Submission dated 28 October 2019
Parliamentary Joint Committee on Corporations and Financial Services:
Regulation of Auditing in Australia
By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. - Chief Justice Warren Burger, writing on behalf of a unanimous United States Supreme Court in the case of United States v. Arthur Young & Co. (1984)
Auditor-client conflicts of interest
In corporate Australia it is the client, not the creditors, stockholders or investing public, who pays, hires and fires the ‘independent’ auditor. Yet it is to the public trust that the auditor owes complete fidelity. In these circumstances can the auditor maintain total independence from the client? University research, referred to below, suggests not.
The Joint Accounting Bodies Independence Guide (‘the Guide’) is, ‘intended to assist professional accountants in understanding and applying the auditor independence requirements of the APES 110 Code of Ethics for Professional Accountants (the Code) issued by the Accounting Professional & Ethical Standards Board’.1 The Guide states:
In today’s competitive world trust and confidence are essential to the stability of capital markets. The auditing profession plays a critical role in the orderly functioning of capital markets by performing independent audits. The independence of the auditor is crucial to this process and helps to build the trust of shareholders, regulators and other stakeholders in financial information which has been subject to audit...
Independence requires an individual member to act with integrity and to exercise objectivity and professional scepticism. Members are obliged to be straightforward and honest in professional and business relationships and not to allow their judgement to be compromised by bias, conflict of interest or the undue influence of others.
Independence comprises both:
• Independence of mind
1 Joint Accounting Bodies Independence Guide, Fourth Edition, February 2013 The major professional accounting bodies in Australia established the Joint Accounting Bodies to speak with a united voice to government bodies, standard setters and regulators on non-competitive matters affecting the profession: the Guide p.2
1 • Independence in appearance
This means that members must not only be independent in action but they must also be perceived, by an informed third party, to be independent. This is particularly relevant when providing assurance services. 2
Implicit is an expectation that the auditor faced with a conflict of interest should, or will, have the mental wherewithal, the conscious ability, not to allow their judgement to be ‘compromised by bias, conflict of interest or the undue influence of others’. Implied also is the assumption that independence and objectivity stem from conscious action and motivation. But is that assumption reasonable? Again, university research, referred below, suggests otherwise.
In Australia, the independent audit is regulated by legislation, predominantly the Corporations Act, Australian Auditing Standards, and APES 110 Code of Ethics for Professional Accountants (the Code) issued by the Accounting Professional & Ethical Standards Board (APESB).3
The Australian Securities & Investment Commission states:
An auditor is required to be independent from the entity it audits. ... Maintaining independence has a number of aspects that the auditor must be mindful of throughout the client/auditor relationship. A brief overview of the areas an auditor must be aware of and implement appropriate responses to include:
conflict of interest situations
o general requirements, including the provision of certain non-audit services, and
o specific relationships of the auditor and/or audit team members with the audited entity,
auditor rotation for listed companies. In certain limited circumstances auditor rotation relief may be granted by ASIC
auditors must be diligent in identifying and evaluating threats to independence and applying appropriate safeguards. If a conflict of interest situation remains in existence after seven days, the auditor must inform ASIC in writing that the conflict of interest situation or that the relevant relationship still exists. More information about breach notification.
When conducting an audit or review of a financial report, the auditor must provide a written declaration confirming that there have been no contraventions of the auditor independence requirements or applicable code of professional conduct.4
The auditor-independence model is thus based on self-assessment - by the auditor and/or audit team member. Only in the event of actual or alleged breach does the independent regulator step in.
2 ibid pp.6,9 3 ibid p.6 4 https://asic.gov.au/regulatory-resources/financial-reporting-and-audit/auditors/auditor-independence-and- audit-quality/
2 The Corporations Act has a general requirement for auditors to avoid and eliminate ‘conflict of interest situations’: sections 324CA, 324CB and 324CC. The situations themselves are not particularised but defined in terms of an actual, potential or perceived absence of capacity for exercising objective and impartial judgement:
(1) For the purposes of sections 324CA, 324CB and 324CC, a conflict of interest situation exists in relation to an audited body at a particular time if, because of circumstances that exist at that time:
(a) the auditor, or a professional member of the audit team, is not capable of exercising objective and impartial judgment in relation to the conduct of the audit of the audited body; or
(b) a reasonable person, with full knowledge of all relevant facts and circumstances, would conclude that the auditor, or a professional member of the audit team, is not capable of exercising objective and impartial judgment in relation to the conduct of the audit of the audited body
(2) ... .5
The Guide refers to the definition6 and additionally adopts a conceptual framework of identifying threats, evaluating their significance and applying various ‘safeguards’.7
One such threat category is the ‘self-interest threat’: ‘the threat that a financial or other interest will inappropriately influence the member’s judgement or behaviour.8 In a described Scenario of a self- interest threat - where the audit manager has an outstanding, apparently contested, motor vehicle insurance claim against the insurance company being audited - the audit manager is said to be obliged to disclose the situation to the audit firm, while the partner is said to be obliged to:
... consider and avoid a conflict of interest situation whereby a member of the audit team is not capable of exercising objective and impartial judgement (refer to Section 220 of the Code and the ‘General requirements’ in s. 324CB and s. 324CD of the Act).
The audit partner will need to decide whether a reasonable person, with full knowledge of all relevant facts and circumstances, would conclude that the audit manager is not capable of exercising objective and impartial judgement in relation to the conduct of the audit. It may require safeguards to be implemented, or the audit manager may have to be removed from the audit.9
The example would seem fairly obvious. More critically, however, neither the Corporations Act nor the Guide identifies as a ‘conflict of interest situation’ or ‘self-interest threat’ the ubiquitous circumstance of an audit firm (as distinct from an audit partner, audit manager or team member) receiving a fee from an audit client for conducting their audit. The Guide’s one exception is where:
5 section 324CD 6 e.g. ibid p.29 7 ibid. p.12 8 ibid. p.12 9 ibid.p.29
3 ... total fees from a client and its related entities represents more than 15 per cent of the total fees of the firm for two consecutive years.10
It is not apparent why an underlying audit fee-for-service relationship is not expressly seen as a self- interest threat, why 15% is the percentage figure of total fees below which a threat is not treated as significant or why a specific dollar amount is not also, or alternatively, a threat benchmark.
Generally, a conflict of interest may be said to to exist ‘when there is a clash between professional responsibilities and personal (often material) interests’.11
Personal and material interests may include financial interests. The Guide – but not, relevantly, the Corporations Act - refers to a ‘financial interest’ and cites a Scenario where the audit partner has an interest in a body corporate that is considering borrowing from the audit-client blank. Here, members of the audit team are said to be required to:
... determine whether a known financial interest ... creates a self-interest threat. The nature of the relationship between the partner and the audit team and the firm’s operational structure could be factors in this assessment. The firm’s quality control procedures may require the partner to disclose the matter to the firm. The firm will also need to consider whether the audit partner should be informed.12
Again, the example seems obvious without addressing the more fundamental issue of an audit firm’s financial interests in the audit client: an interest in receiving fees for not just current but also potentially future or ongoing audit and other services, such as consulting services.
It is submitted that a contractual right or expectation to a fee for a service performed, or to be performed, creates a conflict of interest if there is a clash between the service outcome sought by the payer and the professional responsibility of the person or entity performing the service. An audit firm (including the partners or employees) performing a public audit owes its professional responsibility for the audit primarily to ‘the public trust’ not the audit client. Thus, an audit fee paid to the audit firm by the audited entity inherently creates a conflict of interest. Can the conflict be managed?
Unconscious auditor-bias
The Corporations Act requires a conflict to be avoided or eliminated in circumstances where auditor independence is at risk. A critical question is whether in the presence of an ‘audit fee conflict’ an audit firm has the capacity to ‘maintain total independence from the client at all times’ and exhibit ‘complete fidelity to the public trust’.
A joint university research paper entitled Auditor Independence, Conflict of Interest and the Unconscious Intrusion of Bias observes that:
10 ibid p.35 11 Prof. Sunita Sah, Research-paper, Conflicts of Interest and Disclosure, Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, Cornell University, November 2018 , p.3 12 op.cit p.27
4 Independence is central to the function served by auditors. Although managers may have an interest in exaggerating, misrepresenting, or falsifying reports of their firm’s performance, an independent audit report is supposed to provide a credible, unbiased appraisal of the firm's financial status ...
In analyzing the problem of auditor independence, both the academic accounting literature and the mass media have implicitly adopted what could be considered an “economic” perspective on the problem. Theoretical papers, empirical analyses, and media discussions of the issue of independence assume, sometimes explicitly and sometimes implicitly, that auditor bias is a matter of deliberate choice ...
Auditors are assumed to have the ability to complete high-quality, independent, unbiased audits if they choose to do so. Bias, to the extent that it is thought to exist, is seen as a deliberate response to incentives. This “economic” account of independence and bias is challenged by psychological research which suggests that biased information processing is not only pervasive, but is typically unconscious and unintentional—i.e., seldom a matter of deliberate choice. Applied to auditing, this research suggests that auditors who face conflicts of interest may find it difficult, if not impossible, to avoid bias even if they attempt to do so.13
The conclusion supports the view that the financial nexus between auditor and audited entity needs to be seriously examined, if not eliminated. Differences of opinion over whether audited entities should instead pay an audit fee or levy to a regulator, or other independent third party, who then selects the auditor - thus entirely removing the entity from the ‘hire or fire’ decision - or whether an entity’s shareholders or others should pay it, should not, it is submitted, be allowed to stymie the more important question whether the nexus itself should be eliminated.
In a research paper prepared for the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry entitled Conflicts of Interest and Disclosure, Professor Sunita Sah observed that:
Unintentional and subconscious self-serving biases have also been implicated for the impossibility of auditor independence. Auditing firms benefit from being rehired by their clients to perform audits and are paid by their clients. Hence, they have an incentive to please their clients with (supposedly independent) auditing work. Individual employees of auditing firms are often hired by their past or present clients, and auditing firms often sell other services such as consulting to their clients which again provides reasons to please. This lack of independence is linked to the failure of auditors to notice scandalous finances of firms such as Enron, Worldcom, and Xerox.14
It is submitted that the existing self-assessment and self-management model cannot be relied upon effectively to manage auditor conflicts of interest so as to ensure objectivity, impartiality and independence. To further quote Moore, Loewenstein, Tanlu and Bazerman:
13 Moore, Don & Loewenstein, George & Tanlu, Lloyd & Bazerman, Max. (2002) Auditor Independence, Conflict of Interest and the Unconscious Intrusion of Bias 14 op cit. p.8
5 Auditors rarely set out to commit fraud. However, it is difficult for auditors to be truly independent in a system where auditors’ livelihoods depend on building relationships with clients to solicit business and in which an auditor who issues a critical public audit report dramatically increases the probability that the client will switch auditors. ... Our results suggest that problems of conflict of interest are more profound than is commonly assumed. It is not enough to be conscientious and consciously counteract potentially biasing influences on judgment, because people may simply not be able to adequately correct for biasing partisan influence. Eliminating partisan allegiances may be the only way to eliminate conflict of interest.15
The issue of audit independence and quality, however, is not confined to questions concerning legislative and professional-standards adequacy, but extends to the question whether those who apply the standards should be allowed to set them.
Audit standard-setter conflicts of interest
On a website carrying the Australian Government’s logo the Auditing and Assurance Standards Board (‘AUASB’) states in a Statement of Expectations that:
The AUASB was established as an independent body to set auditing and assurance standards for Australian businesses. Nevertheless, The AUASB operates as part of the Australian Government and is accountable to the Parliament, and ultimately to the public, through the Treasury Ministers, the Parliamentary Committee process and the tabling of its annual report. ...
It is imperative that the AUASB act independently and objectively in performing its functions and exercising its powers as set out in Part 12 of the Australian Securities and Investments Commission Act 2001 (ASIC Act). Nevertheless, the Government expects that the AUASB will take into account the Government’s broad policy framework, including its deregulation agenda, in performing its role and meeting its responsibilities.16
In a Report to Parliament entitled Oversight of ASIC, the Takeovers Panel and the Corporations Legislation No.1 of the 45th Parliament 13 February 2019, the Parliamentary Joint Committee on Corporations and Financial Services at paragraph 2.49, Structure of the Industry, noted that:17
... [T]he industry is dominated both locally and globally by four big firms: PricewaterhouseCoopers (PwC), KPMG, Deloitte and Ernst and Young (EY).
At least 6 of the 11 current Board Members of AUASB are reported as current or past partners of the Big Four firms: Robin Low (PwC), Gareth Bird (Deloitte), Klynton Hankin (PwC), Rodney Piltz (EY), Carolyn Ralph (KPMG) and Julie Crisp (Deloitte).18 19
15 Moore, Loewenstein, Tanlu and Bazerman op. cit. p.31-32 16 https://www.auasb.gov.au/search-result.aspx?search=treasury%20expectations 17https://www.aph.gov.au/Parliamentary Business/Committees/Joint/Corporations and Financial Services/N o1of45thParliament/Report/c02 18 https://www.auasb.gov.au/About-the-AUASB/Current-Board-members.aspx
6 In an article headed ‘Big Four accounting firms emerge as major political donors’, online publisher Crikey Inq’s Bernard Keane states that:
The big global accounting firms -- the architects of multinational tax evasion and systemic conflicts of interest in financial transparency -- cemented their place as Australia's major political donors in 2017-18, an analysis of the Australian Electoral Commission's political donations data shows.20
The firms he lists are Deloitte, Ernst & Young, KPMG and PWC.
The Accounting Professional and Ethical Standards Board (APESB) is an audit co-regulator and its Statement of Purpose is ‘To develop and issue, in the public interest, high quality professional and ethical standards’. Its three Members are the Chartered Accountants Australia & New Zealand (CA ANZ), the Institute of Public Accountants (IPA) and CPA Australia.21
In an article concerning CPA, posted on 13 July 2017, ABC News business reporter Stephen Letts wrote:
CPA Australia has lurched deeper into crisis with an influential group of past state presidents and accounting industry leaders demanding an extraordinary general meeting (EGM) to allow members to take back control of the organisation. The move was immediately frustrated by CPA president Jim Dickson, who declined to release members' email addresses to the dissident group, saying there were issues of "personal privacy" at stake and the mass mailout could be viewed as similar to an online "scam".
The professional accounting body has been mired in controversy over issues of transparency, culture, remuneration of executives, the channelling of members' funds to the promotion of former chief executive Alex Malley's media interests and investing in a loss-making financial planning business.
Over the past six weeks, seven of twelve CPA directors have resigned, leaving the remaining board struggling for a quorum ...
Conflict of interest concerns
The former CPA leaders requested Mr Dickson call an EGM in order to elect a new board and overhaul the body's governance system. 22
In the same article the former CPA leaders are quoted as saying ‘"We also have deep concerns about conflicts of interest of board and management”.
19 https://au.linkedin.com/in/julie-crisp-b0835225 20 https://www.crikey.com.au/2019/02/04/big-four-accounting-firms-emerge-as-major-political-donors/ 21 https://www.apesb.org.au/index.php 22 https://www.abc.net.au/news/2017-07-13/angry-cpa-members-demand-egm/8704508
7 In a later article posted on 3 August 2017, entitled ‘CPA Australia board dragged before senate inquiry over ongoing scandal’, Lyn Hobday wrote:23
The debacle at CPA has already seen the sacking of high profile CEO Alex Malley, as well as the resignation of more than half of the CPA board. Mr Malley was given an almost $5 million dollar payout on his way out in late June, on top of his $1.8 million salary. Senior CPA staffers faced a barrage of questions from the committee at a hearing in Sydney, as they were called to explain their lack of communication with CPA members during the organisation's governance crisis. “The extraordinary behaviour of this organisation, the obfuscation, the opacity, is just mind-blowing," Liberal senator Jane Hume told the hearing.
Concerns about auditor independence, integrity and conflicts of interest extend not just to the auditor-client relationship but to the very composition of Australia’s audit standard setting bodies.
Martin Lock
B.Com (Melb. Uni); Assoc. Dip. Valuations (RMIT); former CPA (resigned); former Australian Taxation Office Manager, Large Business & International Taxation (Withholding Taxes)
23 https://www.abc.net.au/news/2017-08-03/cpa-senate-board-to-face-senate-economics- committee/8772428
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