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

1. Systems and processes of Australian auditors

The ASIC Act requires the FRC to monitor and assess the nature and overall adequacy of the systems and processes used by audit firms to ensure compliance with auditor independence requirements.

In 2006-07, the FRC performed this function by gathering information from ASIC under the terms of its MOU with that body, by reviewing reports published by the Audit Quality Review Board (AQRB) and through meetings with the four largest and two other audit firms.

As a result of this work, 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 inspections by ASIC and reviews by the ICAA (see section 3.2 below) have 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.

The FRC believes that there would be merit in both ASIC and the professional accounting bodies having appropriate educative programmes targeted at auditors. 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 members’ understanding of independence requirements.

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 third report to the FRC on the audit inspection programme describes ASIC’s inspection process together with its observations and findings in relation to the independence systems and audit quality of selected firms where inspections commenced after July 2006 and were completed prior to 30 June 2007. As at 30 June 2007, ASIC’s inspection process had commenced at the four largest audit firms, but had not been completed. Accordingly its report does not include the results of any of the inspection work performed at these firms in the year ended 30 June 2007, or the results of any ongoing inspection work at other firms.

As in past years, the review undertaken by ASIC has constituted a key source of information for the FRC with respect to its responsibilities in this area during 2006-07.

ASIC’s inspection process for the year ended 30 June 2007 covered nine selected firms, five of which were being reviewed for the first time. The reviews were:

• first-year inspections of PKF Melbourne, Stanton Partners and Stantons International Perth, Grant Thornton South Australian Partnership, Pitcher Partners Brisbane and Lewis & Coble/Blackett & Lewis; and
• second-year (follow-up) inspections of BDO Sydney, PKF Sydney, Grant Thornton Western Australian Partnership and Pitcher Partners Melbourne.

Collectively, these firms audit approximately 3 per cent by composition and 0.6 per cent by market capitalisation of the 300 largest entities listed on the Australian Securities Exchange (S&P/ASX 300).

ASIC stated in its report that its observations and findings varied between the firms. It noted that there are marked differences in the firms’ size, extent of centralised resources and international connections. Having regard to these observations, ASIC expressed the view that its general findings for the firms visited may not be indicative of other firms, including other member firms of the associations to which the firms belong.

The FRC is pleased to note ASIC’s observation that the firms have generally responded positively to the amended legislative requirements for auditor independence and audit quality. The FRC commends those firms that have committed additional resources and have further developed existing policies and systems to assist them in complying with legislative requirements.

ASIC reported that the four firms being reviewed for the second time made significant progress in addressing the issues raised with them in 2005-06. Major issues had been addressed and good progress was noted in most areas.

In contrast, ASIC noted that some of the firms being reviewed for the first time have 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. This lack of action on the part of some firms is of concern to both ASIC and the FRC, given:

• the legislative requirements have been in effect for three years;
• ASIC has issued two public reports on the results of its inspection process, identifying common observations and findings which all firms should have considered and proactively acted upon; and
• ASIC had previously visited another member firm of the association to which these firms belong in all but two cases.

ASIC’s inspections of the smaller firms being reviewed for the first time identified that:

• many firms still need to take action to bring their independence policies into line with the requirements of the Corporations Act;
• most firms have yet to commence testing of their independence systems, including the provision of non-audit services, on a sample basis, to monitor compliance with the Act. Firms can place only limited reliance on the effectiveness of independence systems and processes without introducing an effective testing programme;
• most firms do not have adequate documentation supporting decisions to provide non-audit services to audit clients. Some firms did not have a documented policy dealing with the provision of non-audit services to audit clients to ensure non-audit services comply with the independence requirements in the Act and the APESB standard APES 110 Code of Ethics for Professional Accountants;
• in most firms, partner performance reviews are either not conducted or not documented, making it difficult to render partners accountable for non-compliance with audit quality and auditor independence policies and procedures;
• in some firms, criteria for the remuneration of audit partners do not explicitly include audit independence and audit quality;
• at the time of its inspections, most firms were in the process of mapping their audit manuals and related audit software programme steps to the legally enforceable auditing standards applicable to 31 December 2006 interim financial reports and 30 June 2007 financial reports. In some instances where firms were utilising external proprietary software, ASIC identified a number of areas where the requirements of recently revised Auditing Standards were not incorporated into the firms’ auditing manuals or work programmes.

As part of its 2006-07 inspection programme, ASIC examined the processes in place at firms to ensure compliance with the auditor rotation provisions. ASIC has informed the FRC that, while most firms visited had robust processes in place to manage auditor rotation, there was a need for two firms to address the rotation requirements as a matter of urgency to ensure compliance with the Act.

The FRC interviewed two firms which were subject to the ASIC review. The firms were pleased that as far as possible ASIC tried to have continuity of staff on the review and the firms felt that the work was properly conducted. In similar vein to the FRC’s meetings with the major firms, these other firms all offered views on how the system could be streamlined and this is commented on elsewhere in the report.

Staffing for ASIC is an issue as it is for all of the auditing firms; however, in our discussions ASIC advised that it was managing to recruit and retain the appropriate staff to fulfil its mandate.

Reviews by the AQRB

The AQRB reviewed each of the Big Four accounting firms during 2006 and published a public version of the report on each review¹¹ in early 2007. Subsequently, in September 2007, the AQRB published a report summarising the results of its 2006 reviews, which considered issues associated with audit quality as well as auditor independence.

Prior to conducting its reviews, the AQRB sought to gain an understanding of the processes and findings of overseas review organisations, in particular those operating in the US, the UK and Canada. In its report, the AQRB remarked upon the commonality of its key findings and those that were reported by most of the overseas review bodies.

The AQRB concluded, as a result of its reviews, 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.

In its summary report, the AQRB made the following observations about the commitment of the firms to the present auditing environment:

• The leadership of all four firms has taken a strong lead endorsing the importance of adherence to the new legislative and professional requirements. The AQRB noted that this commitment is evident in the firms’ organisation-wide messages of support for the significantly enhanced resources that each firm has committed to quality and risk management.
• All firms have invested heavily to establish policies, systems and procedures to ensure compliance with new legislation and audit standards. The AQRB reported, however, that at some firms these new tools and systems suffer from a lack of integration and, consequently, are not as easy to use as the firms would wish. It indicated that the firms have programmes of enhancement in place to eliminate these problems.
• The new independence standards and provisions of the Corporations Act have required considerable investment in personnel and monitoring systems. The AQRB was impressed with the commitment to embed these requirements, and the understanding of them, within each firm.

A telling comment in the AQRB’s summary report is that ‘no other area of the firms’ activities has received more attention, both internal and external, than their processes for ensuring that they remain independent of their audit clients and compliant with the law and professional standards’. The report also contained the following additional observations about auditor independence and threats to independence:

• All firms have invested heavily in this area in terms of personnel and automated systems. Some firms started on this journey somewhat earlier than others and consequently have better developed automated systems than those who commenced later.
• All of the firms’ monitoring systems have identified breaches (generally minor in nature) of their internal rules for independence which typically set a higher standard than required by regulation. The AQRB noted that these breaches can be worrying as they indicate a potential for breach of the legal requirements.
• All but one firm have policies and systems which require engagement-level independence confirmations from all staff employed on each engagement. The fourth firm relies on its other independence policies, processes and systems.

The AQRB has also made the observation that if independence requirements do not contribute to achieving objectivity in a real sense, they become costly and unnecessary overheads. The FRC elsewhere in this report has reflected upon whether the pendulum has swung too far in terms of the emphasis on audit independence and questions whether, now that more than three years has passed with only minor findings, the regulatory oversight can be somewhat ameliorated. The FRC encourages the AQRB, ASIC and the ICAA to continue to work together to streamline the process and reduce the regulatory burden on the auditing profession whilst still ensuring the regulations are being complied with.

The FRC is pleased to note the AQRB’s positive findings in respect of the auditor independence issues considered as part of the AQRB’s 2006 reviews of the Big Four accounting firms. The findings regarding audit independence are encouraging for the FRC and mirror the findings of ASIC and the ICAA in previous years. Three of the Big Four firms commented that they felt that the work by the AQRB reviewers had helped them improve their business practices due to the experienced former practitioners typically involved in undertaking these reviews.

Meetings with audit firms

During 2006-07 the FRC met with the four major accounting firms and two other firms with auditing practices. The issues discussed at these meetings are outlined below.

• Concentration risk: a number of parties referred to the concentration risk arising from there just being four extremely dominant auditing firms. There were concerns about the legislative regime favouring the big firms, with suggestions that smaller and some medium-sized firms may find it harder to comply with the legislative requirements, with the result that listed entities are moving away from using these firms as auditors. It was noted by some of the other firms that the Big Four had on occasions used the ASIC criticisms in its 2005-06 report against them in the tender process. Possible solutions suggested by some parties were that the CLERP 9 requirements should apply only to, say, the top 300/500 listed entities.
• People issues: people issues and challenges were remarked upon by most parties. The regulatory framework was cited as making the profession less attractive and making it hard for the major firms to recruit suitable personnel. Problems in recruiting become worse for the medium and smaller firms. The challenge in Western Australia, where many of the mining firms are based, was seen to be extreme. Some commentators are also concerned that the profession may be lowering its standards to provide the necessary manpower.
• Streamlining the review processes between the parties: discussions were held with a number of participants as to how after three years the co-regulatory processes for audit inspections and reviews could be streamlined. All parties accepted that ASIC will undertake whatever work it deems necessary in order to comply with its statutory obligations, but wondered whether the FRC should be encouraging continued collaboration between ASIC, the AQRB and the ICAA to streamline the processes. Areas that could be explored include whether: (a) where more than one party will be looking at the same area, the information formatting could be agreed in advance by the reviewing parties so that it is only prepared once; and (b) where both ASIC and either the AQRB or ICAA intend to review a firm, there could be some cooperative scheduling agreed well in advance. This is particularly relevant in view of the resource constraints and shorter reporting timeframes required by ASX. We were informed that roundtables have been held in the US and Europe with affected parties to discuss how all participants can leverage off the various reviews. The FRC strongly encourages all parties to consider these initiatives seriously and work in a cooperative manner.
• Preparation for CLERP 9: The ASIC review revealed that some of the smaller firms reviewed were ill prepared for the CLERP requirements review. The FRC agrees with ASIC that the level of preparedness of some firms is disappointing and would encourage the accounting bodies to run further education or focus groups for their members to help them comply with the legislative requirements. The FRC considers that focus group sessions would be most valuable for those firms that are based outside of Sydney and Melbourne.
• Expansion of non-audit services: A number of the major firms, which sold their consulting practices some five years ago, are now rebuilding their practices in specialist areas. The fees being generated by these non-audit services are growing strongly. This trend is one which the FRC will monitor in 2007-08 to ensure that offering these services does not cause audit independence issues.
• Trusts as a business structure versus companies: One of the national audit firms observed that the Australian corporate landscape and history lead to many businesses trading as trusts rather than as companies. The firm remarked that the emphasis of the regulatory bodies and the FRC is presently directed towards entities operating in the corporate regulatory environment. This is an issue that will be further considered by the FRC’s Audit Independence Committee in 2007-08.

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¹¹ These reports may be viewed on the AQRB’s website at www.aqrb.org.au.