HERMES EQUITY OWNERSHIP SERVICES RESPONSE TO THE FRC S CONSULTATION DOCUMENT: REVISIONS TO FRC GUIDANCE ON AUDIT COMMITTEES: NON AUDIT SERVICES

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1 HERMES EQUITY OWNERSHIP SERVICES RESPONSE TO THE FRC S CONSULTATION DOCUMENT: REVISIONS TO FRC GUIDANCE ON AUDIT COMMITTEES: NON AUDIT SERVICES Background By way of background, Hermes is one of the largest asset managers in the City of London. As part of our Equity Ownership Service (EOS), we also respond to consultations on behalf of many clients from around Europe and the world, all of them long-term owners of companies who therefore are keen to ensure that regulation works effectively in the interests of long-term investment and prosperity. These clients include: the National Pension Reserve Fund of Ireland, Australia s VicSuper, Pensioenfonds PNO Media of the Netherlands, Public Sector Pension Board of Canada and from the UK the BBC Pension Scheme and Lothian Regional Council s pension fund (only those clients which have expressly given their support to this response are listed here). In aggregate EOS has over 60 billion assets under advice. Introduction The quality of the audit of the companies in which we invest is of great importance to our clients. Threats to audit quality are significant and it is important that the audit profession, its regulators and the audit committees of audited companies all play a role to ensure the highest possible standards of audit. However, it is also important that each of them discloses publicly how it has done so in an informative manner. This will enable investors and other interested stakeholders to obtain the necessary reassurance. We have previously raised our concerns about two particular non-audit services provided by external auditors: restructuring advice for distressed companies and internal audit functions. We believe that it is the audit committee, above all, that must ensure that any potential or perceived conflict of interest is reported and managed to the satisfaction of investors. We therefore welcome the FRC s consultation on this matter. As an appendix we attach our response to the parallel consultation by the APB in which we argue that additional disclosure by the audit firms would also be of help. Suggestions on draft guidance We welcome the revised guidance and make a few suggestions which we believe improve further the FRC s proposals. As ever, as in relation to our comments on the UK Corporate Governance Code, we are keen to encourage disclosures by companies in which our clients invest which are substantive and do not just cover procedural matters. We support drafting which guides companies in this direction. Paragraph 4.7: We would note that the linkage between the Turnbull statement in the corporate governance section of the annual report and the risk management section of the business review is often weak, implying that the audit committee is reviewing these statements in isolation rather than holistically. Moreover, disclosure of how such approval is achieved is not often clear. We would recommend that the guidance encourages the audit committee to ensure that the statements are considered holistically. Perhaps, 4.7 could read: the audit committee should review and approve all statements included in the annual report in relation to internal control and the management of risk in a holistic fashion and report to investors in the annual report how it has done so. 1

2 Paragraph 4.8: We note that it is not only the provision of internal audit services by the external auditors that can be problematic; it is also the blurring of the boundary between internal and external audit in the case to which our previous consultation responses have referred the external audit remit was significantly expanded to include work previously done by the internal audit function of the company. We do not believe that the new paragraph addresses this point sufficiently. We therefore suggest that the first sentence should be revised to read: If the external auditor is being considered to undertake aspects of the internal audit function, or if the scope of the internal audit function or of the external auditor changes significantly, the audit committee should consider. As a result the second bullet point should also be amended to read: the nature and extent of the work performed by the external auditor, including any significant changes to the scope of the external audit or non-audit services, and Paragraph 4.16: Further to our point about the blurring of the boundary between internal and external audit we would recommend further bullet points to read: satisfy itself that the division of responsibility between the internal audit function and the external auditors is appropriate; and report to investors in the annual report on the foregoing points in 4.16 and otherwise to demonstrate how the internal audit function, the external auditors and other aspects of risk management work together. Paragraph 4.27: We would suggest that the overriding purpose of audit committee approval of non-audit services work is to ensure the external auditor s independence and objectivity. We would therefore suggest assessments of the external auditor s independence and objectivity should take place at least annually and before approval of any non-audit work and included in the committee s standing authority in this regard. Paragraph 4.28: we have similar concerns to those expressed in relation to As part of the approval process for significant non-audit services (both in scope of proposed service especially those that might be perceived to be pushing at the boundaries of the Ethical Standards - and in level of fee) the audit committee should seek reassurance on its policies and processes for maintaining independence and so forth. Paragraph 4.29: We believe that the audit committee should also take account of the Ethical Standards (and not rely solely on the audit firm s assurances regarding their processes for compliance with them). Paragraph 4.37: This paragraph should be reworded to ensure that disclosure about how auditor objectivity and independence is safeguarded is made even if no nonaudit services are provided by the external auditor. We propose: The annual report should explain to shareholders how auditor objectivity and independence is safeguarded. Paragraph 4.38: Further to our previous suggestions we believe that there should be a final bullet point: provide a reasonable investor sufficient detail to assess that the audit committee has discharged its function appropriately. 2

3 APPENDIX HERMES EQUITY OWNERSHIP SERVICES RESPONSE TO THE AUDITING PRACTICES BOARD S CONSULTATION ON REVISED DRAFT ETHICAL STANDARDS FOR AUDITORS Background By way of background, Hermes is one of the largest asset managers in the City of London. As part of our Equity Ownership Service (EOS), we also respond to consultations on behalf of many clients from around Europe and the world, all of them long-term owners of companies who therefore are keen to ensure that regulation works effectively in the interests of long-term investment and prosperity. These clients include: the National Pension Reserve Fund of Ireland, Australia s VicSuper, Pensioenfonds PNO Media of the Netherlands, Public Sector Pension Board of Canada and from the UK the BBC Pension Scheme and Lothian Regional Council s pension fund (only those clients which have expressly given their support to this response are listed here). In aggregate EOS has over 60 billion assets under advice. The quality of the audit of the companies in which we invest is of great importance to our clients. Threats to audit quality are significant and it is important that the audit profession, its regulators and the audit committees of audited companies all play a role to ensure the highest possible standards of audit. However, it is also important that each of them disclose how it has done so publicly in an informative manner so that investors and other interested stakeholders can obtain the necessary reassurance. Summary The provision of non-audit services can provide a significant threat to the perception of audit quality as well as, we believe, audit quality itself. We therefore believe that appropriate regulation of these services is correct. We therefore support the consultation and recommend some changes to regulation, notably to place limits on the external auditor s ability to provide certain restructuring services. Our other chief concern is that audit firms are adept at assessing formal compliance with accounting standards and similar. We fear that this culture may extend to how they view their own professions Ethical Standards. We believe that the firms should be encouraged to work in the spirit of the revised Ethical Standards and explain how they do so. The UK Corporate Governance Code has encouraged companies to think about their behaviour and culture and we believe that the audit firms need to demonstrate to outsiders that their culture expects the highest standards not merely ticking regulatory boxes. To act as a catalyst and as a supplement to greater openness by the audit firms we also expect audit committees to disclose better how they ensure that their chosen audit firms provides the best possible audit and manages the threats to their independence and objectivity, going beyond mere reliance on the self-professed professional standards of the industry. Finally, as an appendix we attach the parallel consultation by the FRC. 3

4 Question 1: 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? We are broadly supportive of the approach. However, we have a few concerns: The focus on quantitative limits in the discussion is worrisome; it is often the qualitative aspects of non-audit services that present the sharpest potential threats to objectivity and independence; the APB, in its further research should ensure that some evaluation of the type of service as well as the cost of the service is considered. We would encourage the APB to ensure that the audit firms explain clearly how their Ethics Partner considers whether to approve non-audit services. We note that the Ethics Partner is unlikely to have a detailed understanding of the audited entity, the services proposed and the state of the existing relationship. Therefore the audit firms have a need to provide substantive disclosures to overcome assumptions that the role is just to rubber stamp decisions. Once an audit firm has provided explanations of the basis for such decisions, the audit committee of the audited entity can and should ensure that these are well explained in the annual report, taking account of the qualitative issues, not merely cost factors. Moreover, the audit firm should make clear statements under the new audit firm governance regime about how it manages this issue. We are satisfied with the regime as proposed for small or medium sized entities. Question 2: Are the correct services included in the list of audit related services (see ES5 (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). We agree with the list provided. However, we would emphasise that the last bullet point may not include extended audit services which were at the heart of concerns about one listed company s relations with its external auditor when the scope of the external audit was expanded significantly and the scope of the internal audit similarly reduced. Where such significant changes occur, be they described as audit services or audit related services it is imperative that not only are the fees incurred disclosed but also the reasons for the change. It is not the form but the substance that is important. It seems to us that where there is a substantial change in the scope of the external auditor s work be it either in relation to the audit or to audit related services or to non-audit related services there must be a clear explanation provided to the owners of the company. This same principle should apply when audit services are reclassified as audit related services and vice versa. Question 3: Will disclosure of additional information about non-audit services in the form of a template (such as that included as an appendix to ES1 (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? The template seems satisfactory though no doubt issues may emerge as it is used. However, the perception of threats to objectivity and independence may actually increase as a result of this greater disclosure. It is essential for the audit committee to explain the reasons for significant variations to each service and the reasons why the audit firm was used to provide the services, in particular the non-related services. 4

5 We would also note that there will be a strong tendency to ensure that the services appear within less controversial categories. For example, one could imagine that it might be possible to see that assistance with tax returns might include tax advisory services. We would expect audit committees to be alive to this concern and ensure that substance rather than form is how these categories are defined and explained to outsiders. Question 4: 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? We believe that our suggestions in our response to the consultation will help to reduce the perception of threats to objectivity and independence further. We attach our response as an appendix. Question 5: Do you support: The approach taken to the provision of extended audit services in ES5 (Revised) paragraphs [AH] and [AI]? The additional guidance on the threats and safeguards approach in ES5 (Revised), paragraphs [AH] and [AI]? In relation to ES5 AH and AI we reiterate our previous concerns about form and substance; there will inevitably be a tendency to attempt to justify work as being audit related. Moreover, an unintended consequence of the new paragraphs might be increasingly broad audit mandates and more work being done by the audit team to fit the paragraph to meet the formal requirements of the Ethical Standards rather than their spirit. Again, this will require intelligent vigilance and explanation by the audit committee in the committee s annual report and also by the partner responsible for Ethical Standards via the audit firm s transparency report. The strengthening of the role of the Ethics Partner in ES 1 (Revised), paragraphs 21 to 24 and ES 5 (Revised), paragraph [AA]? We would expect that the Ethics Partner be named in the transparency report required by the Audit Firm Governance Code and also expect a report from him within it, explaining how the Ethical Standards are adhered to within the firm and demonstrating how the concerns we have raised within this consultation are managed. We would therefore recommend that such requirements are built into the Ethical Standards. We would also suggest that publication by the audit firm of suitably redacted documented examples of the decision-making process of the Ethics Partner would demonstrate transparently how ethical decisions are arrived at the audit firm. In turn, investors and others with interest in the governance of the audit firms would be able to assess which firms were performing to the standards expected. We would urge the audit firms to publish such documentation, or at least summaries, as a matter of best practice. The amended definition of affiliate and significant affiliate? We are supportive of the proposals. The application of the remuneration and evaluation policies to all members of the engagement team in ES4 (Revised), paragraph 38? We are concerned that the proposed amendment does not go far enough in two respects. Firstly, we note that leads generation for other parts of the audit firm is not excluded by the Ethical Standards. It seems extraordinary that this practice is not explicitly excluded. 5

6 We also note that the engagement team is excluded from the objective of selling nonaudit services but not those who might be supporting the engagement team. We note that one audit firm was criticised for incentivising non-audit services staff who had been supporting the audit in this manner. More fundamentally, audit firms can comply with the letter of the Ethical Standards whilst ignoring, or, at least, not following the spirit. The experience of the Combined Code is that sterile compliance is not beneficial for companies but that behaviour in the spirit of the Combined Code is; this conclusion has been very firmly drawn in the introduction and preface to the UK Corporate Governance Code. We encourage the APB to apply these lessons within the Ethical Standards. We would expect the transparency report of an audit firm to contain a description of the principles it uses to remunerate both audit and non-audit staff and to describe how it minimises any possible conflict. It may be case studies of how it arrives at its decision making would provide a useful demonstration of its approach. One of the concerns about the detailed and complex rules and standards relating to accounting is that they encourage a mindset of formal compliance to the form rather than applying the substance. Unsurprisingly, this had led to a highly technical culture within the audit profession that is adept in interpreting rules to permit certain activity. The Ethical Standards must demand of the audit firms that they not use this approach but to require that they follow the intended spirit of the standards. Moreover, there is an attitude amongst some of the profession that their professional status is sufficient reassurance as to their integrity. We would argue that sadly no professions are immune from failings within their ranks which in turn fuels a desire for transparency which can serve to improve confidence in the audit profession. The other amendments referred to in Section 5? We have no further comments on this section. If not, please explain your reasons and the approach that you think the APB should take. We feel that the Ethical Partner s role is described in somewhat reactive terms. We would expect an individual fulfilling the role proactively to use risk management techniques, including those of internal and external audit to ensure that the culture and practice of the firm was demonstrably of the highest integrity. Question 6: 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? We do not think that any delay to implementation can be justified. Question 7: 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? An outright prohibition would be cleaner and easier. However, there is a practical difficulty in this approach where for example the auditor discovers that the company is in distress, or the auditor believes it to be, and in this situation it must be able to advise the company to take independent advice. This could be construed as preliminary general advice. On balance we are prepared to accept the caveats to an outright ban contained in option 2 but with a caveat of our own: the audit profession is adept at interpreting accounting standards and indeed its own Ethical 6

7 Standards in a fashion that is most favourable to the firm, often adhering to the letter of the relevant standard if not its spirit. Audit committees, audit partners, the partner responsible for the Ethical Standards and the APB itself must be alive to this possibility. We will expect both audit committees and audit firms to disclose how they have managed this risk and we will expect the AIU to examine it in its work. The prohibition should cover all quoted public companies, not just listed companies and it should also cover larger private companies, for instance portfolio companies of private equity firms. Question 8: Does the revised definition of a contingent fee basis give rise to any practical issues? Question 9: Which approach do you consider that the APB should adopt in relation to contingent fees and why? We are assured at all times by the audit firms that they are a professional industry with the highest imaginable standards of professional integrity, akin to the medical profession, for example. The suggestion that contingent fees might have a bearing on their advice and that they should be rewarded more highly if they get a result for their client in relation to a tax matter or similar suggests that these professional standards are not as immutable as the audit firms claim. We perceive that such fees can as a minimum give rise to the perception of self-interest on the part of the audit firms and at worst compromise the advice totally. In turn this might benefit the firms prepared to give the riskiest advice in the hope that they might win a contingent fee. This can put intolerable pressure on the culture of the firm, with the ethics partner placed in a position where he or she is expected to approve work about which he or she feels uncomfortable. Whilst such fees might encourage innovation and entrepreneurial behaviour can they be equated with the industry s claim to be professional? Perhaps this is the question that should have been asked in the consultation. We would also be minded to understand why the audit committee of the audited entity would choose such potentially risky contractual arrangements which might result in a significant downside to the company. We believe that rather than an outright ban these types of questions should more properly form part of the subject matter of a more helpful audit report, the firms transparency reports and their clients audit committee reports with an explicit description of how such conflicts to professionalism within the audit profession and to the effectiveness of the audit and the advice obtained are managed. Question 10: 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? Question 11: 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. We agree that there is a significant issue to be addressed here. Again, we believe that the audit firms transparency reports should explain how such problems are addressed in practice by the firm. We believe that those practical issues that do exist are outweighed by the advantages to the perception of the audit firms integrity that will result from the greater clarity obtained on what is permissible under the Ethical Standards 7