progress in addressing the observations and findings ASIC raised with them in 2005-06. In contrast, ASIC noted that some of the firms being reviewed for the first time had not taken a proactive approach to planning and implementing effective policies, systems and processes to ensure compliance with the legislative requirements for independence and audit quality.
- the AQRB’s 2006 report which concluded that all of the Big Four firms have established policies and procedures that are designed to enable them to complete effective audits within the framework of current Australian legal and professional requirements.
- The ICAA also conducted a review of 32 firms which audited publicly listed companies. The ICAA found that the majority of reviewed firms are meeting independence standards with some minor breaches being noted. Based upon the experience of the firms being reviewed taking swift remedial action, and the recommendation for further training and awareness of independence requirements set out in this report, the FRC believes there is no evidence of a systemic problem in relation to auditor independence.
- As a result of the inspections by ASIC1 and reviews by the AQRB2 and the ICAA3, the FRC formed the view that the systems and processes used by audit firms to ensure compliance with independence requirements are working effectively. However, the FRC notes that the work by ASIC and the ICAA has revealed that some of the smaller firms covered by the respective inspections and reviews do not appear to have a thorough understanding of the legislative and professional requirements on auditor independence.
- In these circumstances, the FRC believes that there would be merit in both ASIC and the professional accounting bodies having additional educative programmes targeted at audit firms. The FRC notes that at least one of the professional bodies, the ICAA, has already instituted a number of measures that are intended to improve its members’ understanding of independence requirements.
Activities of professional accounting bodies
- During this period, the FRC continued its work on monitoring and assessing the nature and overall adequacy of:
- the systems and processes used by the professional accounting bodies for planning and performing quality assurance reviews of audit work undertaken by audit firms; and
- the investigation and disciplinary procedures of the professional accounting bodies as those procedures apply to audit firms.
- In addition, the FRC also continued to monitor the adequacy of the teaching of ethics.
- Having regard to the in-depth reviews of these activities undertaken by consultants in 2005-06, the FRC restricted its work in 2006-07 to periodic meetings with the professional accounting bodies and reviewing publicly available material issued by them.
- The FRC notes that the professional bodies have in place continuing professional development programmes to ensure members are adequately informed about and conscious of the auditor independence requirements and that during the year the bodies conducted educational sessions on a number of audit-related topics.
- As a result of this work, the FRC did not become aware of any matters that would cause it to be concerned about the adequacy of the activities of the professional accounting bodies during 2006-07.
- During 2006-07, the FRC arranged for two consultants to be engaged to undertake additional work flowing out of the three 2005-06 consultancies.
- The Allen Consulting Group reviewed a series of recommendations made in 2005-06 by consultants engaged to review the disciplinary procedures and quality review programmes of the professional accounting bodies. Allen Consulting, which undertook the review from a policy perspective rather than the compliance perspective of the original consultants, found that while a number of issues were raised that require further investigation, currently available evidence does not warrant specific change to the current regulatory framework as recommended in the two previous reports to the FRC. In these circumstances, Allen Consulting did not recommend any immediate change to the regulatory framework.
- Allen Consulting did, however, identify a number of areas for further investigation by the FRC, including that the FRC should examine the costs and benefits of particular aspects of the UK model that could improve the performance of the Australian regulatory framework. As the first stage of this process, the FRC proposes engaging a consultant during 2007-08 to undertake a mapping of the reporting supply chain, identifying all participants, their role, inter-relationships and the reward-punishment incentives which shape their behaviour.
- A summary of recommendations made by Allen Consulting is contained in section 3.2 of this report, with a full list appearing in Appendix D.
- Mr Richard Boele of The Banarra Trust (Banarra) undertook an evaluation of the way in which professional and business ethics are applied in practice by audit firms. Banarra found that ethical practices are highly valued within the accounting profession. Banarra also found that while it could not arrive at any clear conclusions in terms of ethics practice between the Big Four and the significant other firms, there were clear differences in practice between individual firms. A summary of the recommendations made by Banarra is contained in section 3.3 of this report while a more detailed outline of its findings and recommendations is contained in Appendix E.
- As part of its 2007-08 work programme, the FRC will be considering whether there is a need for it to make any recommendations to the Minister and the professional accounting bodies about issues arising out of the consultants’ reports. To facilitate this process, the FRC will be publishing the Allen Consulting and Banarra reports as discussion papers on its website for the purpose of seeking feedback on the recommendations from stakeholders and other interested parties.
- In 2005-06 Australia’s requirements on auditor independence were compared with the equivalent requirements applying in Canada, the European Union (EU), the United Kingdom (UK) and the United States of America (US). As a result of the review, the FRC identified a number of areas in which the Australian requirements differed from those applicable in the other jurisdictions.
- Following consultation with key stakeholders, the Government decided to amend those independence requirements dealing with the multiple former audit partner restriction, the former audit partner ‘cooling-off’ restriction, and adopt a ‘covered person’4 approach in relation to the existing financial relationship restrictions.
- Legislation implementing these changes was enacted by the Australian Parliament during June 2007.
- Information provided to the FRC by ASIC and the Australian Securities Exchange (ASX) shows that the majority of financial reports complied with the auditor-related disclosure requirements examined as part of the review. There were, however, a small number of financial reports that failed to comply with these disclosure requirements. One entity failed to include an auditor’s independence declaration and there were minor exceptions in the declarations for two other entities. The directors’ reports of five companies were identified as failing to disclose non-audit services where it appeared that such services were provided and/or did not include an unqualified statement that non-audit services had not affected the auditor’s independence. As part of its 2007-08 work programme, the FRC will continue to review, and analyse, the level of compliance with audit-related disclosure requirements by considering the information provided by the bodies with which the FRC has signed a Memorandum of Understanding (MOU bodies).
- As part of its 2006-07 work programme, the FRC undertook some preliminary work on the quantum of fees for audit and non-audit services that were received by audit firms from their clients. The FRC’s findings, which were based on a sample of 84 entities5, are outlined in section 3.4 of this report. In 2007-08, the FRC plans to continue its research into the quantum of fees received by auditors of audited entities for audit and non-audit services provided to those entities.
- During 2006-07 the FRC, in consultation with ASIC and the professional accounting bodies, reviewed the Register of Company Auditors to obtain statistical information about the professional affiliations of those auditors. The review was based on the register as at 14 November 2006, when a total of 5,815 individuals were registered. The key finding from this work was that 87.8 per cent of registered company auditors were members of at least one of Australia’s three professional accounting bodies. Inquiries by the FRC suggest that the 12.1 per cent of RCAs who were not identified as being members of a professional accounting body either are in the course of withdrawing from the profession or only perform small audits.
1 An ASIC inspection seeks to enhance public confidence in capital markets through raising the standard of audit quality and auditor independence in the profession. It is designed to assess the firm’s overall audit quality, and its compliance with the independence requirements included in the Corporations Act 2001, auditing standards, and professional and ethical standards. An inspection includes reviews of documentation, interviews with partners and staff, limited testing and verification of systems and processes, and reviews of aspects of a sample of individual audit and review engagements for compliance with the firm’s stated audit methodology and applicable auditing standards as at the date of each audit or review.
2 The AQRB’s current work is with the major firms and is ‘to monitor and report on quality assurance processes … in respect of financial statement audits of publicly listed entities in Australia.’ The AQRB does not ‘examine the merits of a particular audit, the conclusions reached or the appropriateness of the audit opinion other than as merely incidental to the review of the firm’s processes and systems.’ [AQRB Report on 2006 reviews, p 4].
3 An ICAA review ‘assesses the quality control policies and procedures in an accounting practice.’ The reviewer ‘examines manuals … and selects a cross-section of current engagement files to assess whether quality control procedures are being implemented. [ICAA Annual Report on the Quality Review Program for the year ended 30 June 2007, p 11].
4 The expression ‘covered person’ is used in the Securities and Exchange Commission (SEC) Rules to describe members of an audit firm who are subject to financial restrictions because of their involvement with an audit. During 2007 the Australian Government decided to adopt a ‘covered person’ approach to financial investment restrictions by limiting the restrictions to professional members of the audit team rather than all partners in the firm (as occurred at the time of the CLERP 9 reforms).
5 This information was provided by CGI Glass Lewis Pty Ltd and is used in this report with the permission of that firm. Any observations about, or conclusions drawn from, this information in this report reflect the views of the FRC and not CGI Glass Lewis.