IOSCO consults on auditor transparency, communication and ownership structures
- Source: IOSCO consults on auditor transparency, communication and ownership structures, IOSCO, Madrid, 18 September 2009
The International Organization of Securities Commission (IOSCO) Technical Committee has launched three related consultation reports prepared by its Task Force on Audit Services on the Transparency of Firms that Audit Public Companies; Auditor Communications and Exploration of Non-Professional Ownership Structures for Audit Firms.
The Technical Committee is seeking input from investors, audit oversight authorities, industry and other relevant stakeholders on these three reports.
The closing date for responses is 1 December 2009.
The Technical Committee’s Task Force on Audit Services (Task Force) announced in May 2008 its intention to expand the scope of its work to look at a number of audit services related issues, in response to concerns raised by participants at a roundtable on the Quality of Public Company Audits from a Regulatory Perspective in June 2007.
These issues included: the transparency of audit firms and the effect this could have on the quality of audits and the availability and delivery of audit services; the adequacy of the standard audit report; and the impact of audit firm ownership structure on concentration in the market for auditing large issuers.
Transparency of firms that audit public companies
In the first paper, the Task Force explores whether enhancing the transparency of audit firms’ governance, audit quality indicators and audited financial statements could maintain and improve audit quality and the availability and delivery of audit services.
The paper considers the benefits and possible disadvantages of enhanced transparency, while also examining alternative methods of achieving enhanced transparency and ways in which to mitigate any potential limitations arising from increased transparency.
In order to address concerns about the effectiveness of the standard audit report in communicating important information about the audit and audit process, the second paper considers whether changes to the standard audit report or additional auditor communications are warranted to meet investor information needs. The consultation paper:
- highlights the evolution of the audit report;
- describes perceived shortcomings of the report observed by others;
- identifies possible solutions to these issues proffered by others; and
- notes possible advantages and disadvantages of such solutions.
Exploration of Non-Professional Ownership Structures for Audit Firms
The third paper focuses on the impact of audit firm ownership restrictions on concentration in the market for auditing large issuers, but the Task Force recognizes that the ultimate strategy for reducing concentration may need to address several barriers to entry (and any related solutions) together.
The paper describes the current state of audit firm concentration in the market for auditing large public companies, including its impact on the availability of audit services. The paper explores the potential benefits for audit service availability of removing ownership restrictions and discusses the adverse impact that removing ownership restrictions may have on audit firm competence, professionalism, independence, and audit quality. The paper also considers the pros and cons of authorizing alternative forms of audit firm ownership and governance.
Exploration of non-professional ownership structures for audit firms
- Source: Exploration of Non-Professional Ownership Structures for Audit Firms IOSCO (page 20), September, 2009
Investors have an abiding interest in audit firm professionalism, competence, and independence, which serve to protect audit quality. Concentration among those firms that supply audit services for large public companies, which regulators have observed for several years, may threaten investor interests because of the risk that the loss of a single firm could disrupt the entire market for independent auditing of large public companies. In addition, greater choice than presently exists and stronger checks and balances than are provided by market discipline might improve the availability of large public company auditing services.
Further, allowing for non-practitioner ownership might enlarge the sophisticated pool of human capital with appropriate technical expertise, such as information technology, financial engineering, or legal services, which could contribute to improvements in the quality of audits and firm governance. These potential benefits, however, do not justify a compromise to audit quality, which is essential to investor protection. Since auditors’ opinions are expected to enhance the reliability of reported financial information, investors should be able to expect objectivity, independence, professionalism and competence from auditors.
Reconciling the parallel regulatory objectives of audit firm professionalism, competence, and independence, on the one hand, and of mitigating concentration in the marketplace for large public company auditing services, on the other, justifies exploration of alternatives to current ownership restrictions for auditing firms. Reconsidering these limitations may have the potential to result in new competitors to the Big Four firms. Moreover, the entry of new competitors could introduce alternative forms of audit firm governance to the market for large public company audits, such as independent directors on a board responsible for overseeing management. This circumstance might buttress existing auditing firm policies and procedures designed to minimize conflicts of interest, maintain independence, and promote audit quality.
Consideration of the potential benefits of permitting broader firm ownership by non-accounting practitioners requires that securities regulators, legislators, professional bodies, and standard-setters carefully analyze its impact on competence, professionalism, conflicts of interest, and independence. In addition, standard setters, professional bodies, regulators and legislators should consider whether new or enhanced safeguards could successfully mitigate the risks presented by non-practitioner ownership.
US GAO audit of the federal budget
- Source: Audit Report on the U.S. Government’s Consolidated Financial Statements for Fiscal Years 2009 and 2008 Briefing to the Subcommittee on Government Management, Organization, and Procurement, Committee on Oversight and Government Reform, House of Representatives, March 1, 2010
We are unable to, and we do not, express an opinion on the U.S. government’s accrual-based consolidated financial statements for fiscal years 2009 and 2008 because of the federal government’s inability to demonstrate the reliability of significant portions of its accrual-based consolidated financial statements, principally resulting from limitations related to certain material weaknesses in internal control over financial reporting and other limitations on the scope of our work.
- We rendered unqualified opinions on the Statements of Social Insurance for 2009, 2008, and 2007, marking 3 consecutive years for this achievement.
- Material weaknesses resulted in ineffective internal control over the federal government’s financial reporting.
- Our work to test compliance with selected provisions of laws and regulations in fiscal year 2009 was limited by the material weaknesses and other scope limitations discussed in our audit report.
US Advisory Committee on the Auditing Profession
- Source: Advisory Committee on the Auditing Profession US Treasury website
The Treasury Department established the Advisory Committee on the Auditing Profession to examine the sustainability of a strong and vibrant auditing profession. The Committee will consider, among other things, the auditing profession’s ability to cultivate, attract, and retain the human capital necessary to meet developments in the business and financial reporting environment and ensure audit quality for investors; audit market competition and concentration and the impact of the independence and other professional standards on this market and investor confidence; and the organizational structure, financial resources, and communication of the auditing profession.
- October 6, 2008: Final Report
- September 26, 2008: Treasury Advisory Committee on the Auditing Profession Adopts Final Report
- September 26, 2008: Fact Sheet: Final Report of the Advisory Committee on the Auditing Profession
Supreme Court issues limited ruling against PCAOB
- Source: Supreme Court issues limited ruling against Sarbanes-Oxley board The Hill, June 28, 2010
The Supreme Court on Monday ruled that the 2002 Sarbanes-Oxley Act gave too much independence to a new accounting oversight board, but it left the underlying law largely intact.
In a 5-4 decision, the justices found that the Public Company Accounting Oversight Board (PCAOB), created as part of the law to regulate the accounting industry, violated the separation of powers by limiting the president’s power to oust its members. Yet the high court kept its decision narrow and said the board could remain in place as long as the rules governing the appointment and removal of its members were changed.
The Sarbanes-Oxley law was enacted as a response to the corporate scandals involving Enron and other companies that roiled the financial services industry.
The Supreme Court ruled that Congress essentially overreached when it tried to craft a regulatory agency with enough independence to shield it from political influence. As devised in the Sarbanes-Oxley law, the accounting oversight board was housed within the Securities and Exchange Commission, itself an independent agency. The SEC oversaw the PCAOB and appointed its members, but it could only remove them “with good cause.”
- Statement on the Supreme Court’s Decision in FEF v. PCAOB U.S. Securities and Exchange Commission, June 28, 2010
- SOX and the supremes The Economist, June 28, 2010
PCAOB proposes rules on audit committee communications
- Source: PCAOB Proposes Rules on Audit Committee Communications WebCPA, March 29, 2010
The Public Company Accounting Oversight Board has proposed an auditing standard on “Communications with Audit Committees,” and a series of related amendments to interim standards.
The proposal addresses requirements for auditors to communicate with audit committees of public company boards of directors, and considers a number of factors, including the importance of accounting judgments and estimates in financial reporting.
“The proposed standard on audit committee communications is intended to enhance the relevance and effectiveness of the communications between an auditor and audit committee throughout the course of an engagement,” said PCAOB acting chairman Daniel L. Goelzer in a statement.
The proposed standard includes a requirement for auditors to establish a mutual understanding of the terms of the audit engagement with the audit committee and to document that understanding in an engagement letter.
The proposal also includes requirements relating to:
- Communication of an overview of the audit strategy, including a discussion of significant risks, the use of the internal audit function; and the roles, responsibilities, and location of firms participating in the audit;
- Communication regarding critical accounting polices, practices, and estimates;
- Communication regarding the auditor’s evaluation of a company’s ability to continue as a going concern; and,
- Evaluation by the auditor of the adequacy of the two-way communications.
Comments on the proposed standard and amendments are due May 27, 2010. For more information, visit www.pcaobus.org.
CFA's survey on independent auditor's report
- Source: Independent Auditor’s Report Survey Results CFA Institute, March, 2010
Summary of Key Findings
Importance of the Auditor’s Report (Page 5)
- 72 percent of respondents said the auditor’s report is important to their analysis and use of financial reports in the investment decision making process; with 46 percent indicating it is very important.
Report Language Describing the Nature of an Audit & Respective Roles of Auditor and Management (Pages 7 and 9)
- 73 percent agree that the auditor report’s language on the nature of an audit and respective roles of auditor and management could help reduce or manage the expectations gap that exists regarding the financial statement audit.
- Furthermore, 69 percent think it is important to provide these communications within the auditor’s report, with 33 percent indicating it is very important.
Disclosure on Roles of Auditors and Method of Determining Materiality (Pages 14 and 15)
- An overwhelming 91 percent agree that in cases where there is more than one auditor, the identities and specific roles of other auditors should be disclosed.
- 82 percent agree that the method by which the auditor determines/assesses materiality should be disclosed.
Information about the Audit Process & Matters Related to the Audited Financial Statements (Page 11)
- 60 percent of respondents believe the auditor’s report should contain more information about the audit process itself and matters related to the audited financial statements. The findings show also that 37 percent of respondents believe the auditor’s report contains the right amount of information about the audit process itself and matters related to the audited financial statements.
Information on the Audited Entity (Page 18)
- 57 percent think the auditor’s report should contain more information on the audited entity. 40 percent think the auditor’s report contains the appropriate amount of information.
Additional Information in the Auditor’s Report (Page 20)
- 94 percent of respondents would like to see additional information in the auditor’s report
- 77 percent would like to see information about “audit materiality”.
- 72 percent would like to see information on circumstances or relationships that might bear on the auditor’s independence.
- 66 percent would like to see the level of assurance actually achieved in the audit.
FSA - Improving the auditor’s report on client assets
- Source: Improving the auditor’s report on client assets Financial Services Authority , September 27, 2010
The purpose of this Consultation Paper (CP) is to set out the recent actions we have taken to improve the quality of the auditor’s report on client assets, and to seek your views on our proposals for Handbook amendments.
These proposals aim to:
- confirm and clarify the standards required for the auditor’s report on client assets;
- increase and make consistent the information provided within the auditor’s report to enhance its supervisory value; and
- improve firms’ governance oversight of both their auditors and their compliance with the Client Assets Sourcebook (CASS).
FSA-FRC "Enhancing the auditor’s contribution to prudential regulation"
- Source: Enhancing the auditor’s contribution to prudential regulation Financial Services Authority & Financial Reporting Council, June, 2010
1.3 The purpose of this paper is to stimulate debate on how the FSA can best use audit and auditors to meet its statutory objectives. In particular, this paper examines how the FSA, the FRC and auditors can best work together to enhance how auditors can contribute to prudential regulation in the future. Below, we consider the main themes of each chapter in turn.
1.4 Chapter 2 discusses why these issues are topical. The financial crisis has highlighted a number of reasons for examining the role of auditors in prudential supervision. The Treasury Committee has raised concerns about the usefulness of audit for banks and whether the FSA uses external auditors’ expertise in the best way to support its objectives. The FSA’s more intensive approach to supervision in response to the financial crisis has also caused it to question aspects of how auditors undertake their audit and assurance work in particular areas.
1.5 Chapter 3 discusses the quality of audit and assurance relevant to prudential regulation in the UK. Confidence in published accounts (as well as high quality reporting in respect of client assets) is vital to the FSA’s objectives of market confidence, financial stability and consumer protection.
1.6 In this chapter we stress the importance of auditors applying a high degree of professional scepticism when examining key areas of financial accounting and disclosure which depend critically on management judgement. Both the FSA and the FRC believe auditors need to challenge management more. Arising from its more intensive approach to supervision, the FSA has questioned whether the auditor has always been sufficiently sceptical and has paid adequate attention to indicators of management bias. Although the difference between the FSA’s view, what management has done and the auditors have accepted may not be material to whether the financial statements are fairly stated overall, there are concerns that the auditor sometimes portrays a worrying lack of scepticism in relation to these key areas.
1.7 In some cases that the FSA has seen, the auditor’s approach seems to focus too much on gathering and accepting evidence to support management’s assertions, and whether management’s valuations meet the specific requirements of accounting standards. It is important for auditors to also consider if the standards’ requirements have been applied thoughtfully so as to ensure that the objectives behind the requirements have been met.
1.8 Where there are materially different approaches to determining accounting estimates for similar items, a narrative disclosure of the approach adopted is likely to be necessary, given the importance of the underlying judgements. Such diversity should trigger auditors to apply greater scepticism and to challenge management’s judgements about modelling approaches and inputs. Given their corporate access to the approaches to valuations undertaken by their portfolio of clients, auditors may be in a good position to challenge their client on whether their judgements are appropriate and their disclosures adequate.
1.9 There have been significant improvements in the quality of disclosures about credit exposures, and risks and uncertainties in recent bank financial statements. The FSA and FRC believe these improvements should have been achieved earlier, with less need for intervention. They also believe this shortcoming may partly reflect a lack of effective challenge by auditors and the effectiveness with which auditors use available levers to influence management, such as reporting their concerns to the FSA.
1.10 In particular we note that ‘true and fair’ is a dynamic concept and that the disclosures necessary to achieve a true and fair view will vary over time, depending on factors such as the wider economic environment in which the firm operates and what is relevant to investors and other stakeholders. For example, in the earlier stages of the financial crisis there was a significant loss of confidence in banks’ financial reporting, as there were concerns that they did not capture the reality of emerging problems.
1.11 We move on to outline the FSA’s concerns about auditors’ work on client assets and how auditors interpret their duty to report to the FSA under the Financial Services and Markets Act 2000 (FSMA).
1.12 The remainder of the paper examines the regulatory environment in which auditors operate and suggests possible measures to enhance how auditors contribute to prudential supervision.
1.13 Chapter 4 considers how audit could be made more effective for the FSA. We note that, partly in response to the financial crisis, auditing standards and guidance have been or are being strengthened. The FSA and FRC intend to enhance their cooperation and information sharing to optimise the focus of the Audit Inspection Unit’s (AIU) work, and to leverage each other’s knowledge to pursue the FSA’s and the FRC’s regulatory objectives. This should increase auditors’ incentives to enhance the quality of their work.
1.14 The FSA also sees scope to provide direct feedback to the audit committees of high impact firms.
1.15 The FSA is also pursuing, or considering, ways in which the auditors’ duty or right to report to the FSA can work better. The FSA has provided input to the revision by the Auditing Practices Board of Practice Note 19, which gives non-exhaustive examples of where a legal duty to report is likely to arise. More generally, the FSA anticipates that its enhanced engagement with auditors (see below) will help to improve information sharing.
1.16 We also note how, given the significant shortcomings in reporting on client assets, the FSA intends to publish a Consultation Paper on proposals to improve the quality and consistency of auditors’ reports in September.
1.17 Finally, we raise the issue of whether the FRC and FSA’s powers in relation to auditors’ work should be amended so they could be used in a more targeted and proportionate manner.
1.18 Chapter 5 explains that, if the FSA is to use auditors’ skills and knowledge appropriately, it needs to engage more effectively with auditors. We set out a number of ways in which the FSA plans to implement this in this chapter. Notably, the FSA envisages: meetings with auditors of high impact firms will be more frequent and take • place earlier in the accounts preparation process; meeting with audit committees of high impact firms; and• improvements in the flow of relevant information to auditors.•
1.19 Chapter 6 considers skilled persons reporting to the FSA under section 166 of FSMA and whether there is scope for enhanced reporting by auditors to the FSA. Although the FSA has increased its use of skilled person reports, this still remains quite limited. The FSA is undertaking several pieces of work designed to ensure these powers are used so maximum regulatory benefits are secured in relation to cost. This work is expected to be completed in Q3 2010, after which the FSA will consider whether existing practices need to be revised.
1.20 The FSA is concerned about errors in the regulatory returns made by some firms and is considering how this should best be addressed. One possibility would be to impose an audit requirement on some or all returns where this does not already exist (insurance company returns are subject to audit). However, a more cost effective approach might be for the FSA to make greater use of the recently introduced section 166 Return Assurance Reports.
1.21 The FSA is also considering whether it would be appropriate to request auditors to provide reports on specific subjects, e.g. areas of significant accounting judgement, or some form of post-audit report.
1.22 Chapter 7 raises the question of whether Pillar 3 disclosures and prudential information disclosed in the annual report should be subject to audit.
1.23 As noted at the outset, the purpose of this paper is to stimulate debate rather than to set out firm conclusions, and the FSA and FRC encourage stakeholders to respond to any of the issues raised.
UK report on auditor concentration
- Submission to the House of Lords Economic Affairs Committee: “Auditors: Market Concentration and their Role” Financial Reporting Council, September, 2010
AUDITORS: MARKET CONCENTRATION AND THEIR ROLE
- Introduction and main points
- The Financial Reporting Council (FRC) welcomes the opportunity to give evidence to the Economic Affairs Committee’s inquiry into Auditors: Market concentration and their role.
- The FRC is the United Kingdom’s independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. The FRC and its operating bodies have a number of responsibilities in relation to audit, including policy, standards, monitoring and investigations. These functions are carried out with the primary goal of improving audit quality.
- The FRC is concerned about the current concentration in the audit market and we have expressed these concerns for some time. Currently, the audit market is not delivering a fully competitive environment, particularly for FTSE 100 and FTSE 250 companies and in sectors such as banking and insurance. Choice and innovation in the market are therefore less extensive than we would wish. We are also concerned about the disruption and cost that would arise in the event of a large firm leaving the market and a subsequent reduction to three or fewer major players.
- We have attempted to address these concerns over the last five years but with no real change in the level of concentration. A new analysis of the impact of the current market structure is now warranted. It needs to take into account the global nature of the audit market and seek the advice of competition authorities here and overseas.
- The FRC works unequivocally to enhance audit quality, which enables investors to make sound judgments, and thereby supports efficient capital markets. We believe that further safeguards should be put in place to enhance audit quality. Specifically, the regulatory framework which determines the relationship between the FRC, audit firms and professional accounting bodies should be strengthened to provide greater transparency, accountability and independence in the public interest.
- We particularly recommend that the FRC should take on certain functions of the professional bodies and should have a wider range of sanctions to address shortcomings in audit quality and for use in disciplinary situations. For example, we believe the FRC should have responsibility for the licensing of auditors of public interest entities – a task that should be undertaken in addition to the general licensing of auditors within the profession itself. An unambiguously robust and independent regulatory oversight of the audit profession would ensure a speedier response to risks, an increased focus on audit quality and, ultimately, enhanced market confidence in the role and value of audit.
- The Government’s decision to abolish the Audit Commission should be used as a catalyst for greater competition in the audit market. The Commission’s in-house audit practice is the fifth largest in the UK. Although this work is not in the corporate sector and does not address the international coverage issues, if secured by a non Big Four firm it would enhance their scale and strength and so reinforce their ability to compete. Conversely, if the work goes to the Big Four, the reverse will be true.
- Auditors face scrutiny over independence London Times, October 6, 2009
Audit quality in Australia
- Source: Audit Quality in Australia, A Strategic Review Australian Treasury, March, 2010
From page 15:
Australia’s audit regulation framework in the context of audit quality
Key finding 1
Treasury believes that Australia’s audit regulation framework is robust and stable and, as a key driver of audit quality, can be considered to be in line with international best practice.
Key finding 2
Treasury notes that while the EU’s Statutory Audit Directive provides for a seven-year period, the Australian rotation period of five successive years also applies in Canada, the UK and the US and in light of this consistency, the Treasury does not support the proposal that the current requirement should be increased to seven years. This view is reinforced by the fact that the ‘time out’ period in Australia is two years while a more onerous time out period of five years applies in Canada, the UK and the US. Treasury considers that the five-year rotation period with the two-year time out period constitutes an appropriate balance between continuity, the familiarity threat and audit quality.
Treasury proposes to continue to monitor developments on auditor rotation in overseas jurisdictions but does not consider that it would be appropriate for Australia to unilaterally move from a five- to a seven-year rotation period. Such a change should only be considered if similar changes to the existing requirements were to be made in Canada, the UK and the US. Treasury considers that any move to increase the existing five-year rotation period in Australia would raise the question of whether the existing two year time-out period should also be increased.
Key finding 3
While acknowledging that financial reporting and audit requirements apply in a dynamic environment and will require refining from time to time to keep abreast of market developments and regulatory developments in overseas jurisdictions, Treasury does not consider that the overall legislative framework requires any fundamental reform at the present time. In the context of the auditor independence requirements, this includes not making any changes to the present policy approach in relation to auditor-provided non-audit services.
Key finding 4
While the global financial crisis has exposed a number of problems with financial reporting, these are being addressed at the international level, primarily through the International Accounting Standards Board. Australia’s audit regulation framework appears to be functioning effectively during the current uncertain economic conditions.
Key finding 5
Treasury considers that the global financial crisis has highlighted the importance of audit quality in terms of enhancing and maintaining market confidence. Accordingly, Treasury considers that regulators such as ASIC and APRA, and other key stakeholders including the FRC, AUASB and the professional accounting bodies should continue to monitor future developments resulting from the global financial crisis that might have an adverse impact on audit quality, with a view to submitting any appropriate legislative reform proposals to the Government for consideration (also see key finding 9). Having regard to the international context in which auditing is now practised and the importance of global consistency in relation to regulatory practice and standard-setting, Treasury also considers that it will be important that the regulators and other key stakeholders should take account of new regulatory initiatives relating to audit quality adopted in foreign jurisdictions, where the impact of the global financial crisis, in many cases, has been more severe than in Australia.
Key finding 6
Treasury supports the action taken by the Auditing and Assurance Standards Board to issue the suite of Australian Auditing Standards and ASQC 1 Quality Control for Firms that perform Audits and Reviews of Financial Reports, Other Financial Information, and Other Assurance Engagements in clarity format.
- Submissions: Consultation Paper - Audit Quality in Australia: A Strategic Review The Treasury, Australian Government, 21 June 2010
- Australian audit inspection program public report for 2009 ASIC
AU FRC report on auditor independence
- Source: FRC Report on Auditor Independence 2007-08 - Executive Summary Australian Government Financial Reporting Council,
1. Executive Summary
This report outlines the work undertaken by the Financial Reporting Council (FRC) during 2007-08 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 2007-08 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 in the period since 1 July 2004 when the FRC first became responsible for monitoring auditor independence requirements.
Systems and processes of Australian auditors
In 2007-08, 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 the Australian Securities and Investments Commission (ASIC), reviewing reports published by the Audit Quality Review Board (AQRB) and The Institute of Chartered Accountants in Australia (ICAA), requesting relevant information from the professional accounting bodies and through meetings with the four largest audit firms (the Big Four') and three other firms. In reaching the overall conclusion referred to above, the FRC noted:
- ASIC's 2007-08 audit inspection program report in which ASIC indicated that, overall, firms have shown commitment towards meeting their independence obligations. In relation to issues raised in prior year inspections, ASIC notes that all major issues have been addressed and good progress has been noted in most areas;
- the AQRB's 2007 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;
- that during the course of its meetings with audit firms the FRC did not become aware of any systemic issues in relation to the effectiveness of the systems and processes used by firms to ensure compliance with the audit independence requirements; and
- that the quality assurance reviews conducted by the professional accounting bodies did not reveal any serious breaches of the audit independence requirements.
As a result of the inspections by ASIC1 and reviews by the AQRB2 and the professional accounting bodies3 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 has revealed that a number of the smaller firms need to make improvements to their systems to ensure that the systems are robust and comply with all the legislative requirements.
Activities of professional accounting bodies
During 2007-08, 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.
Based on the information provided by the professional accounting bodies, the FRC did not become aware of any deficiencies in either the systems and processes used by the bodies for planning and performing quality reviews of audit work, or in the overall adequacy of the professional accounting bodies investigation and disciplinary procedures.
The FRC also continued to monitor the adequacy of the teaching of ethics by the professional accounting bodies.
The FRC based its observations on information supplied by the professional accounting bodies in response to a request from the FRC and through information gained at periodic meetings with those bodies. Based on its examination of this information, the FRC is satisfied that the teaching of ethics by each of the professional accounting bodies is adequate. That said, as part of its work program going forward, the FRC will continue to encourage the professional bodies and other stakeholders to participate in the debate on ethical behaviour within the profession, particularly on the issue of ethics as it relates to auditor independence.
As a result of its 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 2007-08.
In 2006 and 2007, the FRC engaged a total of five consultants to examine and make recommendations to the FRC in the areas of disciplinary procedures, the teaching of professional and business ethics, the practical application of professional and business ethics by audit firms and quality review programs.
During 2007-08, the FRC considered these recommendations, and considered the adoption (if not already adopted) of these recommendations into the FRC's current and future work programs. In doing so, the FRC also considered the 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 sought feedback on the recommendations from stakeholders and other interested parties.
Information provided to the FRC by ASIC and the Australian Securities Exchange Ltd (ASX) shows that the majority of financial reports complied with the audit-related disclosure requirements examined as part of their reviews. There were, however, a small number of financial reports that failed to comply with these disclosure requirements: the directors' reports of 11 entities did not include an unqualified statement that non-audit services had not affected the auditor's independence. As part of its 2008-09 work program, 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 2007-08 work program, the FRC undertook further analysis of the quantum of fees for audit and non-audit services that were received by audit firms from their clients4. This work carries on from the preliminary work undertaken in 2006-07. The FRC considers that the 2007-08 data does not suggest any problematic trends for auditor independence.
- An ASIC inspection seeks to enhance public confidence in capital markets through raising the standard of audit quality independence in the profession. It is designed to focus on audit quality and independence by promoting compliance with the requirements of the Corporations Act 2001, (the Act) Australian auditing standards, and professional and ethical standards. [ASIC Audit Inspection program public report for 2006-07, p 4]. 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.
- The AQRB's role (as an independent body funded by audit firms) is to monitor the processes by which audit firms seek to ensure their compliance with audit standards and legal obligations relating to independence and audit quality. AQRB's overarching commitment in examining, assessing and reporting on audit firms' quality assurance processes is to contribute to the improvement in audit quality. [AQRB Report on 2007 reviews, p 4].
- The ICAA, for example, as part of its quality review program assesses the quality control policies and procedures that are implemented in an accounting practice. The reviewer considers the quality control procedures that the practice has established by covering the elements of quality control set out in APES 320 Quality Control for Firms. [ICAA Annual Report on the Quality Review Program for the year ended 30 June 2008, p 7].
- This information was provided by CGI Glass Lewis Pty Ltd. Any observations about, or conclusions drawn from, this information reflects the views of the FRC and not CGI Glass Lewis.
"Fraud Happened. The No-Account Accountants Stood By"
- Source: Fraud Happened. The No-Account Accountants Stood By Re: The Auditors, April 19, 2010
The financial crisis is now about fraud.
The word that dared not be uttered, even behind closed doors, has now disturbed the peace of a nascent “recovery.” Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a while?
“Gentlemen, not one of you could have done this on your own. This was a team effort.” Casey Stengel after the Mets 40-120 season.
Why didn’t the Big 4 audit firms warn that these obscenely over leveraged institutions threatened our financial future? Why didn’t the auditors question, push back, or raise objections to illegal and unethical disclosure gaps? Every one of the failed or bailed out financial institutions carried non-qualified, clean audit opinions in their wallets when they cashed the taxpayers’ check.
The largest four global audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – have combined revenues of almost $100 billion dollars and employ hundreds of thousands of people. There’s no hard proof they’re completely corrupt, but they’ve proven themselves to be demonstrably self-interested and no longer singularly focused on their public duty to shareholders.
Something is rotten with the accounting industry.
America’s public accountants – in particular, the Big 4 audit firms – aren’t protecting investors. And no one is holding them accountable.
The crisis that culminated in the near-collapse of the global financial system is still the subject of Congressional hearings.
Almost every player has been called to account.
Last month the Lehman Bankruptcy Examiner’s report told us that there’s “sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from [their] failure to follow professional standards of care.”
This week the Securities and Exchange Commission charged Goldman Sachs and one of its vice presidents with fraud for misleading investors by “misstating and omitting key facts about a financial product tied to subprime mortgages.”
That financial product was a structured collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs, according to the SEC, failed to disclose vital information about the CDO to investors. In particular, John Paulson’s hedge fund, a Goldman client, played a leading role in the portfolio selection process and the hedge fund took a short position against the CDO, without disclosure to Goldman’s other clients.
In one of the most egregious cases of auditor complacence during the financial crisis, Pricewaterhouse Coopers LLP (PwC), the firm that audits both AIG and Goldman Sachs, sat on the sidelines for almost two years while their clients disputed the value of credit default swaps (CDS).
There’s been no public explanation of how PwC presided over the dispute between AIG and Goldman—a dispute eventually pushed AIG to accept a bailout – without doing something decisive to help resolve it. This long-running “difference of opinion” between two of its most important global clients was arguably material to at least one of them. Why didn’t PwC force a resolution sooner based on consistent application of accounting standards?
PwC was paid a combined $230 million by the two firms for 2008 and remains the “independent” auditor to both companies.
Gatekeepers? Or foxes in the hen house?
The auditor’s role is to be a gatekeeper. A watchdog. An advocate for shareholders. This is their public duty.
This public trust is subsidized by a government-sponsored franchise. All companies listed on major stock exchanges must have an audit opinion. Audit firms are meant to be shareholders’ first line of defense, and they are hired by and report to the independent Audit Committee of the Board of Directors.
And yet the same audit firms that stood by and watched Bear Stearns and Lehman Brothers fail – Deloitte and Ernst &Young – are recipients of lucrative government contracts to audit or monitor the taxpayers’ investment in the bailed out firms. Deloitte, the Bear Stearns and Merrill Lynch auditor, works for the US Federal Reserve system. Ernst & Young, Lehman’s auditor, is working for the US Treasury on the original $700 billion TARP program and with the Fed on the AIG bailout.
Who are we kidding?
America’s auditors serve themselves. Focused on “client service” not shareholder advocacy, they’ve remained above the financial crisis finger-pointing fray. Call it skillful lobbying or targeted political contributions… Either way, regulators and legislators have been afraid of getting on the auditors’ bad side.
Investment banks, mortgage originators, commercial banks, and ratings agencies have all been questioned about their role in the crisis. And the Big 4 public accounting firms work for all of them.
But when accused of negligence, malpractice or complicity, the audit firms frequently claim to have been duped. Do you believe them? The industry is an oligopoly. That’s a $10 word for what happens when a market or industry is dominated by a small number of sellers who discuss their strategies in order to achieve common objectives.
The Sarbanes Oxley Act of 2002 (SOx) was enacted after the Enron debacle to restore confidence in the audit profession. Instead, accounting firms reaped huge financial rewards while enforcing SOx, until the tremendous cost to America’s businesses forced regulators to lighten up and the auditors to stand down.
But SOx had another insidious byproduct: the misplaced belief that after Arthur Andersen’s implosion, the remaining four global public accounting firms were too important, and too few, to fail.
This fear of auditor failure precludes any regulatory or legislative actions that might precipitate the loss of another large accounting firm. What do you get when there’s no timely or significant regulatory consequence to repeated auditor malpractice and incompetence? Moral hazard. “Too few to fail” has been as detrimental to capital markets as the notion that some financial institutions are too big to fail. Shareholders are harmed and investors lose confidence.
Every one of the audit firms is a defendant in lawsuits for institutions that failed, were taken over, or bailed out, in addition to several $1 billion plus malpractice, fraud and Madoff-related lawsuits. Any one of these “catastrophic” matters could threaten their viability. However, regulators and the worldwide business community are ignoring this threat or, worse yet, promoting liability caps. Limiting liability only exacerbates moral hazard.
Can a crisis caused by “catastrophic” disruption in audit service delivery be any worse than the one they never warned us about? Why not face fears head on and start re-writing the audit blank check – ineffective audit opinions – before the plaintiffs’ bar does it for us?
- Is Any Other Audit Firm Vulnerable Besides Ernst & Young? Forbes, December 23, 2010
- Big 4 Bombshell: “We Didn’t Fail Banks Because They Were Getting A Bailout” re: The Auditors, November 25, 2010
- Lehman Brothers auditors to face second investigation BobsGuide, October 6, 2010
- Guest Post: Subprime Auditing – The Fox In The Chicken Coop The Auditors, September 3, 2010
Enron, audits and reform
- Source: Auditors' role in Lehmans collapse unites opposition in calls for reform The Guardian, March 16, 2010
Ernst & Young's attempts to brush aside criticism of its role in the collapse of Lehman Brothers has failed to deter critics of the profession. If anything, the accountancy firm has forged an alliance of disparate and usually antagonistic groups disturbed by the role it played alongside law firm Linklaters in providing "window dressing" for Lehman's risky financial structures.
Tory shadow chancellor George Osborne said yesterday he wants reform as much as Liberal Democrat treasury spokesman Vince Cable and Prem Sikka, the radical academic Prem Sikka, who has spent more than 20 years arguing that accountancy firms appear, like the Woody Allen character Zelig, in the foreground at every major corporate crash, only to fade from view when difficult questions are asked.
In their sights are the Big Four accountancy firms, Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers (PwC), which stand accused of charging excessive fees for work that appears to make little difference when things go wrong.
In the case of Lehmans, Ernst & Young was paid $31m. KPMG charged a similar amount for auditing Wachovia, the fourth largest bank in the US until the government forced its sale to Wells Fargo to head off insolvency.
In the UK, Royal Bank of Scotland paid its auditor, Deloitte ,£58.8m in fees in 2008; while PwC was paid £12m by Lloyds TSB in 2007 before its disastrous merger with HBOS, which in turn paid KPMG £9m.
One barrier to reform is the widespread belief that western capitalism cannot afford to see the Big Four reduced to three or two by scandals that result in long-running and costly lawsuits. In short, they are like the banks and too big to fail.
The collapse of Enron, the US gas company turned financial speculator, brought Arthur Andersen to its knees, after the firm was found aiding and abetting the company's use of off balance sheet vehicles. Andersen helped the company hide losses and shredded vital papers when regulators came looking for evidence. A flurry of class action lawsuits buried the accounting firm.
Aware that a similar incident could kill off another audit firm, the profession has lobbied on both sides of the Atlantic to limit their liability when faced by angry investors.
In July 2000, the government passed legislation allowing accountancy and law firms to become limited liability partnerships (LLPs).
Under the old rules, partners in a firm had been jointly and severally liable for the misdeeds of each other. A lawsuit against one was in effect brought against all partners in the firm.
Indemnity insurance rocketed as corporations got bigger and damages suits likewise. For instance, Ernst & Young was sued for £2bn damages for losses after Equitable Life almost went bust.
LLP status allowed firms to ring-fence lawsuits. Only the partner and the firm concerned could be sued, leaving the assets of other partners intact.
More recently, the profession, led by a former PricewaterhouseCoopers partner, Peter Wyman, persuaded the goverment to allow limited liability audit agreements further circumscribing the ability of investors to sue auditors in the case of a corporate failure.
Wyman, who retains an advisory role at PwC, is featured in a lengthy webcast on FinancialDirector.co.uk explaining the benefits of the agreements and how his efforts to persuade the US government to follow suit had failed. Ernst & Young's exposure as a central character in the collapse of Lehman has probably taken the issue off the agenda for several years. And without US agreement, no major corporation can press ahead and agree a deal.
As Wyman points out, all the biggest companies are registered with the Securities & Exchange Commission, the US equivalent of the Financial Services Authority, and the SEC is not budging.
Cap on legal payouts to investors
The profession has also been seeking a monetary cap on legal payouts to investors. Representatives from the Big Four accountancy firms met officials at the Department for Business, Innovation & Skills last spring, to argue that auditors risked going bust if a wave of litigation resulted from investors and liquidators trying to recover losses from big company failures.
Not only banks but a host of corporate failures could be blamed on the failure of auditors to spot rule breaches, excessively risky decisions or criminal behaviour.
Currently, an auditor can be sued for all losses when a company collapses, even if they were judged to be only partly to blame. The Big Four put forward a compromise solution, to limit an auditor's liability to the proportion of their client's loss they are considered responsible for. Under this proposal, shareholders could over-rule the arrangement with the auditors with a vote at an annual general meeting.
Tory MP Michael Fallon, who is deputy chairman of the influential treasury select committee, said he expected a report by the Financial Reporting Council (FRC), which is responsible for promoting confidence in corporate reporting and governance, to come up with reforms of the audit profession in the light of the banking crisis.
The FRC is due to publish its delayed report in the summer after spending more than two years consulting industry figures and the profession on changes to the role played by auditors.
The Institute of Chartered Accountants in England & Wales (ICAEW), the body that regulates the Big Four, among others, is also due to report on proposals to toughen the regime for auditors.
Robert Hodgkinson, an executive director at the ICAEW, said he was concerned that auditors had largely followed the approach agreed with investors and regulators but still failed to signal problems at companies that collapsed. The institute has already published a governance code for audit firms.
Fallon said the select committee was concerned at the transparency of audits of UK banks after the collapse of Northern Rock and the near demise of RBS and Lloyds Banking Group.
Vince Cable said the committee's investigation of Northern Rock showed that auditors should be banned from accepting any consultancy work.
"It is crystal clear that bank auditors should not take fees for other work because it will inevitably create conflicts of interest. But that is just a starting point to cleaning up the whole profession," he said.
A failure of the auditory nerves
The centuries-old system of auditing has long been criticised as too cosy and is once again under scrutiny for failing to spot problems at Lehmans.
Auditors going into a big bank will be led by an experienced partner from one of the Big Four accountancy firms: KPMG, Ernst & Young, Deloitte or PricewaterhouseCoopers.
The team will be made up mostly of trainee and junior accountants who will check the financial statements made by the holding company and its subsidiaries. They will take samples of transactions to satisfy themselves that staff are following accounting and reporting rules. They are also supposed to liaise with internal auditors, who are in effect in-house whistleblowers. However, auditors in times past have accepted transactions chosen by the company, and ignored the warnings of internal auditors.
Auditors are employed by investors to oversee the company and check its results represent a "true and fair" view of its finances. But the audit report is presented to the directors and any rows over potential financial discrepancies or misgivings about corporate practices are kept behind closed doors. If disagreement spirals out of control, auditors may refuse to sign off the accounts. The principles-based auditing in the UK is supposed to get round the box-ticking treatment of accounts in the US, which is deemed rigid and merely establishing that figures meet legal/regulatory rules. Yet investors in Lehman found that stricter US accounting rules prevented the sale and buyback schemes that disguised $50bn of its liabilities, while UK rules allowed them.
- Accountancy has forfeited its right to call itself a profession QFinance, January 24, 2011
- Barney Less Than Frank About Auditor Reform re: The Auditors , January 22, 2011
- The Case Against Ernst & Young: NY AG Cuomo Sues Over Lehman re: The Auditors, December 22, 2010
- Broader expertise needed to beef up internal audit Accountancy Age, December 15, 2010
- Deloitte’s Connolly: propping up bust RBS was more important than providing reliable data to markets IanFraser.org, November 27, 2010
- Lawmakers attack auditors over bank statements Reuters, November 23, 2010
- $100 Million Audit Trail System Proposed to SEC Securities Technology Monitor, August 9, 2010
- Discussion Paper AUDITOR SCEPTICISM: RAISING THE BAR The Auditing Practices Board, August, 2010
- PCAOB Ups Auditors' Double-Checking Duties CFO.com, July 16, 2010
- Critics question effectiveness of auditing oversight board Washington Post, July 11, 2010
- Asking The Difficult Questions: An Article About Audit Committees For The IIA’s Internal Auditor re: The Auditors, July 5, 2010
- Ernst & Young to face investigation over Lehman Brothers' audit BobsGuide, June 17, 2010
- Letter to Wall Street Reform and Consumer Protection Act Conference CFA Institute, Center for Audit Quality, June 15, 2010
- “Barney Less Than Frank About Auditor Reform” re: The Auditors, May 26, 2010
- Lehman Shareholders Amend Class Action Suit To Add Ernst & Young As A Defendant Financial Fraud Law, April 27, 2010
- Investigation Begins Into E&Y's Role In Connection With Lehman's Repo 105 Scam ZeroHedge, April 13, 2010
- My Commentary Part 2: Ernst & Young’s Letter To Audit Committee Members re: The Auditors, April 4, 2010
- All Points Bulletin: Big 4 Auditor Litigation Spans the Globe Going Concern, April 1, 2010
- De(constructing/functing) Ernst & Young ZeroHedge, March 14, 2010
- In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases? re: The Auditors, March 10, 2010
- Online Advanced Accounting Training