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A Consultation Paper issued by The Ethics Standards Board

Comments from the Association of Chartered Certified Accountants
A FEE paper (here as a PDF) is an attachment to ACCA's response. September 2002

Executive Summary

The confidence of investors and the public is of key importance for capital markets to operate effectively and efficiently. The interests of stakeholders, who rely on information in the public domain, must be protected. ACCA believes that any system of regulation of the accounting and auditing profession must be transparent and proportionate, and must reflect global best practice. It must also rise above vested interests which have undermined confidence in the past. ACCA welcomes, therefore, this opportunity to respond to the public consultation paper issued by The Ethics Standard Board (ESB) Setting the Agenda for Ethics.

ACCA considers that:

• ethical standards should be principles-based as this approach is best suited to a rapidly changing business environment; legalistic, rules-based standards encourage creative, loophole-based avoidance
• the fundamental ethical principles of 'being an accountant' should be common to all accountants irrespective of the nature of their work
• audit committees should be mandatory for all listed companies and should play a more prominent role in reviewing the independence status of auditors; audit committees should be required to approve any non-audit services to be provided by auditors, and to justify this in a public report
• guidance should be developed for those charged with governance so that their responsibilities are clearly defined
• although there should be limitations on services which company auditors can perform for their listed clients, ACCA cautions against extending restrictions to small and medium sized entities; listed companies should provide additional disclosures of non-audit fees than is presently required
• there should be a prohibition on senior audit staff moving to audit clients for an appropriate period after they have been personally involved with the audit
  and
  
• while ACCA does not favour compulsory rotation of accounting firms acting as auditors, the audit engagement partner should change every five years for listed and public interest clients; ACCA considers that, where audit committees wish to recommend the re-appointment of audit firms which have served for more than five years, they should be required to state their reasons in a public report.

Comments on Specific Questions

Q1 What factors should be considered when determining the public interest with regard to the ethical standards of accountants?

1. It is important not to confuse what is 'in the public interest' with what is 'of interest to the public'. The standards which are set should protect the public interest and not simply be steered by public opinion.

2. The term 'public interest' lacks a singular definition and, as a concept, is vague. It is, nevertheless, an important expression of intent and an aspiration of desired behaviour within a community. Public interest is not an absolute, but requires reasonable and informed judgement by the accountant and the profession as a whole.

3. ACCA agrees that there should be a common approach so that all accountants engaged in similar activities should be subject to the same professional ethics. In order to achieve a common approach, it is not, however, necessary for the wording of the various professional bodies' ethical requirements to be identical. Where the professional bodies address different sectors, the implementation of a common approach is better facilitated through the flexibility of wording which is appropriate to each of those sectors. The professional bodies should be able to issue guidance which provides an interpretation of the underlying principles to situations specific to the sectors in question. It is also the case that ACCA's Rulebook is enforced globally and not just in the UK. Its wording, therefore, needs to reflect this.

4. In any case, ESB's aim of a common approach and common wording in the highly important area of statutory auditors will occur naturally as ACCA (and the other CCAB bodies) move progressively to adopt the IFAC Ethical pronouncements. However, as these are principles-based, the exact wording is not itself relevant so long as the guidance reflects the underlying principles.

Q2 Should the ethical standards of accountants be based solely on a system of rules or on a system of principles supported by guidance and rules?

1. ACCA fully supports the principles-based approach. This provides a framework for analysing the risks and safeguards which accountants can use to determine appropriate courses of action. It is suited to the rapidly changing business environment as it allows for a multitude of circumstances which may arise in practice. As such, it best serves the requirements and interests of both the general user and the financial markets.

2. The principles-based approach includes giving examples of threats which might arise and appropriate safeguards to deal with them. Such examples are, however, clearly stated to be illustrative and not comprehensive. If an accountant were to appear before a disciplinary tribunal charged with a breach of ethical requirements, it would not be a sufficient defence to demonstrate that every example of threats and safeguards in the ethical code had been addressed. S/he would need to be able to demonstrate that, in the particular circumstances under consideration, the fundamental principles had in fact been observed - a far more rigorous test of compliance.

3. On the other hand, rules are inflexible and cannot accommodate the many circumstances encountered in practice. Rules provide no insight into the relevant threats and safeguards which auditors should consider.

4. There is now a consensus in the major jurisdictions that a rules-based approach is no longer appropriate.
"A core issue arising in Enron's wake is enhancing existing and planned legal standards with ethical and competency standards, for lawyers, accountants, directors and others. The public cannot be served if professionals who serve as gatekeepers merely follow the letter of the law, but not necessarily its spirit. We need to move away from wooden, rigid, literalism, and encourage all upon whom the present system depends to adopt a bias in favor of the needs of the investing public."

5. Attached to this response is a copy of a paper prepared by the Ethics Working Party of the Fédération des Experts Comptables Européens (FEE), in which ACCA participates. Although it was published over a year ago, it provides a wider discussion of the principles-based approach and its relevance to the setting and enforcement of ethical requirements.

Q3 What are the principal ethical issues encountered by accountants in industry, commerce and the public sector? Is additional guidance needed in these areas?

1. For accountants working in industry, commerce and the public sector, the principal ethical issues encountered can be encapsulated in one statement, which is 'knowingly, either directly or indirectly, to mislead users of financial information'.

2. Ethical dilemmas can be grouped into different clashes of values:

• between an individual's beliefs and those of colleagues/seniors
• within the individual
• between an individual's actions and the actions of others
• between what one believes is 'right' and an inability to follow that belief with action
  and
• between an individual's conscience and his/her 'reasoned' actions.

3. Specific examples of potential areas of conflict and contention for accountants in industry and commerce, include:

• short-termism and associated pressures
• manipulation of expenses
• transfer pricing and overseas markets
• shadow directors
• bribes
• dealing with countries which 'enjoy' dubious reputations
• insider dealing
• use of confidential information and whistleblowing
  and
• dual or multiple directorships.

4. Similarly, for accountants in the public sector, potential areas of conflict and contention include:

• problems of legality
• new public management
• issues of externalities
• employing short term economic arguments to achieve longer term public benefits
  and
• economic arguments colliding with moral arguments.

5. Accountants who are members of professional bodies are required to abide by the ethical codes of those bodies; others within their organisations may not have the same obligations. Accountants working in industry, commerce and the public sector may, therefore, face complex ethical dilemmas. Guidance should be available to enable them to deal with such situations, should they arise. ACCA provides such support through its Advisory Services Unit. In addition, ACCA has produced highly practical guidebooks to help members working in industry, commerce and the public sector in handling such situations.

Q4 Should the ethical responsibilities of accountants working within the financial reporting process differ from those of accountants working outside that process? If so, how?

1. The fundamental principles of 'being an accountant' should be common to all accountants irrespective of the nature of their work. ACCA considers that the ethical responsibilities of accountants working within the financial reporting process should not differ from those working outside that process. Any such differentiation is considered unnecessarily complicated, arbitrary and unworkable. Ethics is indivisible.

2. Although the fundamental principles are the same, their application depends on the circumstances in which the accountant finds himself or herself. In particular, those working within the financial reporting process will necessarily encounter different threats in the application of fundamental principles than those working outside the process. Consequently, appropriate guidance has to be developed to assist both categories of accountants to interpret and apply the fundamental principles in their particular situations.

Q5 Is there a loss of public confidence in the independence of auditors in the United Kingdom and the Republic of Ireland? If so, how serious is it?

1. Rarely have newspapers carried so much coverage on accounting issues. Although there is no firm evidence of this, the Enron and WorldCom collapses appear to have undermined the public confidence in the independence of auditors.

2. The 'truthfulness and fairness' of information regarding the financial position of entities is the cornerstone of any capital market, yet the credibility of the information and the regulatory systems which are in place has been brought into question. Users of financial statements are looking for accuracy and certainty about the reported results and expect the audit process to provide this. This misunderstanding of the audit process creates an 'expectations gap' between the standards expected and those prescribed, and this continues to be of concern. The problems exposed by these high profile failures go further, however, than simply a breakdown in auditor performance. They have triggered a wide-ranging debate which has called into question many aspects of the operation of capital markets as well as concerns about financial reporting and auditing standards, regulatory arrangements and the quality of corporate governance in major companies.

Q6 What are the other ethical issues encountered by accountants in public practice? Is additional guidance needed in these areas?

1. Ethical issues encountered by accountants in public practice include:

• objectivity 
• integrity
• competence
• due skill, care, diligence and expedition
• courtesy and consideration
• conflicts of interest
  and
• confidentiality.

2. Guidance is available to accountants in public practice in the above areas. In addition, having revised its guidance on independence (Section 8 of the IFAC Code of Ethics), the IFAC Ethics Committee is currently undertaking a rewrite of the remainder of the Code on a principles-based approach. The IFAC guidance will be incorporated into ACCA's guidance.

Q7 Can company auditors ever be truly independent while they are effectively appointed - and reappointed - by the directors on the advice of management?

1. If the line in question 7 is taken, it is questionable whether auditors can be 'truly' independent as the company pays them for the service which they provide. As noted in Section 8 of the IFAC Code, the use of the word 'independence' creates misunderstandings. It implies that, in exercising professional judgement, auditors should be free from all economic, financial and other relationships. This is clearly impossible as relationships exist between auditors and their clients. It is, therefore, the significance of the relationship which needs to be evaluated in the light of what a reasonable and informed third party, having knowledge of all relevant information, would reasonably conclude to be unacceptable.

2. The legal position is that auditors are, technically, appointed by shareholders. However, ACCA favours a greatly enhanced role for audit committees in the appointment and re-appointment of auditors of listed companies. This will mean audit committees having a much higher profile in the auditor appointment process and will make the appointment of the external auditors less dependent on the executive directors.

Q8 What other models for appointing company auditors should be explored? For example, is there a case for establishing an independent body to appoint auditors to listed companies?

1. It may be worth exploring the creation of an independent panel to deal with appointment of auditors of listed companies. Private sector or even governmental bodies might fulfil this role but for multi-national companies a global, rather than national, approach would be necessary. This would require the full backing of regulatory authorities worldwide.

2. Again, as stated in response to question 7, ACCA considers that enhancing the role of audit committees in the appointment and re-appointment of auditors would enhance confidence in this important area.

Q9 Should audit committees be strengthened in order to play a more active role in achieving auditor independence? If so, how?

1. ACCA considers that audit committees should be mandatory for all listed companies in all major capital markets. The role played by audit committees should be strengthened and this may be achieved by requiring them to:

• carry out mandatory reviews of the independence status of the auditors
• report publicly on auditor independence
• justify any recommendation to depart from normal rotation (as noted in ACCA's response to questions 20 and 21)
  and
• approve any non-audit services to be provided by the auditors, and justify this in their reports.

2. The Enron Audit Committee has been criticised for failing to control the apparent exploitation of US accounting rules in order to present a better picture of performance than was the actual case. It is, therefore, necessary to consider what factors contributed to this and how they can be mitigated in order to improve the effectiveness of audit committees.

3. To counter Enron-type circumstances, consideration needs to be given to the time commitment and effort which is required from non-executive directors whose role is to look after the interests of investors and other shareholders. Greater attention should, therefore, be paid to effective board self-evaluation and evaluation of individual directors, including the question of whether members of audit committees devote sufficient time to this part of their duties as directors.

4. ACCA considers that non-executive directors need to be demonstrably independent of the companies on whose boards they serve. There are obvious weaknesses in a system where former executive directors can become non-executive directors and so be in a position of exercising an oversight function in relation to former colleagues. This means that the ideal of non-executive director independence, on which the oversight role is based, is far from easy to demonstrate.

5. The development of mechanisms for monitoring and regulating the operation of audit committees also needs to be considered. Such mechanisms should be independent of auditors, who are not appropriate parties to examine aspects of corporate behaviour which directly affect their own work. The fuller involvement of investors would add greatly to the credibility of governance mechanisms; ACCA considers that investors, particularly institutional investors, should take an active role in monitoring the activities of audit committees.

Q10 Should guidance be developed for those charged with governance - and, in particular, for audit committees - on their consideration of auditor independence? If so, by whom? (This would fall outside the ESB's remit.)

1. Guidance should be developed for those charged with governance - and, in particular, for audit committees. This is a role which could be undertaken by The Financial Services Authority and the Irish Stock Exchange in their capacities as the listing authorities in the UK and Ireland respectively.

2. It is equally important that a code of corporate governance is developed which is capable of global acceptance. Such a code should build on initiatives such as the OECD Principles of Corporate Governance and the World Bank-driven Global Corporate Governance Forum. ACCA urges the promoters of such initiatives to join forces with market regulators (such as IOSCO) and other global organisations (such as IFAC) to develop a global governance code and encourage compliance with it.

Q11 Should the independence requirements differentiate between different types and sizes of entity? If so, what distinctions should be made?

1. ACCA believes that the principle of independence applies equally to small and medium-sized entities as to listed companies. Its detailed application and enforcement may, however, impose different burdens on these sectors and thus give rise to a different balance of cost and benefit. Sectors will differ in their importance and their significance to the public interest. This will mean that the threats to independence are different and safeguards will similarly be different, particularly in the case of listed companies.

Q12 Should all advisory services provided by accountants in public practice be subject to the same ethical requirements as audit?

1. The considerations which make it essential for accountants in public practice to be, and be seen to be, independent may also be relevant to other reporting assignments requiring a professional opinion, including where a document has been prepared in contemplation that a third party may rely on it. Insofar as other assignments, such as tax work or preparation of accounts, are concerned independence in the strict sense applicable to audits may not apply. Nevertheless, the accountant in public practice should be mindful of factors which affect his/her objectivity and ensure that, where any relevant relationships and conflicts of interest exist, these are appropriately resolved.

Q13 What are the key areas that should be addressed by guidance supporting principle-based requirements for auditor independence?

1. The principles-based approach provides auditors with a framework in which to address the many ethical dilemmas which they face. Auditors should use the information available to them to make judgements and to take appropriate steps to reduce or eliminate threats to their independence. The guidance supporting the principles-based approach referred to at paragraph 42 (page 12) of the paper is only one of the elements which is relevant to independence.

2. Of the matters identified at paragraph 42, compliance is the most important. Auditors will have regard to the principles of auditing, specific auditing standards and relevant guidance. The training which they receive, both as part of their memberships of professional bodies and through firms' quality control systems and procedures means that they operate in an environment which promotes understanding and compliance with ethical requirements. In addition to monitoring and discipline within a firm or a group of firms, the importance of monitoring and discipline by the professional body should not be under-estimated.

3. In relation to the three other matters identified at paragraph 42, these factors will promote an appropriate allocation of responsibility for each assessment, the proper determination of measurement issues and, within the boundaries of relevant standards, appropriate documentation of the assessments.

Q14 Can an accounting firm provide non-audit services to an audit client without impinging on auditor independence?

1. The provision of some non-audit services to an audit client may give rise to threats to independence. The significance of a threat needs, however, to be evaluated (please see ACCA's responses to questions 15 and 16). The accountant in public practice should be mindful of factors - such as conflicts of interest - which affect his/her independence. Where any relevant relationships and conflicts of interest exist, these should be appropriately resolved. Disclosure should be to the audit committee or, where there is no audit committee, to those charged with governance. This allows for informed decisions to be made.

2. ACCA considers that there should be greater disclosure in financial statements than is presently required by statute. It will also be appropriate to require some standardisation of the categories used in disclosure.

3. ACCA recommends that listed companies should be required to provide the following additional disclosures for non-audit fees:

• tax work
• work connected with restructuring and acquisitions and disposals
• other assurance work · financial information systems design and implementation
• other information and communications technologies (ICT) related consulting services
  and
• general consulting services.

4. To assist users of disclosed information, analysis should be given for the current and prior year and should be further split into work undertaken in the UK and outside the UK. Additionally, further explanation of the work undertaken should be given where payment for any category exceeds the amount paid for the audit. Appropriate additional details should also be given to explain any significant variation from the previous year.

Q15 Which non-audit services do you consider present the greatest threat to auditor independence?

1. The greatest threats to independence arise from the provision of any service which involves the auditors in auditing their own work, in the decision-making process or in undertaking management functions for the client.

2. ACCA is already on record as favouring limitations on the services which auditors can perform for their listed company audit clients. ACCA considers the provision of internal audit and major financial/IT systems consultancy to a listed client to be incompatible with the independence of an audit firm.

Q16 Should there be a bar or significant restriction on the provision of non-audit services to audit clients? If so, what would be the impact on the quality and cost of the audit?

1. As noted in its response to question 15, ACCA favours limitations on certain services which auditors can perform for their listed clients. ACCA cautions against extending the restrictions to small and medium-sized entities. The problem arises where an audit firm derives substantial consultancy fees from a listed company audit client. This creates the perception - if not the reality - that the audit opinion may be clouded by a conflict of interest.

2. With small private companies, this conflict is less likely to arise and such entities benefit from a 'one-stop service'. Where such services are provided, safeguards should, however, be employed to counter threats to independence. A total ban would lead to loss of business knowledge and adversely affect audit quality.

3. As noted in the response to question 9, ACCA considers that audit committees should be required to approve any non-audit services to be provided by the auditors to the companies, and to justify this in their reports.

Q17 Should an audit engagement partner be permitted to market the firm's non-audit services to an audit client?

1. An audit engagement partner should be permitted to market the firm's non-audit services but safeguards - such as requiring the audit committee to approve any non-audit services to be provided - should be in place to counter threats to independence. In larger firms, the audit engagement partner is unlikely be involved in marketing the firm's non-audit services; this will be left to the client-handling partner. In small firms, however, this separation may not be possible.

Q18 Is there a threat to independence if the audit engagement partner's performance is assessed and rewarded in the accounting firm on the basis of success in 'selling' non-audit services to audit clients?

1. There is a threat to independence if non-audit fee generation targets are imposed on the audit engagement partner. This is particularly so in the case of listed and other public interest clients. Safeguards should, therefore, be in place to counter such threats to independence. Where other safeguards are not adequate, it should be an explicit requirement of a firm's constitution not to assess and reward the audit engagement partner on the basis of success in selling non-audit services to audit clients. The audit engagement partner's performance should be judged on the quality and integrity of the audit only.

Q19 Should there be tighter restrictions on employment of former accounting firm personnel with audit clients? If so, what should they be?

1. ACCA considers that there should be a prohibition on audit firms providing audit services in instances where senior audit staff have moved to senior executive roles in client companies. This prohibition could take the form of a moratorium prohibiting audit staff from moving to audit clients for an appropriate period after they have personally been involved with the audit.

2. The EC Recommendation 'Statutory Auditors' Independence in the EU: A Set of Fundamental Principles' requires a two-year 'cooling-off' period for auditors who wish to join clients. It is not clear whether there are any Human Rights Act issues associated with this requirement. If there are, the alternative if employees join the audit client is for the audit firm to resign.

Q20 Should there be a requirement for periodic rotation of senior members of the audit team?

1. ACCA is in favour of mandatory audit engagement partner rotation for listed and public interest entities. Although the EC Recommendation requires a seven year rotation period for engagement and audit partners of public interest entities, ACCA considers a five year rotation period to be appropriate.

2. ACCA believes that periodic staff rotation is one of the potential safeguards to counter threats to independence. Where the long association of a senior member of the audit team with a particular audit client is seen to be a significant familiarity threat, rotation is an appropriate safeguard.

Q21 Should there be a requirement for periodic rotation of the accounting firm acting as auditor in order to introduce a fresh approach to the audit after a certain number of years? If so, how often should this occur and what would be the impact on the quality and cost of an audit? If not, should there be a requirement for periodic competitive tendering for the audit appointment?

1. The SEC and others have rejected the requirement for periodic rotation of the accounting firm. The principal reason for this, with which ACCA concurs, is that the quality of an audit is potentially reduced during the time that a new auditor is building up knowledge of the audited entity. ACCA has suggested improvements in corporate governance mechanisms (e.g. enhancing the role of audit committees) as a means of enhancing confidence in the important area of auditor appointment.

2. Nevertheless, the WorldCom failure seems to suggest that there may be cases where rotation of the audit firm would be effective. It may be best to make rotation after five years the norm for listed companies and to require audit committees to justify any departure from this.

Q22 What guidance should be given on what constitutes financial dependence? In particular, what percentage of a firm's total fee income is it acceptable to receive from an audit client?

1. There is guidance in ACCA's Rulebook on what constitutes financial dependence. The public perception is that a firm's independence is likely to be in jeopardy where the fees for audit and other recurring work paid by one client or group of connected clients exceed 15 per cent of the gross practice income or, in the case of a member practising part-time, 15 per cent of his/her gross earned income. Where the public interest is involved, it is particularly important that independence is seen to be preserved and in the case of listed and other public interest companies, the appropriate figure should be 10 per cent of the gross practice income.

2 Auditors should not, however, view the above percentages as automatically indicating that no risk exists below these levels. Depending on the circumstances of both the firm and the client, it may be appropriate to instigate a risk review at lower percentages. The key point here is that there may always be a risk to independence arising from an individual client (or group of associated clients).

3. For this purpose, a figure of 10 per cent or more of the gross practice income arising from accepting or retaining an audit client (or group of associated clients) should probably be the trigger point for instigating a review. In the case of a listed company or other public interest company, a figure of not more than 5 per cent is the appropriate point at which to initiate a review.

4. The consideration of threats and safeguards relating to fees is important but can be accommodated by the explicit requirements of Statements of Auditing Standard 610 'Communications of audit matters with those charged with governance (revised)'. This requires auditors to communicate relevant matters relating to the audit, including relationships which may impact on the auditor's independence.

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