Auditor independence

By Andrew Hay and Tony Lalor.

Key Points:
Although they've been flagged for some time, new auditor independence requirements may have a significant impact on the audit profession and its clients.

One of the key elements of CLERP 9 is the reform of audit requirements and the introduction of auditor independence standards.

The reform implements recommendations from the Ramsay Report, which focused on the importance of auditor independence, and recommendations contained in the HIH Royal Commission Report. A key objective of the reforms is to promote the exercise of objective and impartial judgment in relation to the audit of audited bodies. However, most of the reforms only apply to listed companies and listed registered managed investment schemes.

Reforms - listed companies and listed registered managed investment schemes

Mandatory auditor rotation - listed companies and schemes only

There will be mandatory rotation of individual auditors, or lead or review auditors in audit firms or audit companies, every five financial years, unless ASIC relief is obtained, with a two financial year cooling off period before reassignment to that audited body.

Specifically, the Act prohibits individual auditors or lead or review auditors in audit firms and audit companies playing a significant role in the audit of an audited body for more than five successive financial years, or five out of seven successive financial years. A person 'plays a significant role' if they prepare an audit report (for an individual auditor) or act as lead or review auditor (for an audit firm or audit company).

Importantly, rotation will only apply to individuals and not audit firms or audit companies as a whole. However, obligations are placed on audit firms to ensure that their members, and on audit companies and their directors to ensure that their employees, do not contravene this prohibition and comply with the rotation obligations. Interestingly, an audit firm, audit company or a director of an audit company may not breach their obligations under the Act if they can show that the firm or company had in place a quality control system at the relevant time which provided reasonable assurance - taking into account the size and nature of the audit practice - that the firm or company and its employees complied with the Corporations Act requirements.

The auditor rotation requirements will apply to the audit of financial years that begin on or after 1 July 2006.

Restrictions on persons becoming officers of audited bodies

There are restrictions on the following particular persons joining an audited body for which they are engaged to do the audit (not being a small proprietary company) or, in the case of listed companies, a related body corporate of an audited body:

• members or directors - if a person was a member of an audit firm or director of an audit company, and was a professional member of an audit team for an audited body, the person will be subject to a two year "cooling-off" period before they can be appointed as an officer of that audited body.
• professional employee - if a person was a professional employee of an audit company and lead auditor or review auditor of an audit company (but was not a director), the person will be subject to a two year "cooling-off" period before they can be appointed as an officer of the audited body.
• multiple former members or directors - if a person was a member of the audit firm or director of the audit company they cannot become an officer of the audited body if another person, who has (at any time) been a member of the audit firm or director of the audit company and undertaken an audit of the audited body, is already an officer of that audited body. There is no "cooling-off" period prescribed by the Act.

Employment and financial relationships

Employment and financial relationships between an auditor and an audited body will be further restricted in order to promote 'independence' between the auditor and audited body.

For example, an auditor will be prevented from engaging in audit activity in relation to a company where:

• a service company or trust or other entity acting for or on behalf of the auditor owes more than $5,000 to the company or related body corporate or an entity that the company controls; or
• a service company or trust or other entity acting for or on behalf of the auditor owes or is owed an amount under a loan by, or is liable or entitled to the benefit under a guarantee of a loan to, the company or related body corporate.
• an employee has provided non-audit services to the company during the period to which the audit relates or for the 12 month period immediately before the beginning of the period to which the audit relates exceeding 10 hours and holds an asset (for example, shares) as an investment in the company.

The list of restrictions is quite far reaching and includes a review of the partners and immediate family of the restricted person.

Disclosures and declarations

Auditors will be required to provide directors with a signed declaration of independence in relation to each annual or half-year financial report audit or review conducted.

This will state that they have maintained the auditor independence requirements in relation to the auditor review. The declaration must appear in the audit report which is given to the directors. The annual directors' report must also include a copy of the declaration.

For their part, the annual directors' report will have to disclose all non-audit services provided by an auditor and the fees applicable for each item of the non-audit service.

The directors will also have to state that they are satisfied that the provision of non-audit services does not compromise the independence of the auditor and their reasons for reaching such an opinion.

Attendance and questions at AGM

The lead auditor for a listed company or his/her representative will be required to attend the AGM and answer questions relevant to the conduct of the audit and the content of the auditor's report.

Members entitled to vote may submit written questions to the auditor (through the company) at least 5 business days before the AGM. The auditor will then compile a list of questions for the company. That list must be available to members attending the AGM.

At the AGM, members must also be given a reasonable opportunity to ask the auditor or his/her representative questions about the conduct of the audit, the preparation and content of the auditor's report, the accounting policies adopted by the company, and the independence of the auditor. The chair must also allow reasonable opportunity for the auditor to answer the written questions submitted prior to the AGM. The auditor has the option to table written answers to the written questions and such written answers must be made available to members as soon as practicable after the AGM.

General standard of auditor independence

A general standard of auditor independence will be introduced.

This is aimed at prohibiting an auditor from engaging in any audit activity where there's a conflict of interest.

A conflict of interest situation will be determined using an objective test of what a reasonable person might conclude is independence (see below) and whether the person is capable of exercising objective and impartial judgment in relation to the conduct of the audit. In determining whether a conflict of interest exists, consideration needs to be given to each of the individual auditors, the audit firm and current/former members or the audit company and current/former directors and their relationships with the audited body.

The individual auditor, audit firm or audit company (or director) is required to give ASIC notice of the conflict of interest situation within 7 days after they become aware the situation exists ("start date"). If the individual auditor, audit firm or audit company (or director) fails to notify ASIC within 21 days of the start date that the conflict has been resolved, their appointment as auditor of the audited body will immediately cease.

It is important to note that it is a defence if the individual, audit company (or director) or audit firm can show that they had reasonable grounds to believe a quality control system existed which provided reasonable assurance (taking into account the size and nature of the audit practice/audit firm or audit company) of compliance with the requirements under the Act.

Finally, in relation to both company and scheme audits, the Act provides a positive obligation on individual auditors and lead auditors of audit companies and audit firms to notify ASIC in circumstances where:

1. they have reasonable grounds to suspect there has been a contravention of the Act; or
2. an attempt has been made by any person to unduly influence, coerce, manipulate or mislead a person in the conduct of the audit; or
3. there is or has been an attempt to interfere with the proper conduct of the audit.

Impact

The CLERP 9 reforms as they relate to auditors are an attempt at addressing the audit issues that have received worldwide attention. Some potential issues are discussed below.

The mandatory auditor rotation and prescriptive auditor independence provisions may have an impact on audit industry requirements as well as audit quality and competence. This will be more likely in smaller cities and regional areas. It has been argued that these requirements may force bodies to resort to auditors of less expertise and competence, resulting in audits of poorer quality. In addition, smaller firms may neglect to use co-auditors in audits to ensure that business is not lost after a mandatory rotation passes.

Audit committees for listed and unlisted companies will need to apply and monitor the independence test to their situation. Audit committees will also need to assess the impact of the Act on their particular company, and implement plans to ensure compliance when the Act for the reporting years commencing on or after 1 July 2004.

Company secretaries will need to action the requirements for annual reports and AGMs:

• inclusion of the Auditor Independence Declaration in the directors' report;
• disclosure of non-audit services;
• provision of auditor questions to auditors and in turn, provision of a list of questions to attending shareholders before an AGM;
• allowing reasonable time for shareholders to question auditors at AGMs (notices of meeting should include details of the question time for auditors).

The provisions allowing shareholders to question auditors at AGMs will increase the accountability of auditors and increase the costs of AGMs for public companies and schemes.

There is also concern that the Government has overlooked commercial and industry needs in tightening the employment and financial relationship restrictions. For example, restrictions on the provision of non-audit services may result in increased costs and decreased effectiveness of accounting services for audited bodies.

Overall, it is expected to be more complicated and costly for auditors and audited bodies to monitor compliance with the increased number of specific auditor independence requirements. This may also lead to problems in the supply of auditors.