I am writing in a personal capacity. I am currently chairman of two listed companies and the chairman of three audit committees.

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1 Robert Hodgkinson Esq Project Director Audit Firm Governance Working Group ICAEW Chartered Accountants Hall PO Box 433 Moorgate Place London EC2P 2BJ 28 January 2009 Dear Robert Audit Firm Governance I am following up on our discussions of 20 January. Although I am interested in the process of audit as a user of audit services, it is now more than eight years since I was involved in the management of a professional practice and therefore may lack perfect knowledge of both the current organisational structures of the large audit firms and of the detailed rules of audit regulation. I am writing in a personal capacity. I am currently chairman of two listed companies and the chairman of three audit committees. As a company director and shareholder, I have an interest in the quality and continuity of audit and the need for audit firms to command public trust. I congratulate the working party on examining the issues of audit governance and the potential for a governance Code along the lines of the Combined Code. However, while well intentioned, I believe that in the context of private partnerships the original recommendation of the MPG is flawed and is in danger of producing a box-ticking outturn that is unlikely to have a significant impact on the primary objective of improving audit quality and continuity. As a result I apologise for a more philosophical than technical response to the consultation paper and will comment under three principal headings; Licence to Operate N M Rothschild & Sons Limited New Court, St Swithin's Lane London EC4P 4DU, United Kingdom Telephone: +44 (0) Facsimile: +44 (0) Registered number England Registered office as shown Authorised and Regulated by the Financial Services Authority

2 Licence to Operate Governance Code; Audit Quality and Continuity The large accounting and audit firms clearly have a significant position in the UK economy and dominate the public interest audit market. They are responsible for the audit of the major public companies and public interest organisations, they are large employers, and they take in a significant proportion of the best graduates from the leading UK universities. Certain parts of their operations such as audit and actuarial services are externally regulated but the firms as a whole are unregulated. Given their position of influence it seems appropriate that they should be accountable for their activities and earn their licence to operate. This was an underlying theme of the original proposals for an OFR, which required a broader commentary on business objectives and performance to a wider range of stakeholders and not just shareholders. In my opinion, if the objective of your work is to enhance trust in the audit market, this should be at the heart of your proposals. If stakeholders are to obtain a better understanding of a firm s objectives and performance, then its arrangements for governance will be a key element of that disclosure. My understanding is that the major firms are already well down this path and should be encouraged (required) to provide a free form description of their governance arrangements in the degree of detail that would be offered by a listed company under the Combined Code, but in a form that best reflects their own operating structure. There is a bold unsubstantiated assertion in line 6 on page 5 of the consultation paper that on its own this is not enough. For the reasons set out below, I disagree with this conclusion. Governance Codes I believe strongly in good governance and was a member of the Hampel Committee. In the corporate world, the primary purpose of the codes of governance from Cadbury through Hampel to Higgs have been to deal with the agency/principal issues where owners of joint stock companies are divorced from management. This was clearly the position of Hampel and, while under recent companies legislation responsibilities have been extended to other stakeholders, it remains at the operational heart of the Combined Code. At present, and for the foreseeable future, the major audit firms are not corporations. They are run by their owners in partnership structures that the owners are able to control. I can see no reason why the FRC would wish to establish a preferred template as to how private firms should be run, unless it is part of their licence to operate (which does not require conformity - see above) or to ensure audit quality (see below). /PAS -2-

3 The histories, cultures and expectations of the owners of these private firms will be different, as will the way in which they organise themselves to meet their objectives. It is entirely appropriate that the users of audit firms (the clients) should be able to understand the governance processes and, in my opinion, an OFR-type of disclosure would achieve that. The objective should be to ensure that the governance arrangements of a firm are explained. In my opinion, the case for a Code is not made by the consultation paper; the need for further more helpful information about the strategy and the operations of a firm as key player in the UK economy, or as a basis for choosing a responsible supplier, are understated. We are also in the early stages of understanding the limitations of a Code and there is still a simplistic view that if form is evident, the substance will also be there. The recent problems of the financial markets have clearly shown that while all the major financial organisations had in place best-practice governance structures as required by the Combined Code, governance itself may have been undermined by the human weaknesses of the individuals responsible for it. The requirements for a Code contained in the consultation paper fall into the tick-box category where comply or explain means comply when what we need is a search for substance rather than form. Audit Quality and Continuity The thrust of much of the work of the profession in recent years has been to improve the quality of audit and mitigate the risks of the concentration of major audits in the hands of a small number of audit firms. These are valid concerns and this work is appropriate. The job of the audit regulator must be to ensure that in all material respects the audit practice is fit for purpose and that a firm can reliably be appointed or re-appointed as a company s auditor. That assessment must include consideration of the governance of the audit practice in the context of the firm as a whole. Quality starts with good governance but not necessarily a conformed homogeneous structure of governance. I am not familiar with the detailed requirements of the audit regulator or the AIU, but I assume that in order for the regulator to be satisfied with the quality assurance processes of a firm, it will wish to be satisfied with the governance of that audit business and of any larger entity of which it is a part. I would hope that the audit regulator is already exploring the substance of governance if it is to be able to assess a firm s quality standards as well as the risks elsewhere in the wider business that could prejudice audit quality. If not, perhaps the scope of its work should be extended. Beyond the quality of audit, the MPG is concerned about the continuity of the Big Four. My assessment is that the threats to the continued existence of a large audit firm are principally:- /PAS -3-

4 1. The failure of its audit processes leading to material uninsured losses from the failure of a single audit, or the loss of reputation from a run of failures. 2. Uninsured losses arising from a disproportionate share of loss arising from a company failure. 3. Fragmentation of its network as a result of similar issues in other important jurisdictions. The risks of 1 should fall within the scope of the work of the audit regulator. As regards 2, the UK Government has permitted auditors to contract for the limitation of liabilities. If the risk of a Big Four firm failing as a result of a disproportionate liability for losses following from an event is real, the FRC has it in its hands to persuade corporations, investors and auditors to enter into proportionate liability agreements. In my opinion this really would make a difference; a Code of itself would not. As regards 3, the network status of the large audit firms and their vulnerability to poor performance in key overseas locations represents a significant risk to the viability of any firm. This is clearly an international and not just a UK domestic issue. While firm X in the UK could have a governance structure that complies with any Code that might be established for its UK operations, it could disappear as a global supplier as a result of issues in other jurisdictions. For a multi-national corporation, understanding a large firm s international arrangements should be far more important than its compliance with a code focused only on the board and management structures of its UK business. I am interested in the quality and continuity of an audit firm in the UK. As a user of audit firms I want to know that the audit regulator is satisfied with the quality of their audit work and the viability of its audit practice within the context of the firm as a whole. As a user I am interested in how the firm operates and is governed. As a stakeholder, I want:- To understand how it earns its licence to operate and To know how it will remain viable as a global provider. But I do not need to know that in the detail it is conformed to its peers. I might comment on two further areas where information has been requested. Non-Executive Directors (Q7-9) I am a firm believe in the value of non-executive directors and the independent challenge they can bring. But audit firms may have difference levels at which they might seek non-executive input. They might appoint non executives to the supervisory board of the LLP, or to its executive/management board, or its audit practice board. They could be formal non-executive directors in the conventional sense or work as an advisory group. In a large firm, they could /PAS -4-

5 conceivably work at all levels and be of both types. For firms that are constituted as European practices, should the focus be on the UK operations or those of the European firm? I cannot see how, or why, the FRC would want to prescribe best practice. Better to get to the substance of governance through a description provided by the governance section of the OFR, allowing the user of this information to make his/her own assessment as to whether the structures described appear appropriate to the operations of the firm concerned. Scope of Coverage (Q 10 & 11) By stepping back from the proposals for a Code to a broader requirement that governance is described in an OFR format, there is less need to struggle with question who should be covered by a code? It becomes a matter of choice for the firms involved in the context of the expectations of their clients and Society. Trust is built up by full disclosure trust is good for business! Conclusion As you will have judged from our meeting and this submission, I believe that, whilst well intentioned, the MPG is taking us down the wrong path and these proposals add bureaucratic complexity but little substantive benefit in addressing the reasonable concerns of audit quality and continuity. Please let me know if there is any further information you require. Yours sincerely Peter Smith /PAS -5-