Enhancing Audit Quality: Canadian Perspectives Auditor Independence. Discussion Paper

Transcription

1 Enhancing Audit Quality: Canadian Perspectives Auditor Independence Discussion Paper September 2012

2 ENHANCING AUDIT QUALITY: CANADIAN PERSPECTIVES INDEPENDENCE CONTENTS PAGE Foreword 2 Working Group Members 3 Acronyms Used in this Discussion Paper 4 Chapter 1. Introduction 5 Chapter 2. Background to Canadian Independence Standards 6 Chapter 3. What Is Independence? 7 Chapter 4. Current Canadian Independence Framework 8 Chapter 5. Independence, Professional Skepticism and Audit Quality 9 Chapter 6. Global Proposals on Independence 10 Chapter 7. Guiding Principles for Evaluation 11 Chapter 8. Evaluation of Alternative Proposals 12 Mandatory audit firm rotation, tendering and comprehensive review 12 Mandatory audit firm rotation 16 Mandatory tendering 19 Mandatory comprehensive audit firm review 21 Non-audit services 24 Audit-only firms 26 Joint audits 28

3 Foreword This Discussion Paper is the result of a collaborative initiative by the Canadian Institute of Chartered Accountants (CICA) and the Canadian Public Accountability Board (CPAB), following the latter s audit symposium in December The initiative focuses on three interrelated key areas in enhancing audit quality the independence of auditors, the role of audit committees, and auditor reporting. An accompanying paper provides a project overview that sets out the project s genesis, provides an overview of how the project is organized, outlines proposals made by a number of global bodies and describes certain features of the Canadian environment. Accordingly, readers are encouraged to refer to the Initiative Overview paper for a comprehensive understanding of the CICA/CPAB initiative. The Discussion Paper was prepared by the Independence Working Group (IWG) in response to global proposals to modify auditor independence rules to enhance audit quality. As discussed in the Initiative Overview (see Appendix A thereof), audit quality is affected by many factors other than auditor independence. Indeed, many of the factors affecting audit quality involve parties other than auditors, their firms, or the audit committees of companies they audit. Accordingly, considerations of the broader issues are outside the scope of this paper. The objectives of this paper are to: develop a sound framework of guiding principles to help in the evaluation of the independence proposals emanating from various global bodies; focus on questions of auditor independence with particular emphasis on its effect on audit quality; help to inform and engage stakeholders in the global debate; and present a balanced view of the Working Group s deliberations. Following introductory and background chapters, this paper considers the meaning of independence (Chapter 3), and describes the current Canadian independence framework (Chapter 4) and the role of professional skepticism (Chapter 5). Next, the paper identifies and describes those global proposals in response to the financial crisis that are relevant to independence (Chapter 6). Guiding principles for evaluation of these global proposals adopted by the IWG are noted (Chapter 7). The paper concludes with an evaluation of the relevant global proposals and the consensus reached by the Working Group on each of the proposals (Chapter 8). The Working Group is interested in hearing stakeholders responses to the questions posed in the Discussion Paper. Comments are requested by November 16, They should be sent to eaq.ai@cica.ca. Comments will be available on the website shortly after the comment deadline. 2

4 Working Group Members Peter W. Mills, QC, JD, ICD.D, Corporate Director, Toronto (Chair) William R. Bruschett, FCA, Grant Thornton, LLP, Toronto Patrick Crowley, CA, Executive Vice President & Chief Financial Officer, OMERS, Toronto Gary B. Hannaford, FCA, Institute of Chartered Accountants of Manitoba, Winnipeg Jane E. Kinney, FCA, Deloitte, LLP, Toronto Andrew J. Kriegler, MBA, former Senior Vice President & Treasurer, CIBC, Toronto Paul R. Weiss, FCA, Corporate Director, Toronto Observer Kenneth Vallillee, FCA, Canadian Public Accountability Board, Toronto Project Manager Melissa E. Langlois, CA, Deloitte, LLP, Toronto 3

5 Acronyms Used in this Discussion Paper ACWG AASB AASOC CA CGA CICA CMA CPAB EC EU FRC IESBA IWG NI OSFI PCAOB SEC The Role of the Audit Committee Working Group Auditing and Assurance Standards Board Auditing and Assurance Standards Oversight Council Chartered Accountant Certified General Accountant Canadian Institute of Chartered Accountants Certified Management Accountant Canadian Public Accountability Board European Commission European Union UK Financial Reporting Council International Ethics Standards Board for Accountants Independence Working Group National Instrument Office of the Superintendent of Financial Institutions US Public Company Accounting Oversight Board US Securities and Exchange Commission SOX Sarbanes-Oxley Act of 2002 US United States 4

6 Chapter 1. Introduction 1. Canadian corporate law near the beginning of the 20 th century introduced mandatory audit requirements to Canada s business marketplace, shifting the focus of the accounting profession from bankruptcy work to audit work. Today, all publicly-traded companies and many private entities are required by law to have independent external auditors examine and provide an opinion on their annual financial statements. Although audit appointments are nominally made by shareholders, they are usually proposed by the audit committee and, in practice, are often influenced by the recommendations of management. In providing an opinion on the financial statements, the auditors are then expected to evaluate assertions of the people who influenced their appointment and the payment of the auditors fees. Clearly, this practical connection with management creates an inherent conflict for the independent role of the auditor. 2. One way to handle this inherent conflict would be to change the responsibility for appointing auditors and negotiating their fees. The power could be vested in an outside party and be removed from anyone associated with the company (whether shareholders, audit committees or management). Such radical changes could, however, have unintended repercussions, triggering much more severe problems than those existing under the present system. In addition, introducing such reform is impractical in the short term. In the absence of such structural change, a robust independence framework is essential. 3. An effective relationship between auditors and management encourages information sharing, which should result in a more efficient and effective audit. An effective audit is only achieved if the auditors exercise skepticism and are prepared to challenge management s assertions when needed. Achieving an appropriate balance in this relationship is critical as excessively challenging management could slow down the audit process, decrease information flow, and risk incurring unnecessary costs. An auditor s independence is a key factor that affects the degree of professional skepticism demonstrated during an audit. 4. Given the current focus of global proposals on reporting issuers, the potentially large number of stakeholders for reporting issuers and the exemption of non-public enterprises from many of the regulations discussed throughout this paper, the Independence Working Group (IWG) focused its evaluation of the various concepts on factors that will enhance audit quality for Canadian reporting issuers Global proposals on independence resulting from the economic crisis of 2008 concentrate on possible auditor conflicts of interests. European proposals have also included a focus on the high concentration of audit services put in the hands of a small number of audit firms and on the potential systemic risks if one of the large audit firms were to fail. The IWG chose to focus on independence concepts that may enhance audit quality, including considerations of the proposals potential impact on auditor skepticism. Audit firm market concentration and systemic risk issues are considered to be outside the scope of this paper. 1 Reporting issuer is an entity that offers its securities to the public. The term is used in provincial securities acts and the Business Corporations Act. 5

7 Chapter 2. Background to Canadian Independence Standards 6. Corporate failures in the early 2000s prompted regulatory changes aiming to improve public confidence and trust in companies, as well as in their auditors and regulators. While the United States (US) created the Sarbanes-Oxley Act of 2002 (SOX), Canada s regulatory response took into account the greater number of smaller Canadian reporting issuers and the disproportionate costs and burden that would be imposed by US-style regulation. The initiatives in Canada included: Regulatory oversight: The establishment of the Canadian Public Accountability Board (CPAB) to inspect audit firms that audit Canadian reporting issuers in Public oversight of standard setting: The establishment of the Auditing and Assurance Standards Oversight Council (AASOC) to oversee the work of the Auditing and Assurance Standards Board (AASB) and the development of Canadian auditor independence standards. Audit committees: Regulations (e.g., the Canadian Securities Administrators (CSA) National Instrument (NI) ) that endorsed, inter alia, the fundamental tenets of SOX that is, auditors must be independent of the companies they audit and that prior audit committee approval is needed for any services they provided. NI also included independence rules for audit committee members. Internal controls: Canadian regulations requiring management certifications on internal controls, although without the US requirement for auditing the effectiveness of internal control and management assertions. Independence rules: The amendment of the rules of independence (Rule 204) in the Code of Conduct of the Chartered Accountant (CA) profession (and similar rules for other accounting bodies), which sets standards based on the international ethics standards and is supplemented by Securities and Exchange Commission (SEC) rules. 7. Generally, Canada adopts international standards, including independence rules issued by the International Ethics Standards Board for Accountants (IESBA), with adjustments for Canadianspecific circumstances. An Independence Task Force, working under the auspices of the CICA with participation from both the Certified General Accountants Association of Canada (CGA-Canada) and the Certified Management Accountants of Canada (CMA Canada), is currently revising Canadian independence rules to align with a recent update to the IESBA code. 6

8 Chapter 3. What Is Independence? 8. An audit report accompanying a set of a reporting issuer s financial statements is valuable to readers, but only if it forms a dispassionate, unbiased and impartial view of the results of the company s financial activities. 9. According to the IESBA code, independence comprises: (a) Independence of mind The state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism. (b) Independence in appearance The avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude, weighing all the specific facts and circumstances, that a firm s, or a member of the audit team s, integrity, objectivity or professional skepticism has been compromised. 10. There are various threats to the auditor s independence, including: self-interest threat when auditors could benefit from a relationship (e.g., having a direct or indirect financial interest); self-review threat when auditors could be reviewing their own work (e.g., bookkeeping services); advocacy threat when auditors are in a position to promote the audited company s point of view or opinion (e.g., legal services); familiarity threat when a long and potentially close relationship could create a sympathetic bond between auditors and management, creating a risk of the auditors becoming too accepting of management s work (e.g., auditors long tenure with a company they audit); and intimidation threat when there is either a perception of, or an actual situation, that would intimidate auditors from adopting appropriate skepticism of management (e.g., company employing a former audit team member). 11. Familiarity threats have been already addressed in the principle-based approach at the individual level between management and the audit team (partner rotation rules); however, the marketplace is now identifying concerns about familiarity and self-interest threats between audit firms and the companies they audit at the institutional level. There is a perception that, after an extended period of time, audit firms could develop a potentially close relationship with their clients that could affect the firms independence and, ultimately, their ability to exercise appropriate skepticism. The combined self-interest and familiarity threats at the institutional level will be referred to as institutional familiarity threats throughout this paper. 7

9 Chapter 4. Current Canadian Independence Framework 12. For reporting issuers, Canada has established a combination of a principles-based approach and a set of specific rules and prohibitions to address independence. If auditors identify threats that are not clearly insignificant, 2 they must identify and apply safeguards to reduce those threats to an acceptable level. When safeguards are unavailable to reduce threats to an acceptable level, auditors must eliminate activities, interests or relationships, or refuse to accept or continue the audit engagement. 13. Current prohibitions in the Canadian independence rules address most of the conflicts that could arise when audit firms provide non-audit services to their audit clients. The threats and safeguards framework underlying the prohibitions is effective for analyzing any potential independence implications of new non-audit services or managing any potential gaps in the prohibitions. The consensus of the IWG is that the Canadian combination of rules and prohibitions, along with the threats and safeguards framework, creates an effective structure for dealing with independence. 2 The IESBA Code refers to significant and clearly insignificant threats to independence. In considering the significance of any particular matter, qualitative as well as quantitative factors should be taken into account. A matter should be considered clearly insignificant only if it is deemed to be both trivial and inconsequential. 8

10 Chapter 5. Independence, Professional Skepticism and Audit Quality 14. In the wake of the global financial crisis, numerous regulators, accounting bodies and policy makers outside Canada proposed or considered how to enhance professional skepticism during the performance of an audit. Although shareholders generally appear to have confidence in the integrity of public company audits, audit regulators in and outside Canada continue to voice concerns about appropriate levels of auditor skepticism. 15. As set out in paragraph 9, independence includes independence of mind and independence in appearance. Independence allows the auditor to exercise objectivity and professional skepticism. Objectivity means the auditor does not allow his or her professional judgment to be compromised by bias, conflict of interest, or the undue influence of others. Professional skepticism includes being alert to, for example: audit evidence that contradicts other audit evidence obtained; information that brings into question the reliability of documents and responses to inquiries to be used as audit evidence; conditions that may indicate possible fraud; and/or circumstances that suggest the need for audit procedures in addition to those required by the basic audit standards. Professional skepticism also includes the willingness to challenge management on the assertions and representations they make in preparing the financial statements. 16. Independence is seen as an important element for both the auditor to be objective in their evaluation of an entity s financial statements and to allow the auditor to approach the audit with an appropriate degree of professional skepticism. 17. Auditor skepticism can be influenced by many factors in addition to independence, including: auditor education, training, supervision of staff and knowledge of a company s business, the culture of the audit firm, and the audit firm s relationship with client management and audit committees. Independence at both the individual and institutional level may, in fact or appearance, have an impact on auditor skepticism and the resulting quality of the audit. 18. The consensus of the IWG is that auditor skepticism is an important driver of audit quality. 9

11 Chapter 6. Global Proposals on Independence 19. In an increasingly global environment from global capital markets, accounting and auditing standards, and audit firms to global independence rules Canada cannot isolate itself from the changes being proposed in other countries. Canada needs to be responsive to change and must ensure that Canadian independence rules continue to be of the highest quality so that investors will continue to find Canada attractive. Also, with many Canadian companies now operating in an international environment, it is important that Canada s audit processes and quality align with international rules and standards. 20. In the aftermath of the global economic crisis, which first made itself felt in 2008, several international bodies proposed new requirements to enhance audit quality, as well as address market concentration of audit firms, including revising auditor independence requirements. Proposals focusing on auditor independence include the following: In August 2011, the Public Company Accountability Oversight Board (PCAOB) in the US issued the Concept Release, Auditor Independence and Audit Firm Rotation, which considers mandatory audit firm rotation, but did not specify a time frame. In recent years, the European Commission (EC) has made proposals that would affect auditor independence, including: mandatory audit firm rotation after six years when only one firm is involved; this can be extended by three years with joint audits; audit-only firms; requirements for the tendering process; further restrictions and limitations on providing non-audit services. In May 2011, the UK s Financial Reporting Council (FRC) issued proposals that would require mandatory tendering of audits under the UK Governance code for FTSE Group (FTSE 300) companies. The UK code would require companies that do not comply to explain why. A select committee of the UK House of Lords raised questions on mandatory audit firm rotation that addressed the House of Lords concerns on market concentration and referred the issue to the UK Competition Commission. 10

12 Chapter 7. Guiding Principles for Evaluation 21. The IWG developed a framework of guiding principles used to evaluate global proposals through an analysis and comparison of the following three key factors: 1. Potential effect on independence. 2. Potential effect on audit quality. 3. Work effort and costs for audit committees, the companies and audit firms. 22. The primary focus of the analysis was how various global proposals could enhance audit quality. Other motivations for certain proposals put forward by jurisdictions that were not addressing audit quality, such as concerns about the concentration of audit firms, were not explored. 23. The IWG considers that the culture within audit firms is a key driver of audit quality. Current independence rules address partner compensation, which is part of a broader concept of audit firm culture. The IWG did not focus on the broader cultural dimensions. 11

13 Chapter 8. Evaluation of Alternative Proposals 24. The IWG evaluated various proposals on the appointment and rotation of auditors, as well as the services they should be permitted to provide. 25. For each proposal, this chapter discusses the issues under the following structure: Background on the proposal Potential benefit Main points raised during the IWG s discussion The IWG s consensus Mandatory audit firm rotation, tendering and comprehensive review: A continuum of alternatives 26. The IWG looked at (1) mandatory audit firm rotation, (2) mandatory tendering, and (3) mandatory comprehensive audit firm review by audit committees (mandatory comprehensive review) as a continuum of alternatives. These three alternatives all attempt to address institutional familiarity threats that may affect the independence of long-serving audit firms. Current mandatory audit partner rotation rules only address the individual familiarity threat. 27. These three alternatives also have the potential to enhance audit quality through greater auditor oversight by the audit committee, greater transparency around the role of the audit committee in overseeing the audit, and potential changes to audit firm culture. 28. Table 1 highlights the key differences among the three proposals. Subsequent paragraphs provide the background, the potential benefit, and a more detailed discussion of each of the three proposals. The IWG s consensus is that mandatory comprehensive audit firm review by the audit committee is the preferred alternative. See paragraphs for further discussion. 12

14 Table 1: Comparative analysis of proposals Mandatory Audit Firm Rotation Mandatory Tendering of the Audit Mandatory Comprehensive Review of the Auditor s Performance with a Focus on Audit Quality Concept description A new audit firm must be appointed, usually after a specified period of time. The existing audit firm is not eligible for reappointment to retain the engagement. Potential appointment of a new audit firm, but the existing audit firm is eligible for re-appointment. Existing audit firm will ordinarily retain the engagement, unless the audit committee has determined that the audit firm has not met audit quality expectations or that institutional familiarity threats may exist. Independence Depending upon the length of the rotation period, will eliminate or significantly reduce the institutional familiarity threats since a change in the audit firm must occur. Depending upon the length of the rotation period, will eliminate or significantly reduce the institutional familiarity threat if a change is made. Should reduce the institutional familiarity threats through either a change in the audit firm or through the assessment process itself since an assessment could drive a behavioural change in the audit firm. The process would include an assessment of institutional threats, including a consideration of the length of the service term of audit firms and their senior members. Transparency It is presumed there will be some type of disclosure for all three concepts, but the nature of disclosure will vary. This proposal may result in a loss of transparency in why a change of auditor has taken place since the change would be mandated. As a result, any disagreements between auditors and their audit clients may become less transparent. Provides transparency on the auditor appointment process, especially with the potential comply-orexplain regime; however, as with mandatory audit firm rotation, disclosure of disagreements may become less transparent. Provides a substantial amount of transparency around the process as audit committees would communicate the basis for concluding whether or not to change the auditor. 13

15 Mandatory Audit Firm Rotation Mandatory Tendering of the Audit Mandatory Comprehensive Review of the Auditor s Performance with a Focus on Audit Quality Audit quality The fresh perspective brought by a new audit firm could increase audit quality. Focus of the change process is on evaluating a potential new audit firm and audit fees, not the audit quality and independence of the incumbent audit firm. Could motivate audit firms to enhance audit quality as reappointment can no longer be presumed. Potential for the auditor to be less challenging of management due to the concern of losing the engagement as the audit firm approaches the tendering period. Of the various proposals to enhance audit quality, this has the greatest potential for meaningful change since it has the most comprehensive focus by having the audit committee assess audit quality, independence, objectivity and professional skepticism. For the few countries that have adopted the concept, the IWG found no reliable evidence that mandatory rotation has improved audit quality. The IWG was concerned that a loss of institutional knowledge and difficulties in selecting a new and eligible audit firm with appropriate technical expertise could decrease audit quality. Audit committee focus could be more on evaluating a potential new audit firm and audit fees, not on the audit quality and independence of the incumbent audit firm. Governance impact Reduces audit committee s accountability and responsibility for assessing auditor performance and determining when to rotate or tender the audit. Reduces the audit committee s consideration of the appropriate timing for tendering of the audit. The audit committee would have accountability and responsibility for assessing the quality of the auditor and determining when a change is appropriate. Audit committee time would be focused on audit quality. 14

16 Mandatory Audit Firm Rotation Mandatory Tendering of the Audit Mandatory Comprehensive Review of the Auditor s Performance with a Focus on Audit Quality Work effort / cost Work effort for the audit committee and audit firms would be comparable in mandatory audit firm rotation and tendering. Management will also spend more time with the new auditors to educate them on the company's operations, systems, business practices and financial reporting processes. Shareholders indirectly bear those costs. Work effort for the audit committee and audit firms would be comparable in mandatory audit firm rotation and tendering. If a new auditor is appointed, time and costs would be comparable to mandatory audit firm rotation. More time and effort spent by the audit committees in the review process. If mandatory comprehensive review leads to tendering, there would be costs for both the review and tendering processes. With the process being led by the audit committee, resource constraints could pose some practical challenges. Therefore, the solution would need to be scalable. Less work effort for company management when there is no change in auditor. Increased work effort required by the audit firm to demonstrate to the audit committee its independence, objectivity and professional skepticism. 15

17 Mandatory audit firm rotation Background 29. In October 2010, the EC issued a Green Paper to address financial market regulatory reform in reaction to the 2008 global financial crisis. The proposed regulations, issued in November 2011, included mandatory rotation of audit firms after six years (with an extension to nine if joint audits are used), with a cooling-off period 3 of four years. 30. The PCAOB issued a concept release in August 2011 on ways to enhance auditor independence, objectivity and professional skepticism. The concept release included mandatory audit firm rotation as one alternative for consideration. In discussing that alternative, they did not specify or indicate a specific term. 31. There are certain G20 jurisdictions 4 have introduced mandatory audit firm rotation, including: Brazil for listed companies excluding banks; China for state owned entities and financial enterprises; India for banks, insurance companies, provident trust funds and public sector entities; Indonesia five-year rotation for the central bank, and six-year rotation for public and private companies; Italy nine-year rotation for all listed companies; Saudi Arabia all listed companies excluding banks; and Turkey eight-year rotation for banks, seven-year rotation for insurance companies, five-year rotation for energy companies and all listed companies. 32. Previously in Canada, there was a requirement for banks to have a panel of three auditors. This requirement involved one of those auditors rotating every five years. The requirement for such a rotation was removed at the same time as the joint audit requirement. 33. Brazil s adoption of mandatory audit firm rotation was motivated by negative events involving major banks and was eventually mandated for all Brazilian listed companies. Ironically, Brazil later repealed rotation for banks, which was the reason for adopting the rules in the first place. 34. Some countries have repealed mandatory audit firm rotation in its entirety, but nine smaller jurisdictions still require rotation, including: Laos, Morocco, Oman, Paraguay, Portugal (comply-orexplain), Qatar, Serbia, Tunisia and Uzbekistan. 3 A cooling-off period is the period of time when the predecessor auditor is unable to bid on, or be retained by, a company as the independent auditor. After the time period has passed, the auditor can once again bid on obtaining the audit. 4 The information on global application of mandatory audit firm rotation was taken from International Ethics Standards Board for Accountants (IESBA) meeting Agenda Paper 4 from the June 18-20, 2012 materials. 16

18 Potential Benefits 35. Mandatory audit firm rotation could prevent the potentially long tenures of audit firm appointments. Proponents of mandatory firm rotation suggest that it would enhance auditor independence and would increase audit quality by: preventing audit teams from building unduly familiar relationships with management of companies they audit; bringing the fresh and objective perspective of a new audit firm; encouraging increased audit quality because successor audit firms would review work of incumbent firms; and reducing institutional familiarity threats. 36. The EC also argued that mandatory audit firm rotation would address market concentration by encouraging the appointment of smaller audit firms, making the market for audit services more dynamic. Discussion 37. The key points raised during discussion by the IWG are summarized below: Mandatory rotation imposing a time limit on tenure would directly address the perception of an institutional familiarity threat. The current partner rotation rules and expected personnel changes in both the companies and audit teams already tend to mitigate such individual familiarity threats. Mandatory rotation would result in losing the cumulative audit knowledge gained over the years at arbitrary intervals, resulting in a higher risk of undetected financial statement misstatements. Currently under securities regulations, a change in the auditor occasioned by disagreements requires disclosure. Under a mandatory audit firm rotation regime, disagreements between the auditor and the companies it audits may become less transparent. Audit quality may suffer during the early years of a new appointment as the auditor is still gaining sufficient knowledge of the company. Auditor rotation would increase the amount of time management spends during a transition on educating the auditors on the company s operations, systems, business practices and financial reporting processes. Shareholders indirectly bear those costs. An auditor may be less likely to address longer-term issues that fall outside their term of service. On the other hand, an auditor may be more focused on quality because their files will be reviewed by a successor auditor. Competitive pressure on fees during the tendering process could have long-term negative impacts on audit quality. Mandatory audit firm rotation would reduce the accountability and responsibility of the audit committee for periodically assessing the performance of the auditor and, based on that assessment, for determining if and when to require a rotation or tendering of the audit. 17

19 An arbitrary time frame for changing auditors could cause hardship for a company if it were to occur at an inopportune time (e.g., during a major transaction) and would not be in the best interests of the company s shareholders. Mandatory rotation could be problematic in some smaller regions in Canada, particularly in specialized industries. The number of audit firms with the requisite qualifications and familiarity with reporting issuers and their accounting, auditing, and reporting requirements, and appropriate staffing levels and independence, may be limited in certain geographic areas. Even if audit firms meeting the general and technical requirements were available in those regions, the audit firms might lack the experience required for certain specialized industries. The audit committee could be more focused near the end of the audit term on evaluating potential new audit firms and audit fees, rather than on audit quality and independence of the incumbent audit firm. The choice in a successor auditor could be drastically limited because providers of certain non-audit services to the company would be ineligible to be appointed as the new auditor. Companies in specialized industries (e.g., financial institutions) or with a global footprint could be particularly affected by such a limited choice. Most countries do not have mandatory audit firm rotation. Some have considered it but rejected it. Others have adopted it but later reversed it. Extensive safeguards already exist in Canada to maintain auditor independence and objectivity, including: mandatory audit partner rotation seven years, with a five-year cooling off period; internal audit firm reviews of the audit partner and audit engagement; external inspections by CPAB and provincial institutes, and in the case of SEC registrant companies the PCAOB; second partner quality review required on each engagement; audit firm internal quality control procedures; and oversight by the audit committee of the independence of the auditor, as required by NI

20 Mandatory tendering Background 38. Mandatory tendering has been most recently proposed by the FRC, which would like to see FTSE 350 companies put the audit contract out to tender at least every 10 years, on a comply-or-explain basis. The FRC proposal recognizes that there is the prospect of European Union (EU) action (presumably on mandatory audit firm rotation) and states that targeted and proportionate action to improve practice at the national level may help to alleviate the pressure for more prescriptive action at the EU level. Potential Benefits 39. The arguments supporting mandatory tendering claim that it would: Discussion motivate audit firms to enhance audit quality as reappointment can no longer be presumed; encourage audit committees to assess auditor performance in greater detail; compared to mandatory audit firm rotation, increase transparency around audit committee decisions on audit appointments; provide an environment that reduces the institutional familiarity threat to auditor independence, thereby improving auditor skepticism and audit quality; and increase competition in the audit market and open up opportunities for smaller and mid-tier audit firms to grow. 40. The key points raised during the discussion by the IWG are summarized below: Virtually all the points under mandatory audit firm rotation also apply to tendering if it leads to a change in audit firms. In a comply-or-explain regime, legislation or regulations set out principles that companies may either comply with or, if they do not comply, explain the reasons for non-compliance through public disclosure. Before adopting this concept, it should be assessed to determine how it could be effectively applied in the Canadian environment and if a governance code similar to that in the UK is needed. Existing auditor independence requirements, including audit partner rotation and engagement quality review partner involvement, as well as changes in senior management positions, already address the individual familiarity threat to auditor independence. The timing for tendering an audit is best left to the judgment of the audit committee, not based on an arbitrary rule. Using an arbitrary time frame for a change could cause hardship for a company if it happens at an inopportune time (e.g., during a major transaction), which would not be in the best interests of the company s shareholders. The tendering process may be focused on audit fees rather than audit quality. Competitive pressure on fees in the audit market over time can have a negative impact on audit quality. 19

21 There may be an increased self-interest threat as an auditor may not challenge management s assertions as aggressively as before because of the fear of losing the audit engagement as the firm approaches the tendering period. Audit committee focus might be more on evaluating potential new audit firms and audit fees, rather than on the audit quality and independence of the incumbent firm. Mandatory audit firm tendering would add time and costs for both management and the auditor even though the same auditor may well be appointed. The company would also incur costs for educating new auditors on the company s operations, systems, business practices, and financial reporting processes. Shareholders indirectly bear those costs. 20

22 Mandatory comprehensive audit firm review Background 41. Mandatory comprehensive audit firm review (mandatory comprehensive review) was initially mentioned by CPAB in its response to the PCAOB concept release on independence and auditor rotation 5 as an alternative to mandatory audit firm rotation. Mandatory comprehensive review would also include a requirement to disclose the justification either for retention or replacement in the auditor, as well as the process the audit committee went through to reach that conclusion. Potential Benefits 42. The concept of mandatory comprehensive firm review puts an onus on the audit committee to consider, and report on, the auditor s independence in both mind and appearance, as well as the application of professional judgment and auditor skepticism. The disclosure requirements would improve transparency around the auditor evaluation and reappointment process. The primary focus of this concept is on how audit quality can be enhanced. The IWG recommends a consideration of a comprehensive review led and driven by the audit committee at least every five years or more frequently if problems identified. The current practice of a yearly assessment of the auditor would continue. 43. Audit committees are directly responsible for overseeing the work of external auditors, including resolving financial reporting disagreements between management and the auditors. 6 The objective of the mandatory comprehensive review is to improve the interaction between the audit committees and auditors, and encourage beneficial behavioural changes in the culture of the audit teams and audit firms. As part of the review, the auditor would be required to demonstrate to the audit committee how they exercised appropriate skepticism. This focus should lead to improved audit quality and transparency for shareholders, as well as a better understanding of the auditor s independence and skepticism. Discussion 44. The key points raised during discussion by the IWG are summarized below: 5 CPAB, Request for Comment: Concept Release on Auditor Independence and Audit Firm Rotation PCAOB Rulemaking Docket Matter No. 37, December 19, It is with this in mind that we suggest the PCAOB explore mandatory audit firm review as an alternative to mandatory audit firm rotation. This process would require the audit committee to formally evaluate the effectiveness of the auditor on a periodic basis, and to report the results of this evaluation to the shareholders. In this report, the audit committee would, among other things, justify why the existing auditor has been reappointed or why a new auditor has been appointed. The frequency of this process and the contents of the report would need further study. For this process to work effectively there must be appropriate structure, rigour and transparency applied by the audit committee. Furthermore, there is a need for greater transparency with respect to disclosure of auditor changes. In our experience, disclosure of the reasons for auditor changes are usually boilerplate and the signalling mechanism that this could provide financial statement users should be made more effective. 6 The audit committee s responsibility is extracted from the CSA s NI

23 A mandatory review process would promote the assessment of audit quality, independence and professional skepticism and would influence audit firms to enhance audit quality so that they will do well in the review assessments. As auditors tenures increase, there is greater risk of familiarity threats to independence. The Role of the Audit Committee Working Group (ACWG) has agreed to review the details of the mandatory comprehensive review so that appropriate criteria, tools and guidance could be developed to assist audit committees conduct a mandatory comprehensive review. The following is a list of the types of factors that could be considered in assessing an auditor s performance: disclosing the length of the relationship with the auditor and when the audit was last put out to tender, as well as discussing any institutional familiarity threats, including the tenure of the audit firm; evaluating the tenure of all senior members of the audit team; assessing the qualifications of the audit engagement team; obtaining information about audit regulator findings about the firm; evaluating the amount of audit fees from the reporting issuer in relation to the total partner, office, region or audit firm fees, and the related safeguards to manage any perceived threats; reviewing the results of internal quality control reviews and understanding the audit firm s internal quality control procedures; reviewing the number and type of consultations with the audit firm s national office technical resources; discussing high-risk areas with the auditors, obtaining details of any of their challenges, and how those challenges were resolved; evaluating auditors independence, including any breaches and how they have been mitigated; understanding the type of non-audit services the auditors have provided and the related independence considerations; reviewing any change in the audit fee over the assessment period and whether such a change has affected audit quality or has the potential to do so; reviewing information from investor services related to financial reporting or auditing; and discussing criticisms of financial reporting by securities commissions or others, and the auditor s response. Certain factors may already have been considered by the audit committee in their annual assessment of whether or not to recommend reappointment of the auditor. The ACWG has agreed to examine which factors are part of the annual assessment, which are a part of the comprehensive five-year review, and whether some of the areas covered annually need to be evaluated in greater detail in the comprehensive review. Appropriate criteria, tools and guidance will need to be developed to assist audit committees in carrying out mandatory comprehensive review and related disclosure requirements. 22

24 Consensus In reviewing the factors above, consideration will also be given to the scope of reporting issuers that would be subject to the regime, including a scalable solution for smaller companies. To ensure that mandatory comprehensive reviews are effective and avoid possible management bias, the audit committee needs to make the required assessments. Although this would increase the burden on the audit committee, the time required may well match up with what would be required under mandatory audit firm rotation and tendering. An implementation plan may include applying the reviews to the largest reporting issuers first. Scalability could be also be used to reduce the burden on smaller reporting issuers. One of the components of the process would include information from audit regulator findings. Changes to legislation may be required to make this feasible. This topic is currently being reviewed by CPAB in the Canadian context as it has both benefits and limitations. The IWG also considered whether a multi-year fixed audit term (e.g., term of three years or more) could enhance the culture of skepticism and objectivity because there would be less of a concern about the auditor being terminated. The IWG did not support this proposal as it would constrain the audit committee s accountability and responsibility for assessing and appointing the auditor. 45. The IWG recommends mandatory comprehensive review as both audit committees and auditors would focus more on audit quality and on the exercise of professional skepticism. Audit committees would undertake a comprehensive review process and make related disclosures at least every five years, while continuing their annual auditor assessments. This recommendation will be further developed by the ACWG. 46. Although the IWG agrees that all of the concepts proposed might improve auditor independence to varying degrees, it does not support mandatory audit firm rotation and mandatory tendering because of the potential negative consequences to audit quality and associated company governance. The disruption in the audit services marketplace would be disproportionate to the significance of the problem the concept aims to address (e.g., institutional familiarity risks given that other alternatives exist). Do you agree with the IWG s recommendation? Please explain why. Do you believe that mandatory audit firm rotation or mandatory tendering is a preferred alternative? Please explain why. Do you think that the current rules are appropriate and no changes are required at this time? Do you have any other suggestions? 23

25 Non-audit services Background 47. The EC proposals addressed further changes to non-audit services. These changes include a requirement for permissible non-audit services to be approved by the audit committee. In addition, certain services will: require pre-approval by a Member State designated competent authority; be prohibited and can never be provided; and be capped at 10% of total statutory audit fees (permitted related audit services). 48. These proposed changes differ from the current Canadian rules in that they would increase the number of prohibited services, require an additional body outside of the audit committee to preapprove the performance of certain services, and require audit committees to consider a threshold of services that can be provided. Potential Benefits 49. Further restrictions or prohibitions on the provision of non-audit services that audit firms can offer their audit clients could reinforce auditor independence. These changes would address the conflict of interest threats (self-interest and self-review) inherent in the current business model of advisory services to audited companies. Further restrictions on non-audit services may also enhance investor perception of auditor independence, as well as their confidence and trust in audits. Discussion 50. Summarized below are the key points raised during the discussion by the IWG: In Canada, there are safeguards to reduce threats to auditor independence when non-audit services are performed, including: pre-approval by the audit committee for non-audit services; and disclosure of fees for non-audit services provided by the auditor in the company's public filings. As well, there are prohibitions on certain non-audit services where those services are perceived to conflict with the auditor's role or where safeguards have been determined to be inadequate. There are, for example, prohibitions on the auditor performing bookkeeping, valuations, internal auditing outsourcing, information systems design or implementation, human resources functions, corporate finance activities, and legal or actuarial services for an audit client. Particularly for smaller companies, it is more efficient for them to have their auditors offer permitted non-audit services than having to employ advisors with little knowledge of their business. 24

26 Consensus The total fee paid to an auditor for all services, including the audit, is also a relevant factor in assessing whether there is a self-interest threat to the auditor's independence. This is arguably a greater threat to independence than the ratio of non-audit services to audit service fees. Evaluating the amount of a client s fees in relation to the total partner, office, region or audit firm fees and related safeguards was included as a factor for review by the audit committee in the mandatory comprehensive review. Based on a review of the TSX60 disclosures, non-audit services (excluding audit related) represent on average less than 20% of total fees billed to companies in Canada by their auditors. The view of the IWG was that the extent of non-audit services provided by auditors today in Canada does not support further significant prohibitions on non-audit services provided by auditors 51. The IWG recommends the continued use of the Canadian principles-based approach to evaluating threats to, and safeguards for, the provision of non-audit services, with appropriate rule-based prohibitions for services when threats cannot be overcome. The IWG identified three differences between the Canadian and SEC/PCAOB prohibitions and recommends that those establishing independence rules in Canada assess these differences on a rule by rule basis. The three differences are personal tax services for individuals in financial reporting oversight role, aggressive and confidential tax transactions and providing non-audit services on a contingency fee basis. The IWG would support additional prohibitions with respect to the first two in the Canadian independence rules. The IWG recommends further study on the question of non-audit services being performed on a contingency fee basis to assess the impact on auditor independence. Do you agree that additional prohibitions similar to the SEC/PCAOB rules would be appropriate? Do you believe further restrictions are necessary and, if yes, what further restrictions should be considered and why? 25