CONSULTATION PAPER ON REVISED DRAFT ETHICAL STANDARDS FOR AUDITORS

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1 18 October 2010 Our ref: ICAEW Rep 103/10 Hazel O Sullivan The Auditing Practices Board Limited 5 th Floor Aldwych House Aldwych London WC2B 4HN By h.osullivan@frc-apb.org.uk Dear Hazel CONSULTATION PAPER ON REVISED DRAFT ETHICAL STANDARDS FOR AUDITORS ICAEW is pleased to respond to your request for comments on the APB s Consultation Paper on Revised Draft Ethical Standards for Auditors. Please contact me should you wish to discuss any of the points raised in the attached response. Yours sincerely TONY BROMELL Head of Integrity and Markets T +44 (0) E tony.bromell@icaew.com The Institute of Chartered Accountants in England and Wales T +44 (0) Metropolitan House F +44 (0) Avebury Boulevard Milton Keynes MK9 2FZ UK icaew.com

2 ICAEW REP 103/10 ICAEW REPRESENTATION APB CONSULTATION PAPER ON REVISED DRAFT ETHICAL STANDARDS FOR AUDITORS Memorandum of comment submitted in October 2010 by ICAEW, in response to the Auditing Practices Board s Consultation Paper on Revised Draft Ethical Standards for Auditors published on 23 July Contents Paragraph Introduction 1 Who we are 2-3 Major points 4-7 Responses to consultation questions 8-48 Other comments 49 1

3 INTRODUCTION 1. ICAEW welcomes the opportunity to comment on the Consultation Paper on Revised Draft Ethical Standards for Auditors published by the Auditing Practices Board. WHO WE ARE 2. ICAEW operates under a Royal Charter, working in the public interest. Its regulation of its members, in particular its responsibilities in respect of auditors, is overseen by the Financial Reporting Council. As a world leading professional accountancy body, we provide leadership and practical support to over 134,000 members in more than 160 countries, working with governments, regulators and industry in order to ensure the highest standards are maintained. We are a founding member of the Global Accounting Alliance with over 775,000 members worldwide. 3. Our membership includes numerous audit committee chairs, finance directors and members involved in investment management activities as well as auditors. Members provide financial knowledge and guidance based on the highest technical and ethical standards. They are trained to challenge people and organisations to think and act differently, to provide clarity and rigour, and so help create and sustain prosperity. We ensure these skills are constantly developed, recognised and valued. MAJOR POINTS 4. We note that the overwhelming majority of respondents to the previous consultation endorsed the fundamental approach of disclosure to investors and other stakeholders, together with a threats and safeguards approach to auditor independence requirements. This is a critical endorsement of the approach which in our view is most likely to result in a proportionate balance of cost to business and investor confidence, and is a marked rebuttal of regulatory creep. 5. On the whole we believe the suggested improvements in disclosure and governance are a useful step forward, though we have some comments on the detailed requirements, included in our responses to the detailed questions. 6. We are concerned about the scale and scope of the proposed prohibitions in the revised ES, many of which go beyond mere clarification of existing practice. These, particularly in the areas of restructuring, connected parties and contingent fees, are largely based on the unsupported views of a very small number of respondents to the previous consultation, even when analysing by class of respondent. We believe that many will result in disproportionate extra costs to businesses of all sizes (a point raised by many corporate respondents to the previous consultation), but particularly those at the smaller end of the scale. There is absolutely no basis for applying these to audits of unlisted entities and we have major concerns about the balance of actual cost and alleged perceived benefit in the audit of small cap and AIM listed entities. Companies in the SME sector value the facility of having a suite of advice from their auditors, and the provision of advice from audit firms presents no insuperable problem from an independence perspective. Regulators must strike a balance that serves the competitiveness (and in some instances survival) of UK commerce best and not allow concerns over perceptions about independence that are not widespread, to lead to prohibitions where none is necessary in actual independence terms. 7. Again, we include detailed comments on the issues raised in our responses to the detailed questions. 2

4 RESPONSES TO CONSULTATION QUESTIONS Q1: Do you support the approach outlined in paragraphs 2.10 to 2.18? If not, please indicate what, if any, other action should be taken. In particular, does the proposal in paragraph 2.15 present practical difficulties to auditors of small or medium sized entities? 8. We note that APB s approach is to enhance fee and governance disclosure, rather than to implement an outright prohibition on NAS. We support this approach in general terms as proportionate, though we see no case for applying the requirement for high fee ratios to audits of entities that are not listed, as the issue is generally accepted to be seeking to address perceived threats to independence, rather than an actual threat. 9. We have some concerns about the requirement to discuss the NAS/audit fee ratio with the Ethics Partner as set out in the amended para 18 of ES 5. First, there is a risk that with what are often routine matters being referred to the Ethics Partner, the mindset that the Engagement partner has ultimate responsibility could start to be eroded. Second, to the extent that they are relevant at all, audit to non-audit fee ratios are really only relevant to investors in listed companies so at a minimum the requirement should be limited to such audits. Third, the most meaningful ratio would be the ratio of non-audit fees (excluding audit related fees) to audit and audit related fees. Q2: Are the correct services included in the list of audit related services (see ES 5 (Revised), paragraph AD)? If not, please identify the changes that should be made and indicate whether the provision of such services gives rise to threats to auditor objectivity and independence (other than threats which are clearly insignificant). 10. The point of the fee-category analysis is to provide enough information for stakeholders to understand whether the audit committee has exercised proper stewardship in this area. Focus should be on the additional disclosure about significant amounts of such work, in which case which category it is included in should become secondary. However, we recognise that some external stakeholders place particular focus on the ratio of NAS to audit fees, in which case categorisation is relevant. To the extent that there is a relevant ratio, it should be the ratio of NAS (excluding audit related services) to audit fees plus audit related fees. 11. With additional disclosure, in principle the category after audit ought to cover work that auditors most logically perform, which is wider in scope than APB s list. This could include, for example: reports on extraction of financial information and other letters (e.g. turnover certificates) required by other third parties; non-statutory audits of financial information; and pension scheme audits, given their nature, as well as reporting (whether public or private) on investment circulars, which will be subject to the ES-like ESRA. To include such services in the other category will confuse the purpose of the categorisation, obscuring transparency. 12. In addition, the APB should clarify whether and if so where, audit fees for the audits of significant affiliates (JVs, associates, etc) should be disclosed. Disclosure of these is important from a transparency point of view. Q3: Will disclosure of additional information about non-audit services in the form of a template (such as that included as an appendix to ES 1 (Revised)) reduce the perceived threats to objectivity and independence arising out of the provision of non-audit services? Do you have any suggestions to improve the template? 13. APB s proposed template is suggested for use by auditors in disclosure to audit committees. APB also notes that it may help influence the detail provided in the accounts. 3

5 14. Again, the objective is to provide enough information for stakeholders to understand whether the audit committee has exercised proper stewardship in this area and thus reduce misperceptions caused by the current confusing statutory disclosure requirements. To that extent, and as a helpful basis for disclosure by audit committees under the draft revised FRC guidance on audit committees, a template would be useful, but should not be made compulsory. 15. We assume APB will continue to liaise with the government, who are responsible for the Regulations that would actually require disclosure in the financial statements. Q4: Will the proposed changes to the FRC s Guidance on Audit Committees reinforce audit committees' responsibility for: determining whether a company's auditor should be permitted to provide particular non-audit services? If not, what further guidance should be given, and providing information about the non-audit services provided by a company's auditor and therefore reduce the perceived threats to auditor objectivity and independence arising from the provision of non-audit services? 16. We support the proposal for greater disclosure about the governance arrangements and additional considerations. The corporate sector responded in significant numbers to the previous consultation and overwhelmingly suggested that it was already capable of assessing these matters. However, disclosure of the governance arrangements is variable and moving general disclosure up to the practice of the best will enhance stakeholder understanding. Q5: Do you support: the approach taken to the provision of 'extended audit services' in ES 5 (Revised), paragraphs AH and AI? the additional guidance on the threats and safeguards approach in ES 5 (Revised), paragraphs AH and AI? the strengthening of the role of the Ethics Partner in ES 1 (Revised), paragraphs 21 to 24 and ES 5 (Revised), paragraph AA? the amended definition of 'affiliate' and 'significant affiliate'? the application of the remuneration and evaluation policies to all members of the engagement team in ES 4 (Revised), paragraph 38? the other amendments referred to in Section 5? If not, please explain your reasons and the approach that you think the APB should take. Extended audit services 17. We note that the APB proposes not to change the requirements relating to internal audit work significantly but to add discussion determining what is extended audit and what is internal audit. We support the general approach as a proportionate one, in an area where there seems to be a perception issue in some quarters, though no actual problem. 18. However, it is unfortunate that some of the wording moves APB further away from the IESBA s position. In particular we are concerned about the additional wording in ES5,45 and 46, which states that outsourcing the whole function is unacceptable even if the specific circumstances which generate threats (taking management decisions, designing internal controls, taking responsibility for risk, etc) do not arise. This seems unnecessary, as the lack of such circumstances would suggest that there are not significant threats. As it covers all audits, it will also particularly affect smaller companies, including small caps, AIM and private equity 4

6 investee companies, and owner-managed businesses, that cannot afford an internal audit function of their own. In such circumstances, to the extent the auditor provides internal audit services, it could be regarded as full outsourcing (and thus prohibited regardless of the circumstances) because it is the only identifiable internal audit activity, even it is relatively insignificant. Additional threats and safeguards guidance 19. We assume that APB means to refer to the additional guidance in ES1 46 to 50 and ES5 V to X and 32 to Z rather than the reference they have in the question, which is to the extended audit discussion. On that basis, we support the guidance. Role of the Ethics Partner 20. We agree that the role of the ethics partner as envisaged by the ES is clearly a very important one and emphasis and support of this are welcome. However, it is not clear to us that the reaction to the AIU s findings referred to in 5.13 is proportionate to those findings. If the AIU identifies specific instances where the ethics partner is not applying appropriate control, they can report that opinion in their public report and allow the market to take its own view. 21. We also do not see that combining the role with others (an entirely practical need in many firms) necessarily conflicts with or diminishes that, as the paper implies. 22. We believe caution is needed in appearing to involve the independent non-executives (INEs) in audit decision making. It should be reasonable to presume that any partner, not specifically the ethics partner, has access to the INEs and/or the firm's senior governance body. The fact that this is specifically referred to in the revised ES could be seen to place an expectation on the INEs of involvement in complex audit judgements and there is a risk that they could be deemed to be part of the safeguard structure and thus a part of the firm's system of managing risk. This could put them in the chain of command. While the APB has included a carve-out in its own standards, the attitude of others, particularly in the US, is also clearly key. Complex judgement issues should be referred elsewhere, for example to a panel of experienced partners. Affiliate definition 23. We applaud the move towards adopting the IESBA definition although we believe that materiality is always a matter of judgement and not purely quantitative. The addition by the APB of the words "qualitatively or quantitatively" is unnecessary and will merely raise questions about what is intended to be different. Furthermore, the additional discussion on materiality and significance as regards the relationship between the audited entity and the other entity seems to state that which is obvious, so we see little point in this add-on. As regards the discussion on the relation ship between the audit firm and the other entity, it could be argued that such relationships should have no bearing on whether it is an affiliate of the audit client or not (ie, an affiliate should be an affiliate based on its relationship with the audited entity only). Remuneration and evaluation policies 24. We note that the APB proposes to extend the prohibition to the entire engagement team, although in the early 2009 consultation, most respondents supported keeping the prohibition to key audit partners. The paper gives no clear reason why the views of the majority have been ignored and the APB has felt the need to go beyond the requirements of the IESBA code. As noted in our response in May 2009: We do not believe that there needs to be an additional prohibition on such staff. In principle the threat could arise where a member of staff, from whatever discipline, makes key audit judgments and it may be useful to clarify this in the discussion following ES4 38. However, it would be rare for such staff to be in that position so general threats and safeguards requirements are appropriate in these circumstances. In 5

7 addition, there is a risk that firms will be prevented from using the most appropriate specialists to assist in audit work. Other amendments in section We agree with the changes proposed. Q6: Are there any reasons why the revisions to the Ethical Standards proposed by the APB in Sections 2, 4 and 5 will be difficult to implement for audits of financial statements for periods commencing on or after 15 December 2010? If so, what further transitional arrangements might be necessary? 26. This is a particularly long and complex set of proposals in one consultation. We believe the disclosure requirements are particularly welcome and could be addressed reasonably quickly. However, we suggest that the proposed timetable for implementing new independence requirements is unrealistic, particularly for smaller audit firms who often rely on external training providers to assist in dealing with new requirements. It is clear from the options given in a number of areas that there will need to be further careful drafting. Given the 23 October consultation deadline the standards will be finalised at best, shortly before the implementation date. While there are some proposed transitional reliefs allowing new requirements to be put in place during the next audit period, practitioners should at least have the chance to be aware of what they need to do by the beginning of the period. Depending on the eventual changes agreed, there may be difficulties in dissemination and absorption of this information in a busy environment, at that time of year, with clarified ISAs already being absorbed. 27. We believe that there will either need to be extensive further transitional relief allowing, for example, new requirements to be introduced during the next period (this is alluded to in the draft ES revisions but it is unclear to what extent it can be applied), or the implementation date should be detached from accounting periods completely. 28. While on the subject of transitional arrangements, we would point out wording inconsistencies between ES1, 68 and 69 (which overrides which?) and the lack of transitional arrangements in ES4 re contingency fees. In addition we repeat our previous comment on non-cash valuations: while we do not disagree with the changes in respect of work which legislation specifies may be performed by an auditor, we believe that there could be an impact here and we believe that an additional transition period of, say one year for simplicity, should be permitted. We also believe there need to be arrangements to deal with pre-existing valuations by the auditors in the financial statements, included under the current exception. Q7: Which of the options (to address the self review threat arising from the provision of restructuring services) set out in paragraph 6.14 should the APB adopt? Should the option that you have chosen apply to all entities, or only to listed entities? 29. In our response to the March 2009 consultation, we supported the proposed collation of selfreview guidance, in order to emphasise the issue to practitioners. We also supported the proposal that no new prohibitions were of themselves necessary. We remain of the view that what is now described as option 3 is the appropriate and proportionate response to something which we do not believe has actually resulted in independence issues, whether in relation to those companies which have institutional investors or at the lower, SME or owner-managed end of the scale. The proposed prohibition is based on the perception of a small number of investors and we do not believe this reflects the view of that community generally. 30. Most of the arguments as to why the provision of restructuring services by auditors to the entities they audit is appropriate are well articulated in the consultation paper and are persuasive. In addition, the auditor may well get a better insight into the attitude of the capital providers and hence is more likely to draw the right audit conclusion. 6

8 31. The counter arguments also included in the paper are subjective and unevidenced. they fail to recognise that the existence of a self-review threat does not of itself support their conclusion that restructuring services to a company in distress should be prohibited, in the face of sound public policy arguments in favour; they presuppose a ready availability of alternatives, something which will not necessarily be the case outside major metropolises; they underplay the importance of management s trust and confidence in professional advisers they know; and they discount the value of management time in seeking those alternatives, which will be in particularly short supply in, for example, an AIM company in a distressed situation. Our fear is that, in seeking to make further prohibitions and therefore limit the discretion of the auditor, the consequence would in fact be to limit that of the entity, to its severe prejudice. Collateral damage to an innocent party would not represent sound regulation. 32. We wholly support the need to address threats, particularly where the auditor s involvement is so significant that the degree of association of the auditor with the content of the restructuring plan is extensive. We also support increased transparency as part of the proposals on disclosure considered above. However, we do not believe that the case for a prohibition is evidenced, necessary, or proportionate. The potential benefits that a prohibition would bring, in terms of increased confidence to those who advocate such an approach, would not outweigh the disadvantages of frustrating the process of obtaining rapid advice just at the moment a business most needs it, from the most realistic (sometimes only realistic) independent professional source. 33. In particular, we can see absolutely no rationale for even a partial prohibition, based on perception issues, being applied to the audits of unlisted entities, where any perception problem among the small number of stakeholders, can be adequately addressed by direct involvement. 34. The potential effect would be exacerbated by the potentially wide-ranging set of services that could be considered to be restructuring services. Were the prohibition to apply to charity audits, for example, it is unclear if advice by auditors about transferring the activities of a charity into a separate trading company would be included under this umbrella, or helping charities make statements/certificates relating to Section 36 and Section 38 of the Charities Act Auditors of charities do get involved in these at the moment and charities would like to continue to have the choice about approaching their auditors on such matters. 35. If the APB does decide to extend prohibitions to the audits of other than listed entities, it is important to ensure that the potential wide range of such organisations have had the opportunity to consider the full implications of what is proposed. As it is, a number of charities, for example, could be considered to be public interest entities and potentially affected under ES1, Where prohibitions are extended to unlisted audits, we welcome the derogations being addressed in PASE, as prohibitions in that context are seldom cost effective or necessary. However, we question the value of an exemption that requires an entity that has come through a financial reorganisation, to have to include an exemption statement dwelling on a period when it was in distress. This should be treated as an alternative rather than an exemption. Q8: Does the revised definition of a contingent fee basis give rise to any practical issues? Q9: Which approach do you consider that the APB should adopt in relation to contingent fees and why? 37. The answers to these questions are inextricably linked and they are accordingly dealt with together. 7

9 Approach 38. In terms of the general approach, we acknowledge that contingent fee arrangements can result in a perception that the auditor is aligning too closely with management. However, we are not aware of any evidence that the existing requirements have resulted in an actual independence problem. 39. Contingent fees can be applied to a variety of services, many of which are of a comparatively routine nature, allowing smaller entities to access professional advice that they might not otherwise feel able to afford. A prohibition could make it more difficult for small cap and AIM companies, private equity investees and SMEs to contemplate entering into transactions and share issues. It would also, for example, prevent audit firms with a number of listed audit clients advising class actions to challenge tax rulings as they would be unable to be sure that existing audit clients would not be involved in the class addressed. 40. We consider the case for an additional prohibition has not been made when the existing threats and safeguards approach seems to be effective. If there is felt to be a need to address the potential perception issue, this should be restricted to listed entity audits as in other areas perception can be addressed though direct discussion. Additional measures might include a requirement for audit committee approval for other than insignificant amounts, with appropriate disclosure. Definition 41. We endorse the proposed clarification, as differential fees have resulted in a number of queries. However, as the definition is being revised, it is not clear why the IFAC definition should not be adopted. 42. It is important that fee changes which reflect changes in cost in terms of time and/or risk (of which abort fees are the obvious example) should not be prohibited. These are very different in nature from the types of fee arrangement that result in a significant self-interest threat. We would prefer they be excluded from the definition given the difference in nature but the key point is that it should be made clear that the prohibition does not apply to such fees. Q10: Does the definition of a connected party give rise to any practical issues? If so, how could those practical issues be addressed? What are the relative advantages and disadvantages of the alternative approach suggested in paragraph 8.6? 43. We note that the proposal seems to be based on the requirements of one government enquiry, where it was noted that the actual audit work did had not been compromised. Therefore, we are again considering a potential perception issue and proportionality of response. 44. It is wholly reasonable to highlight that parties other than the entity being audited may cause independence issues. However, the proposed ES wording goes beyond that, requiring auditors to proactively identify any party that, subjectively judged, might have an ability to exert influence. This is likely to require the implementation of systems and procedures that could result in significant costs for little potential benefit: if the auditors are not aware that a party is in a position to be able to exert influence, they are unlikely to be in a position to pose a threat to auditor independence. The costs will arise not only to the auditors but to the audited entity as well, as the directors have to be part of the process for assessing who could influence them and will need to establish information collection systems of their own. We do not believe that it should be necessary to perform a proactive search, but instead to consider parties known about. This would identify relevant parties without the need for unnecessarily expensive systems and procedures. 8

10 45. The connected party proposals are raised in the context of conflicts of interest. This is a much wider professional ethical subject than auditor independence and conflicts could arise from any number of circumstances beyond those that paragraph 8.3 addresses (for example, from parties whose interests are in line with those of the audited entity). All auditors are, as well as the APB s ethical standards, already obliged to follow the conflict requirements of their professional body. In the case of ICAEW these are based on s220 of the IESBA code, which considers conflict of interest issues in terms designed to address all potential conflicts. Q11: Would the adoption of any of the approaches discussed in Sections 6, 7 and 8 give rise to any significant costs that would not be outweighed by the benefits of the relevant proposal? If so, please describe and, to the extent possible, quantify the costs that you think would be incurred and why the benefits would not outweigh the costs. 46. All additional prohibitions have a cost, particularly to the entity being audited in terms of management time to make alternative arrangements and/or increased fees to cover additional procedures. The issue is whether the benefits in terms of increased confidence from public perception outweigh those costs. 47. For listed audits, we believe that in a number of instances, the proposals are disproportionate and we refer you to our comments above. 48. For unlisted audits we see no evidence at all of a confidence issue and think it likely, therefore, that costs of any extra prohibitions would significantly outweigh any benefits. OTHER COMMENTS 49. We note that the APB has amended ES5,78, which prohibits preparing tax computations for listed clients, from for the purpose of preparing accounting entries, to that are or may reasonably be expected to be used when preparing accounting entries. We note that this change has not been referred to in the discussion document. We assume that the APB intends that the purpose of the amended wording is to clarify what they already meant the paragraph to mean. Nevertheless, this could be regarded as a change of substance. The existing wording could reasonably be seen not to prohibit the preparation of tax computations for tax return purposes, even where they are in advance of the accounts being finalised for tax, provided the computation is actually filed with HMRC or equivalent, and not a draft used to circumvent the spirit of the requirement. The fact of HMRC review would therefore provide a safeguard, given the need to preserve reputation in dealings with HMRC. This is already quite a draconian prohibition, particularly affecting AIM and other small cap listed companies whose management time is best not well spent having to deal with multiple sets of professional advisers. We believe this amendment should be consulted on separately. E tony.bromell@icaew.com Copyright ICAEW 2010 All rights reserved. 9

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