9 May

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1 9 May Steven Leonard Project Director, Audit & Assurance Codes & Standards Division The Financial Reporting Council 5th Floor, Aldwych House Aldwych LONDON WC2B 4HN Dear Steve REVISION TO ISA (UK AND IRELAND) 700 REQUIRING THE AUDITOR S REPORT TO ADDRESS RISKS OF MATERIAL MISSTATEMENT, MATERIALITY AND A SUMMARY OF THE AUDIT SCOPE IMA represents the asset management industry operating in the UK. Our members include independent fund managers, the investment arms of retail banks, life insurers and investment banks, and the managers of occupational pension schemes. They are responsible for the management of 4.2 trillion of assets, which are invested on behalf of clients globally. These include authorised investment funds, institutional funds (e.g. pensions and life funds), private client accounts and a wide range of pooled investment vehicles. In particular, IMA members manage holdings amounting to 34% of the domestic equity market. In managing assets for both retail and institutional investors, IMA members are major investors in companies whose securities are traded on regulated markets. Therefore, IMA has an interest in the requirements governing the audit of these companies financial statements and the auditor s report to its members as users. A main concern of investors is that the judgements made and processes followed during the preparation of the financial statements and their audit are often opaque. Specifically, many of the concerns investors have about the quality of audits are a product of the fact that they feel excluded from the audit process and real findings. Currently the only communication auditors have with investors is through an audit report which is of limited use with its binary opinion, pass or fail, and boilerplate, technical language. Investors would welcome a more enlightened audit report and we support the FRC issuing this consultation. The proposals are a significant step forward and go a long way towards enhancing the value of the audit report by requiring the disclosure of the auditor s assessment of the risks of material misstatement, audit materiality and how the scope addressed these matters. These additions would provide a helpful insight into the audit process and its adaptability, and help inform investors discussions with companies and their audit committees. However, there are aspects of the proposals where we have reservations and some investors question whether they go far enough. 1

2 We set out in the attached Annex our comments on the detailed questions and our main observations below. The proposals focus on the audit process but, as noted above, investors feel excluded from the real audit findings. These include an evaluation of: risks and controls; valuations; and write downs and impairments. Investors do not want dual reporting by companies and auditors in that it is the responsibility of the board/audit committee to disclose information on the judgments and valuations in the financial statements, and matters arising in the discussions with the auditor. However, investors would welcome auditors being required to give positive confirmation on the completeness and reasonableness of the board s audit committee s report. Certain investors would like auditors to go further than this and to disclose their evaluation of and information around the sensitivity of management s judgments and valuations. As part of auditors considering the risk of material misstatement, investors consider that where the accounting framework is based on the concept of neutrality, i.e. IFRS, auditors should be required to state explicitly in their report that the financial statements are a neutral representation of the position and performance of the entity. This is something the auditor has to judge during the course of the audit and making it explicit ensures that there is a lever to challenge management on too aggressive or too conservative accounting treatments. In this context, a number of investors believe that in order for financial statements to give a true and fair view, the underlying framework should be based on the concept prudence as opposed to neutrality. Thus instead of auditors considering the cumulative effect of a lack of neutrality, as required by A2 on page 20 of the Consultation Paper, auditors should address the effect of a lack of prudence. They consider this would link the auditor s report on the financial statements to UK company law and the true and fair view, as opposed to the IFRS conceptual framework, and ensure investors can better assess capital and management s underlying performance. Whist the proposed disclosures are welcome, investors would be concerned if they were to become boilerplate and aimed at ensuring compliance as opposed to being meaningful and tailored to a company s particular circumstances. We suggest this is something that the Audit Quality Review Team should keep under review in the future. We recognise that in enhancing UK requirements the FRC may help drive standards for auditor reporting internationally. In this context, we set out in question 2 our observations on the proposed scope. Specifically, the UK asset management industry invests internationally around 63% of all equities managed are listed overseas. Ideally corporate reporting and auditing standards should be harmonised internationally and in developing policy on auditing, the FRC should seek to influence the international agenda and ensure there is comparability globally as opposed to developing a separate regime for UK companies. Please contact me if you would like clarification on any of the points in this letter or if you would like to discuss any issues further. Yours sincerely Liz Murrall, Director, Corporate Governance and Reporting 2

3 Set out below are IMA s answers to the detailed questions raised Overall View 1. Do you agree that the auditor s report should include a description of the auditor s assessed risks of material misstatement, materiality and the audit scope? If not, why not? Many of the concerns investors have about the quality of audits are a product of the fact that they feel excluded from the audit process and real findings. Currently the only communication auditors have with investors is through an audit report which is of limited use with its binary opinion, pass or fail, and boilerplate, technical language. Investors are concerned over the lack of transparency around the audit process and would welcome a more enlightened audit report. Thus IMA welcomes the proposals for auditors to report: the identified and assessed risks of material misstatement which had the greatest effect on the audit strategy; on how the auditor applied the concept of materiality; and a summary of the audit scope and how it was responsive to these matters. The proposals are a significant step forward and would provide a helpful insight into the audit process and its adaptability. However, currently investors have little information not only about the audit scope but also the real audit findings. This includes an evaluation of the: risks and controls; valuations; and write downs and impairments. Investors do not want dual reporting by companies and auditors in that it is the responsibility of the board/audit committee to disclose information on the judgments and valuations in the financial statements, and matters arising in the discussions between the auditor and the audit committee. However, only auditors can report on their own work. Investors would welcome auditors being required to give positive confirmation on the completeness and reasonableness of the board s audit committee s report as opposed to the reporting by exception as required by the October 2012 changes to the ISAs (UK and Ireland). Some investors would like this to go further and for auditors to disclose their evaluation and sensitivity of management s judgments and valuations. 2. Do you agree that these proposals should be limited to entities that explain how they comply with the Code? If not, why not? We recognise that in enhancing UK requirements the FRC may help drive standards for auditor reporting internationally. In this context, the UK asset management industry invests internationally around 63% of all equities managed are listed overseas. Ideally corporate reporting and auditing standards should be harmonised internationally and in developing policy on auditing, we consider the FRC should seek to influence the international agenda and ensure there is comparability globally as opposed to developing a separate regime for UK companies. That said, in principle we agree that the proposals should be applied to the audit reports of companies that comply or explain against the UK Corporate Governance Code, i.e companies in the Premium segment of the Official List. However, we have some observations on this scope. The main focus of an audit report is whether the financial statements give a true and fair view. Companies listed on an EU regulated market have been required to prepare their 3

4 financial statements under international accounting standards, IFRS, since The proposed scope means that although the EU companies financial statements will be prepared under the same requirements, companies in the Premium segment will have a different audit reports from those listed elsewhere in the EU. Moreover, in recent years the Premium segment has increasingly included overseas incorporated companies that want access to the UK markets through a UK listing. Whilst these companies are required to comply or explain against the UK Corporate Governance Code, they often operate and are audited overseas. It is not clear how these requirements will be interpreted and implemented by overseas auditors potentially resulting in different audit reports in the Premium segment. Furthermore, today UK asset managers only hold around 34% of the UK equity market in that increasingly it is held by overseas investors. Whereas UK investors may understand the differences in the audit report, overseas investors may not necessarily do so which could cause them to be cautious in their asset allocation and impact companies ability to attract overseas finance. 3. (a) Do you consider that the provision of such information by the auditor will be of benefit to shareholders and other users of the financial statements and, if so, can you explain what those benefits would be and how they would arise? (b) Do you believe such information would provide an effective hook for investors and other users to start a dialogue with the company about the audit? Investors will value the additional disclosures of the risks the auditor has focused on in the conduct of the audit (question 3(a)). The proposed additions would provide useful information for investors to focus discussions with companies/audit committees on the audit (question 3(b)). 4. Do you believe that directors are likely to disclose information about the audit (of the type that would be required in accordance with these proposals) under the September 2012 changes to the Code? Is it more appropriate for such information to be provided in the auditor s report or by the board in the section of the annual report addressing the work of the audit committee, and why? A particular concern of investors is that the judgements made and processes followed during the preparation of the accounts and their audit are opaque and we would welcome the board or the audit committee addressing this. We believe the board or audit committee should disclose matters relating to the information in the accounts: accounts are the responsibility of the board. Whilst directors/audit committees could disclose matters arising in the discussions with the auditor, we do not believe they could disclose the information proposed on the audit process under the September 2012 changes to the Code in that only auditors can effectively report on matters that relate to their work. Assessed risks of material misstatement 5. What do you believe would be, if any, the benefits, costs and other impacts of the proposed requirement to describe in the auditor s report certain risks of material misstatement that were identified by the auditor? 4

5 We believe the benefits for investors of the audit report describing risks of material misstatement in terms of better transparency would outweigh any costs. In particular, any additional costs are likely to be minimal in that the proposals are simply a public statement on what the auditor does already. As part of auditors considering the risk of material misstatement, investors consider that where the accounting framework is based on the concept of neutrality, i.e. IFRS, auditors should be required to state explicitly in their report that the financial statements are a neutral representation of the position and performance of the entity. This is something the auditor has to judge during the course of the audit and making it explicit ensures that there is a lever to challenge management on too aggressive or too conservative accounting treatments. In this context, a number of investors believe that in order for financial statements to give a true and fair view, the underlying framework should be based on the concept prudence as opposed to neutrality. Thus instead of auditors considering the cumulative effect of a lack of neutrality, as required by A2 on page 20 of the Consultation Paper, auditors should address the effect of a lack of prudence. They consider this would link the auditor s report on the financial statements to UK company law and the true and fair view, as opposed to the IFRS conceptual framework, and ensure investors can better assess capital and management s underlying performance. 6. Do you agree that the basis for determining the risks of material misstatement to be described in the auditor s report (see proposed paragraph 16A (a) of ISA (UK&I) 700) is appropriate? We agree that the basis for determining the risks of material misstatement in the auditor s report is appropriate and allows the auditor flexibility to tailor the disclosure to the company s particular circumstances. Investors would be concerned if such disclosures were to become boilerplate and aimed at ensuring compliance as opposed to being meaningful and specific to a company s particular situation. We suggest the Audit Quality Review Team should review these disclosures in the future. 7. The risks disclosed by the auditor in complying with proposed paragraph 16A (a) of ISA (UK&I) 700 may well differ from the principal risks disclosed by the directors in the business review in the annual report. What are your views about this possibility? We believe the risks disclosed by the auditor in complying with proposed paragraph 16A (a) of ISA (UK&I) 700 should differ from the principal risks disclosed by the directors in the business review in the annual report. The directors disclosures focus on the key risks faced by the business as a whole whereas those disclosed by the auditor specifically relate to the risk of material misstatement and the impact that this has on the audit. 8. Do you believe that the omission from the auditor s report of a particular risk of material misstatement would pose a threat of significant loss or damage to the auditor if, after the event, it became evident that the risk had given rise to significant damage to the company? We consider it would depend on the circumstances whether an omission from the auditor s report of a particular risk of material misstatement would pose a threat of significant loss or damage to the auditor if, after the event, it became evident that the risk had given rise to 5

6 significant damage to the company. The auditor s judgement of the risk of material misstatement should be based on its perception up until the date the financial statements are authorised for issue as is required by IFRS. Each such event would need to be viewed on a case by case basis. Materiality 9. How do you assess the benefits, costs and other impacts of the proposed requirement to provide in the auditor s report an explanation of how the auditor applied the concept of materiality in planning and performing the audit, including specifying the threshold used by the auditor as being materiality for the financial statements as a whole, and the balance between them? Investors would find it helpful for auditors to disclose the level at which audit materiality is set and how it is used and this proposal is supported. This will enable investors to compare materiality year on year not only for the same company but between different companies. Investors would expect the threshold for materiality to differ for the financial statements as a whole and for particular disclosures such as those that relate to, for example, directors remuneration or related party transactions. However, the proposal appears to require the disclosure of both planning and performance materiality. Investors may not necessarily understand the difference between the two and to require both may only confuse rather than clarify. Summary of audit scope 10. How do you assess the benefits, costs and other impacts of the proposed requirement to provide in the auditor s report a summary of the audit scope, and the balance between them? Does the illustrative disclosure in Section 3 provide a sufficient explanation of how the audit scope was responsive to the auditor s assessment of risks and materiality? We believe the benefits for investors of the audit report providing a summary of the audit scope in terms of better transparency would outweigh any costs. In particular, any additional costs are likely to be minimal in that the proposals are simply a public statement on what the auditor does already. We assume that the scope with regard to particular subsidiaries, branches and joint ventures would reflect the auditor s assessment of the risks and materiality of each. These disclosures would act as a trigger for discussions about entities in the group. In principle the illustrative example is appreciated because it sets out how the auditor responded to the assessed risks and links back to the risk of material misstatement. Our concern would be if this was adopted as a template for reporting such that it became standardised. Avoiding standardised language 11. Do you believe that the wording of paragraph 16A and paragraphs A9A to A9Cis sufficiently principle-based so as to avoid standardised language IMA believes that the wording of paragraph 16A and paragraphs A9A to A9C is sufficiently principles-based so as to avoid standardised language. It is to be hoped that auditors that 6

7 disclose entity specific information will attract favourable comparisons with those that resort to standardised language. We suggest the Audit Quality Review Team should review these disclosures in the future. Effective date 12. Do you foresee any difficulty if the effective date is periods commencing on or after 1 October 2012? IMA welcomes these changes and would like to see them implemented soon. We understand that this date has been chosen to coincide with changes to ISAs and proposed new Guidance on Going Concern following the Sharman inquiry. 7