Robert Hodgkinson Project Director, Audit Firm Governance Working Group ICAEW Chartered Accountants' Hall PO Box 433 Moorgate Place London EC2P 2BJ

Transcription

1 Our Ref NJJ/SAM/FIRM GOVERNANCE Your Ref AUDIT FIRM GOVERNANCE Robert Hodgkinson Project Director, Audit Firm Governance Working Group ICAEW Chartered Accountants' Hall PO Box 433 Moorgate Place London EC2P 2BJ 30 January 2009 National Office Grant Thornton UK LLP Grant Thornton House Melton Street London NW1 2EP T +44 (0) F +44 (0) DX 2100 EUSTON Dear Mr Hodgkinson Evidence gathering consultation paper: Audit Firm Governance We welcome the opportunity to comment on the evidence gathering consultation paper. Grant Thornton promotes effective corporate governance As one of the leading firms which audit public interest entities Grant Thornton has a strong commitment to effective corporate governance. We believe that good corporate governance practices are vital components in maintaining successful and sustainable entities, be they listed companies and other public interest entities or the firms which audit them. Moreover, we believe that transparency of those corporate governance measures are an important aspect of providing ongoing confidence in the capital markets. We are supportive of a code of corporate governance for audit firms but any such code faces important challenges We are enthusiastic to contribute towards this consultation. We would be pleased to see an effective and proportionate code of governance for audit firms emerge. However, we believe there are important challenges to ensure that any code which does emerge fulfils the objective of building confidence in auditing and the capital markets. The challenges include: the genesis of the Murray Committee is the policy objective to reduce the excessive concentration of large company audits on a small number of audit firms which the final report of the Market Participants Group (MPG) envisaged would " mitigate the risks arising from the characteristics of the [UK public interest audit] market". The MPGs recommendations were made within the overall context of ensuring that audit quality and the needs of investors and share owners are seen to be of paramount importance. The impact of any audit firm governance code must be focussed clearly on this policy objective and not be allowed to become an amalgam of "good ideas" that some commentators should be included for other reasons; similarly, while the Committee is likely to draw on codes in other areas of business, for example the Combined Code applied to listed companies, there must be clarity of thinking in ensuring that any audit firm governance code avoids the temptation to borrow aspects of codes designed for different purposes and which apply to entities with different ownership and governance structures from audit firms, without being satisfied that they will prove to be effective in the context of audit firm governance. A Chartered Accountants B Member firm within Grant Thornton International Ltd C Grant Thornton UK LLP is a limited liability partnership registered in England and Wales: No.OC Registered office: Grant Thornton House, Melton Street, Euston Square, London NW1 2EP D A list of members is available from our registered office. E F Grant Thornton UK LLP is authorised and regulated by the Financial Services Authority for investment business.

2 We support the Committee's view that any code of governance should be specific to the needs of audit firms and the users of financial statements In this context we strongly support the proposal of the Committee to produce a code specific to the needs of audit firms and those who use audited financial statements and not to bolt an audit firm governance code onto the Combined Code. The Combined Code has evolved from agency theory as a means of helping to protect the needs of investors in listed companies where usually there is a separation of ownership and management. Most of the larger audit firms already have in place governance arrangements which protect any conflict between the needs of the owners, ie the partnership at large, and management, ie the small leadership teams which determine day to day decisions in pursuit of the firm's objectives. Any new code should recognise the large amount of existing disclosures made by leading firms about their corporate governance arrangements Almost all leading audit firms in the UK have established LLP or limited liability company structures which require publication of audited financial statements and other related disclosures. As part of the Coordinating Group on Audit and Accounting issues (CGAA) review of the UK audit profession after the collapse of Enron most of the leading firms also made undertakings to the Secretary of State for Trade and Industry,, to publish certain information on a voluntary basis. This includes, inter alia, information about their ownership and relationships with international organisations, independence and quality processes and their governance arrangements. To some extent, these disclosures have now been brought into statute via the UK's implementation of Article 40 of the European Commission's Statutory Audit Directive. Transparency of audit firms is further enhanced by public reporting of Audit Inspection Unit (AIU) findings on inter alia firm-wide procedures. While the firms incur considerable cost and effort to make these disclosures they are not necessarily widely understood or read by market participants. It would be a useful output of the Committee to increase awareness of market participants of these existing disclosures and to ensure that any new code avoids unnecessary duplication. There are three detailed objectives, within the overall policy objective of reducing concentration while maintaining and building audit quality, against which any new audit firm governance code should be measured Building on our earlier statement that the genesis of the Committee is the policy objective of reducing the excessive concentration of large company audits on a small number of audit firms (within the context of primacy of audit quality and investor and shareowner needs), there appear to us to be three detailed objectives of an audit firm governance code. We believe that any new code, and its constituent parts, should be rigorously benchmarked against these detailed objectives and rejected as not fit for purpose unless they pass one or more of the following tests: will the code make a meaningful contribution to quality so as to reduce the risk of a firm being associated with a corporate failure in which audit failing is perceived to have played a part? will the code prevent unwarranted premature failure of a firm that is associated with an actual or alleged audit failing? will the code help to promote a net increase in choice from a wider range of audit firms? While we support the eventual emergence of a new audit firm governance code which we believe could answer affirmatively to these questions, we strongly believe it would be regrettable if the regulators and other market participants failed to take other measures which we believe would advance those objectives significantly more quickly than the time required Page 2

3 for a new audit firm governance code to emerge. Regulators and market participants should pursue other measures, alongside development of a code, which would significantly advance the detailed policy measures outlined above We believe there are three measures which should be pursued urgently alongside development of a code on audit firm governance: Improving governance disclosures to bring about a further improvement in audit quality and encourage participation in the listed company audit market from a greater number of firms - Investors and audit committee chairs should use the results of the AIU's findings on individual audit firms in assessing audit quality on appointment and re-appointment decisions Grant Thornton is one of the few audit firms which has consistently called for the overall findings of the independent AIU findings to be made public and we welcome the recent development of the FRC to put the reports on individual firms into the public domain. We believe that this measure could bring about over time both a continued improvement in audit quality and also stimulate greater choice by enabling firms such as Grant Thornton to compete on the basis of actual audit quality rather than perception. We recommend that through its work the committee strongly encourages investors and audit committees to use the AIU findings on firms to help in auditor appointment and re-appointment decisions. While asking firms to explain how they communicate AIU findings to market participants could be part of the output of a code, we believe it would be regrettable if the committee and market participants fail to pursue this matter until a code is developed. Implementing an effective policy measure to reduce the risks of further concentration in the listed company audit market - Regulators should address the failure of the Companies Act 2006 to bring about reform of auditor liability in practice in the listed company sector The policy intention of Government to bring about liability reform has to date largely failed in the listed company sector (from where a claim causing the destruction of a large audit firm is most likely to emerge). We do not believe anything in a code could achieve this objective as effectively as statutory intervention. We recommend that the committee asks the regulators and Government to address this policy failure and consider bringing forward appropriate liability reform via statute. We recognise that this measure is most likely in the short term to have an impact in avoiding further concentration, ie the loss of one of the four largest audit firms, rather than a longer term aim of increasing choice. We further recognise that policy measures should avoid promoting the idea that a firm is too big to fail if it suffers from systemic or cultural weaknesses that seriously impair audit quality. We believe that the most appropriate liability regime is one which is based upon proportionate liability, ie one in which each party bears responsibility for its share of a loss caused by a company failure, possibly supplemented by a cap based upon a multiple of the audit fee. Implementing an effective policy measure to remove a serious barrier to entry into the listed company audit market - Regulators should work with banks and other finance providers to amend the practice of inserting private covenants in lending arrangements that serve to protect the market position of the largest four audit firms In our opinion, currently the largest barrier to entry into the listed company audit market is private covenants built into many loan and other funding agreements which seek to restrict the choice of audit firms which the company can appoint regardless of assessments of audit Page 3

4 quality. We believe that action by regulators and certain market participants to make meaningful change to this practice would be the most effective means of significantly reducing concentration levels and would lead to some reduction in concentration almost immediately. We recognise that to a large extent these three policy suggestions are outside the direct ambit of the committee's terms of reference. However, we believe that if regulators and market participants were to fail to act on these three issues alongside the development of an audit firm governance code, and instead were to hide behind the work of the committee, then there would be a danger that in due course the development of a code, an objective we support, would be seen to have obstructed meaningful reform and improvements in the very areas that are the objectives of the committee's work. We therefore urge the committee, in addition to developing an audit firm governance code, to discuss these three suggestions with regulators and other market participants. Other key observations We suggest that it is too early to consider a comply or explain basis for an audit firm governance code Despite the many initiatives taken by leading audit firms in developing and publishing their governance arrangements in recent years, development of best practice is still emerging. For example, Grant Thornton is exploring the issue of appointment of independent, external directors. However, there are important issues to consider, such as: should such appointments start with the UK firm or at the international organisation level? what is the appropriate board upon which such directors should sit (eg the leadership board or the governance board)?; and what are the appropriate attributes of such people? We believe that firms should feel free to develop their thinking in these areas without feeling constrained by a code. Therefore, we believe it is too early for a code to be introduced on a comply or explain basis, as increasingly this can be viewed as "comply or else". We believe that it would be more helpful in the short term for a code to be brought forward in the form of a list of questions for the firms to address eg "How have you ensured that direction of audit policies is influenced by independent, external thinking and views of the investor community?" In due course, once more ideas have been tested in practice, then we agree that a code could be modified to a comply or explain basis. Requiring further additional disclosures of complaints and claims could seriously damage audit firms and defeat the underlying objectives of the committee. We are very concerned about the suggestion that audit firms could be asked to disclose additional information about claims and complaints. The audit firms already publish audited financial statements which contain information where appropriate about provisions and contingent liabilities in respect of claims. In our view, any disclosure requirements, beyond those currently in UK law and accounting standards, risk proliferation of speculative claims which could be damaging to the capital markets and not just the firms. We are also concerned that such enforced disclosure could offend against natural justice, as we believe the negative consequences to a firm of greater disclosure before it has had the opportunity to defend its position, outweigh any public interest benefit. Some years ago, we made the equivalent point is respect of the Financial Reporting Review Panel (FRRP) ie that the FRRP should not disclose open investigations because the potential adverse consequences on the companies Page 4

5 concerned would outweigh any public interest benefit. We support the objective to increase net choice in the audit market, and we support a code of governance of audit firms but without a "comply or explain" requirement. In this way we believe the code will avoid hypothetical procedures and will be a positive influence for desirable behaviour. Should you have any questions about any part of this response letter, please contact either myself or Nick Jeffrey ( nick.jeffrey@gtuk.com; phone ). Yours sincerely Steve Maslin Partner, Head of External Professional Affairs For Grant Thornton UK LLP T F E Steve.Maslin@gtuk.com Page 5

6 Consultation questions We do not believe that the Audit Firm Governance project should proceed along a course which is too closely aligned with the Combined Code on Corporate Governance. The Combined Code is designed to protect the interests of owners, whereas the Audit Firm Governance Code has objectives which are quite different. Therefore we answer the specific questions from the consultation paper in that context. Stakeholders of firms that audit public interest entities Question 1: Which groups of stakeholders do you think the Audit Firm Governance Code should primarily serve and in what ways, if any, do they have differing interests? Grant Thornton response: The Code must be absolutely clear that it relates to national firms, and not international networks, and that the Code is written for use by stakeholders. The Audit Firm Governance Code should primarily serve investors, and audit committees. Investors are likely to be more concerned with the wider public interest, whereas audit committees will be more immediately focused on issues which are directly relevant to appointment of their auditor. Risk management Question 2: What approach should a Combined Code-style Audit Firm Governance Code adopt to risk management and internal control? Grant Thornton response: The Audit Firm Governance Code should adopt a high level, principles-based approach to risk management and internal control which should be entirely consistent with disclosure requirements for a Transparency Report. Question 3: To what extent do the firms face unique issues in discussing their principal litigation and claims risks without causing damage to the sustainability of the firm? Grant Thornton response: Conceptually the issues facing audit firms are no different to corporate entities, and the issues of interest to stakeholders in audit firms will by and large mirror those issues of interest to stakeholders in corporate entities. However, it is clear that in recent years, in a climate of unlimited liability, audit firms have been more susceptible than many other sectors to speculative claims, which follow the "deep pocket" theory. Consequently in this regard audit firms should face disclosure requirements which are no different to corporate entities. In our view the Audit Firm Governance Code should not impose disclosure requirements on claims and complaints, but if it does refer to claims then the disclosure requirements should no more extensive than those required by IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Question 4: Do you agree that the Audit Firm Governance Code should focus on risk management and internal control of the firm as a whole including its non-audit business and, if not, what alternatives would you propose? Grant Thornton response: Risk management and internal control are of primary interest to owners, and so in our view reference in an Audit Firm Governance Code to risk management and internal control is not appropriate. However, if internal control and risk management is referred to then the requirements of the Code should be no more prescriptive than the disclosure requirements of Article 40 to the European Commission's Statutory Audit Directive which relates to the auditor's Transparency Report. Page 6

7 International structures of the firms Question 5: In the case of a UK firm that is part of a regional or an international structure, should the Audit Firm Governance Code specify the level at which it is applicable or should the firm be given some discretion to determine the level at which it applies the Code, explaining why this level has not been chosen? Grant Thornton response: Our preference is that the level of applicability should be left to the reporting entity's discretion. However if the Audit Firm Governance Code were to contain a required level then the requirement should go no further than the UK registered audit firm. Under most or all current structures of the international organisations in which large audit firms are members, it would not be possible for the UK firm to impose the requirements of code outside of that UK firm. Question 6: Do you think that the Audit Firm Governance Code should contain code principles and/or code provisions covering an audit firm's dependence on, and exposure to the risks of, other network members and how it ensures consistent quality and application of auditing standards? Grant Thornton response: We believe that there is a limit to what it is possible for a UK Code to impose in this area. On auditing standards the UK audit firm is responsible only for consistent quality and application where it is the primary group auditor and to the extent that it is required to consider quality and audit procedures of other group auditors by ISA 600 Using the work of another auditor. The Transparency Report typically will discuss structure of international network, network protocols and procedures designed to enhance cohesive service, quality and consistent application of global audit methodology. Our interpretation is that the consultation paper is suggesting that users would want to know the potential impact on the UK firm if fellow network member firms were to fail. We believe that most firms will elect in transparency reports to provide such information. Governance structures and independent non-executives Question 7: In principle, do you think that the Audit Firm Governance Code should support the appointment of independent non-executives by the firms and, if so, what might it say on the number or proportion of non-executives and their position, role and responsibilities in a firm's governance structure? Grant Thornton response: The major audit firms are already subject to independent oversight from among others the FSA and the AIU. The current findings of the independent regulators give no indication that audit quality is either impaired or potentially impaired by current audit firm governance arrangements. The current findings point neither to systemic weaknesses in governance arrangements of the large audit firms, nor to a need for external directors embedded within audit firm governance structures. Therefore, while the Audit Firm Governance Code could describe the sort of activities that an external director could conceivably undertake, the Code should not raise any expectations as to the role, ratio or numbers of external directors in audit firm governance positions. We do believe that appointment of external directors, either at the UK firm or network level, are interesting ideas to explore, but we believe this is a sufficiently untested area at present Page 7

8 that such developments are better left to the market than to impose via a code. Question 8: Other than matters related to auditor independence, are there any barriers, regulatory or otherwise, to the appointment of independent non-executives to firms? Grant Thornton response: Matters related to auditor independence are not immaterial, nor in our view are they insurmountable. However, there are other barriers which are primarily related to the individual, including: the perception and attitude of the potential external director to the high risk of personal litigation the balance between risk to the individual's reputation and the financial reward for the work they will perform. Question 9: What other governance structures and models are there that provide for independent oversight which might be considered by the Audit Firm Governance Working Group? Grant Thornton response: The purposes of the Code are to enhance audit quality and facilitate greater choice in the UK public interest audit market. We believe it unlikely that other governance structures and models would be developed with these goals in mind. Accordingly, we believe it would be preferable to start afresh when designing a Code for Audit Firm Governance. Scope of firms to be covered Question 10: In order to determine which firms the Audit Firm Governance Code applies to, should the definition of a public interest entity be based on the narrower listed company market definition used for transparency reporting purposes or the wider definition used by the AIU or some other definition? Grant Thornton response: There is a large amount of overlap between disclosures that might form the basis for a Code of Audit Firm Governance and those which are required or typically given in a Transparency Report. However, a scope related to the Statutory Audit Directive would apply to many more audit firms, some of whom audit only one public interest entity. We believe it would be unfair to impose, or at least to raise an expectation of,compliance by those firms. In our view a realistic and appropriate scope for the Code would be those firms who are subject to regular public reporting by the AIU, and nevertheless allow others to comply voluntarily if they wish. Question 11: Do you think that a distinction should be made between firms that would be required to apply the Audit Firm Governance Code and firms that would be encouraged to apply it on a voluntary basis and, if so, where should that distinction be drawn? Grant Thornton response: Other than those firms expected to implement the Code, the Code should be silent in encouraging other firms to use the Code. In this way the Code will not unreasonably raise the level of expectation in users, and so appropriately leave it to the discretion of individual firms to implement the Code as they see fit. Implementation and monitoring Question 12: Based on the assumption that the comply or explain approach will apply, to what extent do you think that the implementation of the Audit Firm Governance Code should be "left to the market" because owners of the firms and shareholders and directors of Page 8

9 listed companies can be relied on to ensure that the firms apply the Code and appropriate explanations of non-compliance? Grant Thornton response: For the reasons expressed in our covering letter we do not agree that the comply or explain approach should be applied, but we do agree that implementation should be left entirely to the market. The reports published by independent oversight bodies do not identify systemic audit quality weaknesses which are symptomatic of weak governance arrangements. We believe that audit firms will soon be notified if their governance procedures, or what they disclose about audit firm governance, is in some way out of alignment with what investors and audit committees need or expect. Question 13: What need, if any, do you think there will be for: Audit regulations to require the firms to make comply or explain disclosures in relation to the Audit Firm Governance Code? A regulatory or other body to monitor and to check either compliance with the Audit Firm Governance Code or the appropriateness of explanations of non-compliance? Involvement of auditors appointed by the firms? Grant Thornton response: In order to preserve the voluntary nature of the Code there should be no reference to the Code in law or regulations. We believe that market expectations will be sufficient to generate change if change is needed. External monitoring or assurance should be allowed to evolve if desired by stakeholders so there should be no such requirement in the Code or law or regulations. If governance disclosures are made by the reporting entity within the annual report which contains audited financial statements, then the disclosures will fall within the scope of review by external auditor. Under ISA (UK and Ireland) 720 (revised) Section A Other information in documents containing audited financial statements the external auditor will report in the event of material misstatement of fact, whether incorrectly stated or presented. However, there should be no express requirement for the engagement of the external auditor in this regard. Question 14: Can you suggest any potential deregulatory measures to eliminate possible duplication that could be linked to the implementation of the Audit Firm Governance Code? Grant Thornton response: If there is to be a Code on Audit Firm Governance then the Code should incorporate the Transparency Report requirements of the Statutory Audit Directive in their entirety. To avoid different interpretations or the risk of creating new requirements, Article 40 should be reproduced in precisely the same words with no rephrasing. Reporting and communication Question 15: What measures should be taken in relation to how and where the firms disseminate information about their application of the Audit Firm Governance Code so as to enhance its usefulness? Grant Thornton response: There should be no requirement as to method of communication in the Code. However, the user might expect that audit firm governance Page 9

10 disclosures will form part of the firm's Transparency Report. However we believe that publication of governance information on the firm's website should also be sufficient. Question 16: Should the Audit Firm Governance Code call for disclosure of specific matters, such as major changes in governance practices, responses to specific concerns raised by the AIU, and any other matters? Grant Thornton response: We agree that major changes in governance practices should be disclosed, and these would ordinarily be covered in the audit firm's Transparency Report. There should be no requirement to respond to specific concerns raised by the AIU, which concerns may or may not be in the public domain, which may or may not be accepted by the audit firm. These are matters to be dealt with between the firm and AIU, even if the AIU concerns are in the public domain. It must remain at the audit firm's discretion whether or not it is appropriate to publish actions taken by the audit firm. Areas to be covered by the Code Question 17: Are there principles and provisions in the Combined Code which you think are particularly relevant or inappropriate for application to the firms and are there major issues relevant to the firms that are not included in the Combined Code? Grant Thornton response: The Combined Code is an inappropriate starting point for the content of a Code on Audit Firm Governance. One reason is because the Combined Code is written for corporate owners, who have different needs to those seeking to understand how audit firms safeguard their public interest responsibilities. We strongly recommend starting from afresh. Question 18: Are there any compelling reasons for departing from the Combined Code structure of preamble, principles and provisions? Grant Thornton response: The Combined Code has evolved into a structure which is principles-based and therefore isuseful to both preparers and users. We support the structure being replicated in a Code on Audit Firm Governance. Question 19: Can you provide examples, whether or not derived from the Combined Code, from other non-listed company sectors where you think that appropriate governance codes have been developed, giving information on their potential relevance to the firms? Grant Thornton response: We know of no such examples. If suggestions are made to the working group, care will be needed to ensure that any examples incorporated in to a Code on Audit Firm Governance remains relevant to audit firms and to the stated objectives to enhance audit quality and facilitate increased choice in the UK public interest audit market. Question 20: Do you have any other observations about matters not covered by earlier questions that you think would be useful to the Working Group in drafting the Audit Firm Governance Code? Grant Thornton response: Yes. As set out in the covering letter with have three suggested policy measures which believe should be pursued urgently alongside development of a code: investors and audit committee chairs should use the results of the AIU's findings on Page 10

11 individual audit firms in assessing audit quality on appointment and re-appointment regulators should address the failure of the Companies Act 2006 to bring about reform of auditor liability in practice in the listed company sector regulators should work with banks and other finance providers to amend the practice of inserting private covenants in lending arrangements that serve to protect the market position of the largest four audit firms. Page 11