Home > Reports > FRC Report on Auditor Independence 2006-07

Introduction

Under section 225 of the Australian Securities and Investments Commission Act 2001 (ASIC Act), the FRC is responsible for monitoring the effectiveness of auditor independence requirements in Australia and giving the Minister reports and advice about those requirements. In addition, the FRC’s functions include giving the professional accounting bodies reports and advice about aspects of their quality review programmes and disciplinary procedures. A summary of the FRC’s auditor independence functions appears in Appendix A of this report.

The FRC has put in place a number of administrative arrangements designed to facilitate its performance of the auditor independence functions. These arrangements include:

• the establishment of an Audit Independence Committee, which deals with day-to-day matters associated with the performance of the function in consultation with the FRC’s auditor independence consultant; and
• a programme of regular meetings, and the exchange of information, with the bodies with which the FRC has entered into MOUs and with selected audit firms.

More information about these arrangements, including the membership of the Committee and the names of the MOU bodies, is contained in Appendix B.

During 2006-07, the FRC continued to perform the auditor independence functions in a manner broadly similar to the way in which the functions were performed in 2004-05 and 2005-06. In 2006-07, the FRC’s work addressed each of the core issues that comprise these functions: systems and processes of audit firms, quality review programmes and disciplinary procedures of the professional accounting bodies, the teaching of ethics by, or on behalf of, those bodies and compliance by companies with audit-related disclosure requirements.

The auditor independence work performed by the FRC during the period under review, including the findings and conclusions reached by the FRC in the performance of its functions and the actions (if any) that it took, is described in later sections of this report. Appendix F lists the key matters arising from the 2005-06 independence report and the action that was taken by the FRC in respect of each of those matters during 2006-07.

Auditor independence since 2004-05 — a review

The FRC’s functions were significantly expanded from 1 July 2004, when the comprehensive package of audit reforms contained in the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (CLERP 9 Act) came into operation. The expanded functions include monitoring the effectiveness of audit independence requirements in Australia and giving the Minister reports and advice about those requirements.

The FRC, through its Audit Independence Committee, has now conducted its work for three years and has issued a report for each of the three years (including this year’s report). This section overviews the FRC’s findings over these three years and makes recommendations, based upon its observations and findings, as to the way forward.

In the first year, 2004-05, the FRC’s main focus was on the systems adopted by the four major firms that dominate the audits of publicly listed entities. Meetings and discussions were also held with the MOU parties to assess how they were adopting and adapting to the new requirements. The overall conclusions were positive:

• There was an open approach to the significant changes required by CLERP 9 by all of the MOU bodies and the major audit firms. The ‘tone at the top’ regarding independence at all these bodies was positive.
• The major audit firms had significantly upgraded their systems, quality control, training and disciplinary processes. These firms had different approaches to some of these issues but all complied with the level required by CLERP 9.
• The regulators had updated their processes to monitor compliance with CLERP 9 and in the case of ASIC had completed their first round of visits to the major audit firms.
• The ICAA had reviewed its monitoring of the major audit firms. Whilst not performing any reviews of the major continuing audit firms since 2002, the ICAA would ensure that reviews were done in 2005-06.⁶
• The need for the auditing profession to have a clear public interest focus in its activities should be reinforced. Public trust in the profession is heavily influenced by perception of its actions, which needs to be taken into account by the profession in its conduct. This is a key component of the strategic direction that the FRC has given to the AUASB with respect to its auditing standard setting activities and is an area that we will continue to monitor closely.
• Audit firms need to ensure that the appropriate ‘tone at the top’ is reflected in a strong message conveyed to staff on the importance of adherence to their own systems and processes, including attendance at training on audit independence requirements.

Some minor unintended consequences of the technical amendments included in the CLERP 9 legislation were identified by the various stakeholders and processes were started to address those issues. These processes were completed during 2006-07 with the enactment of the Simpler Regulatory System Bill.

In 2005-06, the FRC’s work on auditor independence was conducted building largely on the work of the first year. ASIC again conducted a review of the four major firms and extended its review to six⁷ other firms with significant audit practices. The scope of ASIC’s inspections in 2005-06 was similar for both the Big Four and other firms and included both independence and audit quality. A summary of ASIC’s report to the FRC noted that:

• the firms had generally responded positively to the new Australian legislative requirements for auditor independence and auditor quality; and
• its observations and findings varied considerably between the Big Four firms and the other firms, as the challenges faced by these respective firms and the resources available to them were significantly different.

ASIC’s report contained the following comments concerning independence at the Big Four firms:

• all the firms had 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 recognised that the firms had had limited time since the completion of the first-year inspections to implement all of its observations and findings; and
• while the necessary improvements could be characterised as further enhancements to an already fundamentally sound process, there was a need for further improvements in the quality of audit work 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.

In respect of the other firms, ASIC noted that its observations and findings varied considerably between the firms. It acknowledged that there were significant differences in the other firms’ size, structural complexity, extent of centralised resources and international reach. Accordingly, it stated that its observations for the firms visited might not be indicative of this group of firms as a whole, or of other member firms of the associations to which they belong.

In 2006-07 the FRC’s work again built upon the work of the first two years. ASIC is in the process of reviewing the four major firms but at the date of this report has not issued its report covering these firms. The Big Four firms were reviewed by the AQRB for the period to December 2006 and the AQRB in its report in September 2007, which is summarised in section 3.1 of this paper, issued positive findings in respect of its reviews of these firms.

ASIC reviewed four other firms for the second time and five other firms for the first time. Details of the ASIC findings are also set out in section 3.1 of this report. With respect to the firms being reviewed for the second time, major issues have been addressed and good progress was noted in most areas. With regard to the firms reviewed for the first time, ASIC remarked that many firms need to take action to bring their independence policies into line with the requirements of the Corporations Act. In addition, ASIC has informed the FRC that its inspection work highlighted the need for two of the other firms to address the rotation requirements as a matter of urgency to ensure compliance with the Corporations Act.

The ICAA also conducted a review of 32 firms which audited publicly listed companies. The ICAA found that the majority of reviewed practices are meeting independence standards, with some minor breaches noted as set out in section 3.2 of this report. Based upon the experience of the firms being reviewed taking swift remedial action, and the recommendation for further training and awareness set out in this report, the FRC believes there is no evidence of a systemic problem in relation to auditor independence.

The FRC, as stated above, has now conducted its work and issued its report for three years. The profession has embraced the requirements of CLERP 9 in terms of clearly demonstrating the right tone at the top, and the firms that audit the vast majority of listed entities have invested heavily in the systems and processes that allow them to comply with CLERP 9. ASIC, the AQRB and the professional accounting bodies have also invested considerable resources into ensuring that audit firms are complying with the Act and, with the exception of some of the smaller audit firms that audit a small percentage of listed companies, are satisfied that independence requirements are being followed. Except as mentioned above, during this period no serious independence breaches have been brought to the attention of the FRC.

Given the Government’s aim of reducing red tape and the regulatory burden on business, the FRC believes that the co-regulatory reviews for ensuring compliance with auditor independence requirements, which were so crucial in the three years following the commencement of the CLERP 9 legislation and the enhanced professional requirements, should be streamlined. While the primary role of ASIC in reviewing the audit firms is acknowledged, the FRC encourages ASIC, the AQRB and the professional accounting bodies to continue to work together to streamline their review processes and reduce the regulatory burden on the audit firms whilst still ensuring that CLERP 9 is being complied with. The objective would be to reduce the compliance costs which are inevitably passed on to the companies being audited.

In conducting their reviews, ASIC, the AQRB and the accounting bodies have focused on the firms’ procedures for approving non-audit services. The FRC has obtained information about audit and non-audit fees paid or payable to the auditors of 84 entities, the majority of which are included in the S&P/ASX 100 index. The FRC’s preliminary observations include that:

• fees for audit services represented more than 75 per cent of the total fees of the auditors of 43 entities, while the fees for these services for a further 28 entities were between 50 and 75 per cent of the total fees of their auditors;
• fees for audit and audit-related services represented more than 75 per cent of the total fees of the auditors of 55 entities, while the fees for these services for a further 20 entities were between 50 and 75 per cent of the total fees of their auditors;
• fees for other services represented more than 25 per cent of the total fees of the auditors of 10 entities (including, in the case of two of these entities, more than 50 per cent of their auditors’ total fees);
• fees for taxation services represented more than 25 per cent of the total fees of the auditors of 12 entities (including, in the case of two of these entities, one each in the ranges 50 to 75 per cent and over 75 per cent).

The quantum of non-audit fees versus audit fees in respect of some of the entities reviewed appears to be quite substantial. The ASX, which also has an interest in this matter, has informed the FRC that it does not analyse the information about remuneration of auditors that is included in annual reports of listed entities except to ensure that the disclosure is made in accordance with the legal requirements.

One of the main drivers for change that led to CLERP 9 being passed was a view that in some instances the non-audit services provided by the auditing firm could impede its independence. The FRC is also aware that some of the major firms are expanding their consultancy services now that the non-compete clauses with the purchasers of their consultancy practices some five or more years ago have begun to expire. In contrast to the comments regarding the extent of review of independence being reduced and streamlined for the auditing firms, the FRC is of the view that the provision of audit services versus non-audit services needs to be considered further to ensure that there is no systemic problem. This exercise, whilst looking at the services in monetary terms, will focus on the nature of the work to ascertain whether it may impede auditor independence, and is on the FRC’s work programme for 2007-08.

In concluding this review of auditor independence since 2004-05, there is one systemic issue which the FRC believes needs to be kept under review: concentration of audit amongst the Big Four, which collectively audit approximately 88 per cent by composition and 96 per cent by market capitalisation of the 300 largest entities listed on the ASX.⁸ The concentration of audit is an issue about which the UK FRC has been undertaking research and which the International Forum of Independent Audit Regulators (IFIAR) is monitoring and discussing. Anecdotal evidence noted by the FRC suggests that national audit regulators, in adopting a common regulatory regime for all firms irrespective of their size and business models may have contributed to the concentration of audit business in the largest firms. The smaller firms, while often having fewer resources than the larger firms, operate in an environment in which their partners are closer to each other and to their clients than may be the case with the largest firms. Consequently, while compliance with the law and regulations is not negotiable, the FRC believes that the manner in which this is achieved could vary between firms of different sizes. ⁹

Future work programme

For the immediate future it is envisaged that the FRC’s auditor independence function work programme will continue the work undertaken by the FRC during the last three years.

In addition to undertaking the ongoing work associated with monitoring and assessing the nature and overall adequacy of the systems and processes used by Australian auditors to ensure compliance with auditor independence requirements, the FRC will also seek to consolidate its work on the quality review programmes and disciplinary procedures of the professional accounting bodies and the teaching of ethics by, or on behalf of, those bodies.

A detailed outline of the work programme for 2007-08 is contained in Appendix G of this report.

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⁶ ICAA reviews of the major audit firms are conducted on a three year cycle and no reviews of these firms were scheduled for 2004-05. The ICAA has informed the FRC that its reviews of the major firms were undertaken in 2005-06 and 2006-07.

⁷ Only four of these firms are included in the second-year reviews included in ASIC’s 2006-07 audit inspection programme report. The inspection of a fifth firm was still in progress at the deadline for the preparation of the ASIC report for the FRC, while the sixth firm had merged with a Big Four firm and is incorporated in ASIC’s inspection of the latter firm.

⁸ AQRB report on 2006 review, p 3.

⁹ ASIC has advised the FRC that ASIC’s inspection process is tailored to reflect differences between firms in relation to size, structural complexity, extent of centralised resources, and international reach, among other factors. However, legal requirements are common to all firms and it is ASIC’s expectation that all firms will comply with their legal obligations.