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  1. 1. AUDIT REFORM: A FOCUS ON PURPOSE AND TRANSPARENCY (December 2004) Introduction In February 2004, Morley Fund Management submitted its analysis1 on the state of audit and auditor liability to the Department of Trade and Industry (DTI). This called for the moves to change the liability regime applying to auditors to be suspended and only taken forward as part of and based on wider reform of the UK’s audit framework. Following its consultation and dialogue with interested parties the DTI has deferred moves to introduce further changes to auditor liability pending more detailed deliberations on wider audit reform and audit quality. In response to that development, this paper sets out a summary of the proposals that should be taken forward as part of those deliberations. The focus of these is three- fold: • to re-empower auditors to act more effectively in the interests of shareholders; • to ensure that they are clearly able to do so, free from the significant, conflicting pressures that have evolved; and • as an extension of the above, revive the audit’s value as a key shareholder protection framework. In the interests of (relative) brevity, we have not sought to articulate again all the trends and issues underpinning the need for these recommendations. These were covered in the earlier analysis of audit and auditor liability. 1 We recommend these proposals to Government, the Financial Reporting Council, the audit profession and other investors, as providing a clear basis for reform of the Statutory Audit and to support auditors in acting on shareholders’ behalf. Conceptual framework 1.1 Given the drive towards harmonisation and the adoption of international standards, recognition of the critical differences between the financial reporting and accountability frameworks of boards and auditors in the UK compared to the US2 is important when considering reform of the UK’s audit regime. In the US, despite attempts in the 1930s to adopt a framework similar to the UK’s, they have taken a divergent and fundamentally different approach. This reflects the limitations of Federal Law in its interaction with State Law. The US approach is based in Federal Law under the 1933 1 : “Bringing Audit Back From The Brink: Auditor liability and the need to overhaul a key investor protection framework” (February 2004). 2 : See “Where Economics meets the law – The financial reporting system of the USA compared to that of other jurisdictions” Tim Bush (2004), Hermes Focus Asset Management Ltd Morley Fund Management is a business name of Morley Fund Management Limited, registered in England No. 1151805. Registered Office: No.1 Poultry, London EC2R 8EJ. Authorised and regulated in the UK by the Financial Services Authority and a member of the Investment Management Association. Morley Fund Management is also a business name of Morley Fund Management International Limited. Both are Aviva companies. Telephone calls may be recorded for training and monitoring purposes.
  2. 2. Securities Act, which deals with the sale of securities, rather than in incorporation law (as in the UK) which is the preserve of State Law. Unlike in the UK therefore, the US system is not concerned with laws of property and rights but, rather, is primarily concerned with market pricing, a ‘general- purpose’ function. As a result the US system does not have the same governance and stewardship function, or system of accountability, as the UK’s. 1.2 The UK needs to retain and build on the existing approach to accounts and audit established under the UK Companies Acts, with its focus on accountability to and the interests of the ‘shareowners’. Any trend towards a more US styled model that does not embody this, either in the UK or through the EU, needs to be avoided. Auditors’ duty of care and purpose 2.1 Under the UK system, Statutory Auditors should play an essential role in the governance framework, with privileged access inside companies. In line with Company Law and the House of Lords’ opinion in the Caparo case, auditors need to act clearly and specifically on behalf of and in the interests of shareholders. It is the key function of auditors to inquire, so far as possible, into whether the financial information as to the company's affairs prepared by the directors accurately reflects the company's position and provides a true and fair view, in order: (i) to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing; and (ii) to provide shareholders with reliable intelligence on the company's affairs, that is timely, relevant and sufficient to enable shareholders to scrutinise management's conduct and disclosures and to exercise their collective powers through general meetings. This focus should be clearly embedded at the heart of the UK’s audit framework and explicitly integrated into related standards and best practice. 2.2 It is important that regulators and those developing best practice standards ensure that this fundamental focus can no longer be compromised by the intervention of other interests, whether commercial or corporate in origin. 2.3 The current trend amongst some advisers and companies to intercede in or abrogate this responsibility is illustrated in the following extract from a FTSE 100 company’s audit committee terms of reference: “In executing [its] responsibilities the duties of the [Audit] Committee shall be …in relation to the external audit… to ensure that it is clear that the external auditor is ultimately responsible to the Committee and the Group Boards, as representatives of the shareholders” Auditor independence
  3. 3. 3.1 Following on from the above, the UK framework needs to ensure that auditors are clearly supported in exercising and evidencing the necessary professional judgement, critical approach, level of objectivity and ability to expose weaknesses, that is reasonably expected of them. 3.2 In that context auditor independence and the related professional and ethical standards are particularly important and must support auditors in: (i) focussing on acting with integrity, exercising objectivity and professional scepticism; (ii) doing so in the clear interests of the audit’s beneficiaries (the shareholders), free from those pressures (e.g. management pressure) and other factors (e.g. commercial conflicts) that might or do compromise the auditors’ ability to make robust and unbiased decisions; and (iii) ensuring that discovered breaches, and other matters of emphasis or concern etc, are reported (see section 7 below). 3.3 In this context, directors‘ control of the appointment and removal of auditors needs to be revisited (see sections 4 and 5 below). The level of direct or indirect management control or coercion that arises from the current arrangements must be recognised for the issue that it is. This may particularly be an issue where the revenues are significant to a business unit in the accounting firm or the individual audit partner in question. Appointment of Auditors 4.1 Consideration should be given to the introduction of alternative arrangements for the appointment and oversight of auditors. A number of proposals have been suggested in the ongoing debate and the practical merits of these should be looked into with a view to addressing the kind of problems alluded to in, say, section 3 and 5, as well as paragraph 4.2(iv) of this paper: (i) drawing on other European experience, e.g. from Sweden, shareholders representing at least ten percent of the issued shares, or one-third of the shares represented at a general meeting, can move that a special auditor be appointed for one year; as well as others: (ii) by a shareholder panel that acts as an oversight body for the audit; or (iii) that auditors be appointed by a regulator (e.g. the FRC or the FSA); 4.2 In addition, the following measures should be introduced: (i) disclosure of terms of engagement and related matters ahead of the shareholder vote to (re)appoint the auditor;
  4. 4. (ii) disclosure of key tests/limitations to be used by the auditor e.g. how ‘materiality’ will be approached and defined, as well as the guidelines and approach used in determining the significance of accounting items and errors; and (iii) clarity on how any areas the auditors identify as requiring additional investigation/scrutiny should subsequently be agreed and funded. Resignation and removal of Auditors 5.1 Clarity is also required on the reasons for a parting of the ways between an auditor and a company. Current Section 390 letters (Companies Act 1985) do not necessarily provide the coverage required nor do the ‘statement of issues’ disclosures work effectively – this needs to be overhauled. 5.2 Consideration needs to be given to what other information is required to ensure shareholders have a proper understanding of the reasons for auditor turnover. This must not be limited to an obligation on auditors; it needs to apply to companies as well.3 Auditor accountability 6.1 A key theme of the auditor’s duty shareholders is accountability. As part of the focus on providing ‘reliable intelligence’, the right of shareholders to ask appropriate questions of the auditors needs to be clearly established. In this regard, the UK should look to introduce a mechanism similar in essence to Section 250 of the Australian Corporations Act 2001 that enables shareholders to put questions to the auditors. This should, however, go further for UK purposes to avoid some of the limitations of that Antipodean framework. 6.2 In summary, the Australian approach allows a member (shareholder) of the company to submit a written question to the auditors that relates to the content of the auditors’ report to be considered at the AGM or the conduct of the audit of the annual financial report to be considered at the AGM. This must then be made available to shareholders attending the meeting. The company is obliged to allow: (a) the auditors a reasonable opportunity at the AGM to answer the written question(s); and (b) shareholders to ask the auditors general questions about: (i) the conduct of the audit; (ii) the preparation and content of the auditors’ report; 3 : In recent case, involving a well known UK plc, management uncovered an unacceptable, previously undisclosed and potentially material conflict of interest at the audit firm involving competing bids for an acquisition that led to the auditor being changed. The issue only came to light after proactive engagement with the company.
  5. 5. (iii) the accounting policies adopted by the company in relation to the preparation of the financial statements; and (iv) the independence of the auditors in relation to the conduct of the audit. 6.3 The scope of such an arrangement should be extended to cover all work undertaken by the auditors on an audit client, including work on internal controls and the OFR. It is frequently argued that there are particular synergies and benefits from having the Statutory Auditors undertake other non-audit work and by extension this should be reflected in the scope of shareholders’ ability to submit written questions. Auditor reporting 7.1 Given the importance of the focus on shareholder interests, there should a specific requirement for auditors always to attend listed company AGMs and to be heard in any part of the meeting that concerns the audit/auditor. This should apply even where the board has ‘removed’ the auditor or the auditor is retiring/resigning. 7.2 The UK should re-introduce/reinforce and enhance ‘matters of emphasis’ reporting. It not clear what has happened to the alternative opinions that seemed to be used, albeit infrequently, until the early 1990s. These non-standard audit reports broke down into 4 types: (i) Inability to give an opinion because of a fundamental matter of uncertainty, i.e. a total disclaimer. (ii) Inability to give an opinion on a material issue of uncertainty, i.e. subject to caveats, confirmation could be given. (iii) Inability to give an opinion on a fundamental issue of disagreement, i.e. in light of said issue confirmation could not be given. (iv) Inability to give an opinion on a material issue of disagreement, i.e. excluding said issue, confirmation could be given. A healthy, vibrant audit market would have built on and enhanced this framework, both in relation to unqualified and qualified opinions, rather than reducing it to the point where such caveats are rarely seen. This is an area where appropriate clarification and guidance is needed. 7.3 Auditors should provide affirmative confirmation that to the best of their knowledge the company has applied/complied with the accounting policies it has disclosed and outline any overrides or departures. 7.4 The Audit Engagement Partner should personally sign the audit report.
  6. 6. 7.5 In looking further at what the Caparo duty on the provision of “reliable intelligence” would entail in practice, one key aspect is for the audit standards and report to be enhanced (recognising the need to ensure an appropriate balance between management disclosure and auditor reporting) to bring clarity of reporting on: (i) Changes in accounting policies and their effect on financial statements. (ii) Explanations of deviations in cashflow and earnings. (iii) Issues around revenue recognition and earnings management. (iv) Key assumptions being used, changes to them and any inconsistencies. (v) Identification of any grey areas of interpretation and the issue they raise. (vi) Any other issues of potential concern (e.g. ‘old’ Cable & Wireless – lien over cash and segmental reporting / e.g. ‘old’ Marconi – lien over cash and option hedging exposures). (vii) Effects of changes in treatment on executive remuneration (many share schemes rely on, for example, EPS that is a key focus of accounting manipulation. (viii) Any area where the auditor could not obtain all the information it required. (ix) Disclosure of areas/issues which the auditor felt would have been appropriate to shareholders’ interests to investigate further, but was unable to undertake that work (e.g. time constraints or a refusal to fund the extra work required), perhaps linked to enhanced matters of emphasis reporting4. (Anecdotal evidence from auditors is that this issue does arise and cause problems). (x) Any other concerns that the auditor has that have not been addressed that are relevant in relation to the duty and purpose outlined in paragraph 2.1 above. (xi) Any non-GAAP measures disclosed and used by management, along with a comparison with GAAP (e.g. embedded value or various of the adjusted earnings measures). (xii) Enhanced ‘matters of emphasis’ reporting (see paragraph 7.2 above) 4 : See paragraph 7.2 above
  7. 7. 7.6 The ‘Management Letter’ submitted to the Audit Committee or Board, by the auditors, should be made available to shareholders. Before the Cadbury Committee Report (1992), the Management Letter generally contained minor housekeeping points only, on the basis that anything else was relevant for shareholders. It was also issued after the accounts were signed off, which had the implicit effect of ensuring it did not become a "private" auditors' report to directors, that might bury bad news. This sadly no longer seems to be the case. 7.7 We suspect that the management letter has become a surrogate for matters of emphasis, internalising issues that should arguably have been flagged and addressed to shareholders. This is another facet of the concerns reflected in paragraphs 2.2. and 2.3 above. This problem is illustrated in the Management Letter that was published in the DTI inspectors’ report on the failure of Transtec plc. The clues about the problems that brought the company down can be found in that ‘private’ report. 7.8 There is an increasing regulatory focus on reducing reporting periods, which is another US trend. However, this puts stress on the quality and delivery of audits. The reality is that on any balance sheet the riskiest items are those that are not settled e.g. stock, debtors etc. and this trend means there is less time for things to come out in the wash. What appears to happen in the US is that November is audited, then December is "rolled forwards" - fine if nothing happened in December. Looking back it is worth noting that ‘old’ Cable and Wireless was the fastest reporter in the FTSE100 in 2002. The effect of proposed changes to the reporting cycles on the delivery of effective audits should be considered. Auditor Liability 8.1 In respect of the question of liability, the creation of an appropriate framework that satisfies the focus in Caparo and ensures reliable intelligence is provided to shareholders, would provide a proper basis from which to consider this issue. We recommend the use of safe-harbour provisions that limit liability on a proportional basis where auditors had acted promptly, in line with the framework outlined in this paper. 8.2 In addition, the current scope under the Companies Act for management to pressure/accuse the auditor on defamation, using shareholder funds, needs to be examined and appropriate steps taken to ensure that it does not hinder or inhibit the provision of “reliable intelligence” to shareholders as per Caparo. Auditors should be protected from defamation suits by management where they are providing information in good faith. This issue needs to be addressed for needed enhancements to auditor’s accountability (e.g. scope for shareholders to ask questions) and reporting (e.g. audit reports, resignation letters) to be effective. Professional development and structure 9.1 Within reason, the key driver for investors is quality rather than cost. In that context, there would be merit in the oversight bodies and the profession itself, reviewing whether the arrangements around remuneration, retention and development of audit staff are appropriate to deliver and maintain what should be
  8. 8. the ‘gold standard’ of the profession. The impending transition to IFRS has highlighted instances where some of the more advanced companies have flagged surprise over their auditor preparations, with audit staff being felt to have lagged behind the company’s own internal training and transition programs. Other 10.1 Consideration should be given to the accounting treatment of the cost of the statutory audit. This could be taken below the line, rather than above the line as at present. It is after all a ‘shareholder’ cost. 10.2 Are people truly satisfied that an incoming auditor has full access to the previous auditor’s engagement files and working papers? Arrangements should be put in place to ensure work done for and on behalf of shareholders is passed on to their incoming advisers. (December 2004)