House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Regulation Impact Statement and Financial Impact Statement

Regulation impact statement

Schedule 1 - Cooperative arrangements concerning audit oversight and ASIC's audit inspection powers

Background

The Sarbanes-Oxley Act of 2002 (SOX Act) substantially changed the US companies and auditors regulation regime. That legislation, and the rules made pursuant to it, creates extensive new obligations for companies that access US capital markets; for auditors of those companies; and for auditors indirectly involved in the preparation of audits for United States (US) capital market participants.

Many of the SOX Act obligations relate not only to the activities directly undertaken in the US, but also to the structure and operation of the activities of companies and auditors in Australia. This could result in an increased burden for Australian companies that seek to raise capital within US capital markets, or to have their securities listed on US markets. The SOX Act also has extensive ramifications for Australian auditors involved in the audit of entities regulated by SOX Act provisions.

A number of major Australian companies have asked ASIC for assistance with the potential inefficiencies created by the concurrent operation of both the Australian regime (as enhanced by the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (the CLERP 9 Act)) and the US regime. These companies acknowledge the need for US-based capital raising rules to apply to US activities but point to the potential for substantial regulatory duplication between the Australian regime and the US rules as they apply more generally, including to the audit process.

ASIC has undertaken discussions with the US Securities and Exchange Commission (SEC) and the US Public Company Accounting Oversight Board (PCAOB) about the regulation of:

(a)

Australian companies whose capital market activities are subject to regulation under both the Australian and the US regimes; and

(b)

Australian auditors similarly subject to regulation under both regimes.

These discussions have concluded that there is potential for significant rationalisation of the two regimes applying to the audit inspection process. ASIC and the PCAOB are continuing their discussions with a view to concluding the details of a cooperative arrangement.

US regulation of Australian auditors

The PCAOB is the front line regulator responsible for ensuring auditors' compliance with US rules. The rules apply to any auditor who prepares or participates in the preparation of audit reports for an entity that is registered with the SEC as an issuer of securities within the US.

Compliance requires registration as an auditor by the PCAOB, adherence to US rules applying to audits of US issuers, and regular compliance inspections by the PCAOB.

To address the special issues raised by non-US audit firms, the PCAOB has developed a framework under which the PCAOB could implement the SOX Act provisions by relying, to an appropriate degree, on a non-US oversight system.

In light of the global nature of capital markets, the PCAOB believes that the effects of a corporate reporting failure in one country tend to ripple through the financial market of another, potentially causing substantial economic damage. The PCAOB considers that it is in the interests of the public, investors and the PCAOB's non-US counterparts to develop an efficient and effective cooperative arrangement where reliance may be placed on the home-country system to the maximum extent possible.

The PCAOB's approach towards the oversight of non-US firms endeavours to build upon the work of overseas regulators in order to minimize administrative burdens and legal conflicts that firms face and to conserve PCAOB resources, without undermining or ignoring the PCAOB's statutory requirements. The more independent and rigorous a home-country system, the higher the PCAOB's reliance on that system. The reforms introduced by the CLERP 9 Act have significantly enhanced Australia's auditor independence regime. In particular, the key regulatory role is played by ASIC as the statutory regulator, which is completely independent of the audit profession. This is a key determinant for PCAOB assessment of non-US based audit regulation regimes.

The other key determinant is the scope and adequacy of inspection programmes undertaken by the non-US audit regulator. For Australian companies and auditors, this means the auditor inspection programme undertaken by ASIC. The existing ASIC programme has been upgraded as part of the CLERP 9 implementation process. However, further modifications will be required to ASIC's audit information-gathering powers in order to take account of the PCAOB's requirements.

Canada and the UK have already concluded cooperative audit inspection arrangements with the PCAOB.

Problem identification

The audit function plays a key role in relation to the efficiency of capital markets and the independent auditor constitutes the principal external check on the integrity of financial statements. Auditor independence is fundamental to the credibility and reliability of auditor's reports. Auditor independence can be compromised by bias, conflict of interest or susceptibility to undue influence or pressure.

The SOX Act was enacted in 2002 in response to a series of major financial scandals in the US involving once prominent companies such as Enron, Worldcom, Tyco and others which undermined investor confidence in the integrity of the US securities markets. Among its goals, the SOX Act sought to:

restore confidence in the accounting profession;

improve corporate disclosure and financial reporting;

strengthen the enforcement powers of the SEC and establish the PCAOB to create an independent regulatory board to oversee the accounting profession.

While Australia did not experience the same level of financial scandal or corporate governance concern as in the US, there was widespread concern about the efficacy of the audit function and some aspects of financial reporting in the wake of a number of corporate collapses, including HIH. The major audit and financial reporting reforms contained in the CLERP 9 Act include auditing standards being given the force of law, the introduction of a comprehensive auditor independence regime, enhanced executive remuneration disclosure, requiring CEO/CFO sign off of listed company accounts, strengthening the role of ASIC in relation to compliance with, and enforcement of, the audit process and financial reporting, and giving the Financial Reporting Council new monitoring and advisory functions in relation to auditor independence and a new role to oversee the setting of auditing standards.

There is potential for substantial regulatory duplication between the Australian audit regime (as enhanced by the CLERP 9 Act) and the US rules as they apply to the audit process. The concurrent but separate inspection programmes will lead to inefficiencies and increased regulatory complexity which will result in increased compliance burdens and costs for Australian companies that seek to raise capital within the US markets and their Australian auditors.

While the PCAOB is prepared to rely on the home jurisdiction's information-gathering powers for purposes of an audit inspection, the US still requires compliance by non-US based auditors with the US audit requirements, including registration with the PCAOB.

Objectives

The objective of any action to address the problem of regulatory duplication posed by similar yet separate regulatory regimes in relation to Australian auditors registered with the PCAOB is to provide a legal framework to enable ASIC to cooperate with the PCAOB to ensure the streamlining of the information-gathering process, within a single, joint audit inspection process.

Identification of options

Option 1

One option is for ASIC not to seek a cooperative arrangement with the PCAOB in relation to a joint inspection process in respect of Australian auditors registered with the PCAOB. This will result in Australian auditors being subject to two separate inspections by ASIC and the PCAOB.

Option 2

The second option is for ASIC to enter into a cooperative arrangement with the PCAOB to ensure that Australian auditors that are registered with the PCAOB are subject to a single, joint inspection process by ASIC and the PCAOB in relation to the firm's compliance with Australian and US audit requirements.

This would require some amendments to the Australian Securities and Investments Commission Act 2001 (the ASIC Act) to support the co-operative arrangements entered into between ASIC and the PCAOB. The amendments to the ASIC Act would cover the following matters:

ASIC would require a power and functions relating to the entering into of a co-operative arrangement with a regulatory body of a foreign country so that ASIC could assist the foreign regulator to ascertain compliance by an Australian audit firm with the audit requirements of the foreign country.

ASIC's power to enter such arrangements would be expressed in general terms and would not be 'PCAOB specific'. The legislation should enable ASIC, in the future, to enter into similar co-operative arrangements on audit regulation with regulatory bodies from other foreign jurisdictions. With the advent of global capital markets, cross-border operations by multinational corporations and the development of international accounting and auditing standards, it is possible that ASIC will in the future become involved in co-operative audit inspection programmes with regulators in other foreign jurisdictions.

The legislation would require ASIC to publish a notice in the Gazette after it had entered into an arrangement with a foreign regulatory body which would identify the foreign body, give brief particulars of the arrangement and identify the audit requirements to which the arrangement relates. The notice would be published for purposes of certainty and transparency. The foreign laws, regulations and rules would be required to be identified in a generic form and at a sufficiently high level.

ASIC would be required to include in its annual report information about the activities it has undertaken during the reporting period in relation to audit inspections under a foreign audit regulation programme.

ASIC's information-gathering powers in relation to audit inspections would be enhanced to ensure that ASIC could participate in joint audit inspections with the PCAOB. The amendments would empower ASIC to seek information from an Australian auditor about the auditor's compliance with audit requirements applying to the auditor under a foreign law covered by a co-operative audit arrangement between ASIC and a foreign regulatory body. ASIC's enhanced information gathering powers would also apply to ASIC's domestic audit functions both to reduce compliance costs and to clarify uncertainty about the scope of its existing audit inspection powers which the Financial Reporting Council (FRC) identified in the FRC's 2004-05 Report on Auditor Independence.

ASIC's existing power to provide information to a foreign government or agency of a foreign government would need to be expanded to authorise disclosure to a foreign body, which, although not an agency of a foreign country, performs regulatory functions conferred on it under a law of that foreign country. This amendment is necessary because the PCAOB, while established under the SOX Act, and given regulatory functions under the SOX Act, is expressly described as not being 'an agency or establishment' of the US Government.

Other options

The PCAOB's policy in relation to recognition of home jurisdiction regulation of the audit inspection process may allow for some intermediate approach, such as closer working co-operation between the PCAOB and the foreign regulator. However, as such an approach would not involve the elimination of additional costs to Australian auditors arising from duplication of the inspection process; such an option has not been considered further.

Impact group identification

The proposed US-Australian audit regulation programme between ASIC and the PCAOB will impact on:

The audits of Australian companies that are US registrants. There are currently 24 such companies, including many of Australia's largest companies.

Australian auditors who are registered with the PCAOB. There are currently 36 registrations with the PCAOB by Australian audit firms.

While every auditor registered with the PCAOB, is required to be inspected by the PCAOB, the PCAOB proposes to give priority to the inspections of the five major Australian audit firms that audit the Australian companies that are US registrants. It is understood that the other Australian firms registered with the PCAOB are involved in US related audit work on an agency basis for overseas audit firms registered with the PCAOB.

Australian companies and their auditors which are subsidiaries of a US or other overseas parent company where the PCAOB requires compliance with the SOX Act audit requirements by the parent company and its subsidiaries.

Analysis of the impact of options 1 and 2

Option 1 - Benefits

Having regard to the fact that the problem identified relates to the inefficiencies, complexity and additional cost that will result from Australian auditors and their Australian audit clients being subject to two concurrent but separate audit regulatory systems, no benefits, from a regulatory impact perspective have been identified. In terms of budgetary implications, there would be a benefit in that there would be no new cost to ASIC.

The arguments that ASIC should only focus on domestic audit compliance and that the number of companies and auditors affected by the US requirements are insignificant can be rebutted on a number of grounds:

The companies involved are among the most economically significant in the Australian corporate sector and the auditors include all of Australia's major audit firms.

The US capital markets are the most important fund raising markets globally and access to those markets is vital for the Australian economy.

Regulatory coordination and cooperation among the world's securities and audit regulators is of great importance because of the expansion of global business, international capital flows and cross-border holdings and transactions.

A cooperative audit arrangement between ASIC and the PCAOB will enhance the credibility and reputation of Australia's capital markets.

The proposed cooperation between ASIC and the PCAOB on audit inspections may be a stepping stone to further agreement on mutual recognition arrangements between Australia and the US in the area of corporate regulation more generally.

One of ASIC's existing objectives under the ASIC Act is to strive to reduce business costs.

Option 1 - Costs

It would be necessary for Australian auditors subject to the US audit requirements to accommodate two separate audit inspection processes in relation to the Australian and US regulatory regimes. In particular, the ASIC and PCAOB audit inspection processes would be quite separate and uncoordinated which would provide no scope for rationalisation of the two inspection regimes.

While inspection costs will be borne by the audit firms in terms of a higher compliance burden, it is anticipated that these costs will be passed onto audit clients in the form of higher audit fees. It is difficult to quantify these costs as the audit fees in relation to particular audit engagements between auditors and their audit clients, including a breakdown of the costs of a particular audit, are not publicly available. It is expected that the costs faced by Australian auditors under Option 1 would include: the cost to the firm of allocating personnel to the inspection process, costs of having personnel available to the inspection team, accommodation and travel costs for the personnel involved, the cost of locating and producing documents, responding to queries, being subject to on-site inspections and responding to draft statements/reports on inspection findings. These costs will be incurred by audit firms subject to Australian inspections by ASIC, and for those firms which are also registered with the PCAOB, similar logistical costs would need to be incurred in order to comply with the separate PCAOB audit inspection requirements.

In their submission on the Government's consultation paper, the seven major audit firms estimated that an ASIC audit inspection would typically involve a large audit firm in a five month project.

Option 2 - Benefits

Eliminating duplicative inspection processes by a single, joint inspection in relation to Australian and US audit requirements will result in significant cost savings for auditors and, if this is reflected in reduced audit fees, for Australian companies.

The benefits of this option will be to eliminate or reduce the costs associated with accommodating two separate audit inspection processes which have been identified above under Option 1.

At a practical working level, under a cooperative arrangement between ASIC and the PCAOB, it is proposed that ASIC and the PCAOB would agree on an audit inspection work programme. ASIC would have the power under the ASIC Act to serve a single notice on the audit firm seeking information relating to the joint audit inspection. Once the firm had provided the required information to ASIC, the information would be passed to the PCAOB which would assess the information in light of the US audit requirements. ASIC would assess the information received from the audit firm in light of the Australian audit requirements. The PCAOB generally considers that it would deal directly with the audit firm in relation to follow-up work relating to the US requirements. PCAOB inspections of Australian audit firms registered with the PCAOB will be undertaken on a triennial basis.

The proposed US-Australian audit regulation programme will facilitate access to US capital markets by removing regulatory duplication. The proposed programme will result in benefits for Australian companies seeking access to US capital markets including:

enhanced ability to gain cost-effective access to those markets;

reduced audit costs and compliance burdens; and

flow-on reduced cost of capital.

Option 2 - Costs

There may be some transitional costs for an audit firm in terms of any modifications the firm has to make to its systems to ensure that they are compatible with a joint ASIC/PCAOB arrangement. However, similar transitional costs are also likely to be incurred by an audit firm for purposes of a separate PCAOB inspection (under option 1) because the PCAOB has not yet undertaken the first of its triennial audit inspection programmes in Australia.

ASIC was provided with $6.3 million over three years in the 2005-06 Budget to implement the US-Australian Audit Regulation Programme. The funding will be used by ASIC for the purpose of capacity building in relation to its existing audit regulation program to ensure that it is able to perform its functions effectively under the proposed ASIC/PCAOB cooperative audit arrangement. ASIC proposes to develop and agree clear plans with the PCAOB for the conduct of joint inspections. The PCAOB's methodology closely aligns with the existing methodologies that ASIC has developed.

Consultation

The Government released a consultation paper Audit Inspection Powers of the Australian Securities and Investments Commission on 30 September 2005 which discussed the proposals necessary in order to provide a legal framework to enable ASIC to cooperate in a joint audit inspection arrangement with the PCAOB and to clarify ASIC's information-gathering powers in relation to audit inspections. The period for public submissions closed on 18 November 2005.

ASIC, the Australian Bankers Association (ABA), the Group of 100 (G100) and the Australian Shareholders Association (ASA) broadly supported the proposals.

The ABA noted the significant compliance costs imposed by the SOX Act on Australian companies registered with the SEC (including all the major banks) and on their auditors. The ABA said that it was approaching the proposals in the consultation paper primarily on the basis that if some or all of the proposals are implemented, the prospects of reciprocal recognition of Australia's corporate regulatory system by the US (and other overseas countries) will be significantly improved.

ASIC said that it regarded the proposals as an essential contribution to Australia's ability to participate in a more effective means of regulating, on a cross-border basis, the global audit of global entities. ASIC considered that this in turn, would contribute to Australia's reputation in global capital markets as a well regulated, but efficient, place to do business.

Following the close of the consultation period, the Government held extensive discussions with ASIC, the professional accounting bodies and the five major audit firms who will be primarily affected by the proposed ASIC/PCAOB joint audit inspections. The main focus of these discussions involved concerns raised about the scope of ASIC's enhanced information-gathering powers in relation to audit inspections. After the consultation period ended, the Business Council of Australia wrote to the Parliamentary Secretary to the Treasurer noting the concerns raised by the audit firms and urging the Government to give serious consideration to them.

The major audit firms and the professional accounting bodies were particularly concerned about the proposal in the consultation paper that ASIC would be given the power to replicate the PCAOB's functions and conduct an inspection on its behalf, including the power to form conclusions as to an Australian audit firm's compliance with US audit requirements. They argued that such an arrangement would lead to an unnecessary overlay of additional regulation.

The audit firms said that PCAOB inspectors had particular expertise in US accounting and auditing standards. In order to support the US regime, the major audit firms had developed US accounting and auditing desks and built up direct links in dealing with the PCAOB and the SEC. The audit firms argued that because of the specialist expertise required in relation to US audit requirements, it would be more efficient if the Australian audit firms were able to deal directly with PCAOB inspectors after the initial information-gathering stage of a joint inspection had been completed.

The PCAOB has now also come to the view that it cannot delegate to a foreign regulator the power to undertake an audit inspection on its behalf, including the delegation of power which would involve the foreign regulator forming conclusions as to compliance with US audit requirements, as such an arrangement would result in the PCAOB failing to discharge its statutory obligations under the SOX Act.

Having regard to the position adopted by the PCAOB, and in order to address the concerns of the audit firms and the professional accounting bodies, the Government decided to reduce the scope of ASIC's role under a joint inspection arrangement with the PCAOB so that it related to the provision of information-gathering and other assistance to the PCAOB in undertaking its audit inspection functions, rather than ASIC being given the power to conduct an audit inspection on behalf of the PCAOB and to form conclusions as to an Australian audit firm's compliance with the US audit requirements.

The audit firms and the professional accounting bodies are satisfied that this change to the initial proposals addresses their fundamental concern that if ASIC were to replicate the PCAOB's role in Australia, it would involve an additional layer of regulation and increased costs for the audit firms.

The Government also decided to make two further changes to the legislative aspects of the initial proposals in light of its discussions with the audit firms:

a new transparency provision will be included that will require ASIC to inform an Australian auditor of the details of any information or books which ASIC has obtained from the auditor and passed onto a foreign regulator in accordance with an agreement or arrangement ASIC has entered into with the foreign regulator; and

the proposal that an auditor should be required to provide all reasonable assistance to ASIC in relation to the performance of ASIC's audit functions will not be proceeded with. The deletion of this proposed measure addresses concerns raised by the audit firms as to the extent of ASIC's powers under the proposed requirement and how ASIC might exercise this power.

The Chairman of the Financial Reporting Council (FRC) also wrote to the Parliamentary Secretary to the Treasurer after the consultation period had ended to provide an FRC perspective on the ASIC audit inspection powers proposals. The Chairman said that while the FRC had not been able to reach a consensus on the proposals, he said that minimising the compliance burden should be a relevant criterion and this is most likely to be achieved through cooperative arrangements between ASIC and the PCAOB relating to the information gathering process under a single joint inspection of an Australian auditor.

All the following key stakeholders who made submissions on the consultation paper support the proposals:

ASIC;

the Australian Bankers' Association;

the Australian Shareholders Association;

the Group of 100;

the three main accounting bodies (CPA Australia. The Institute of Chartered Accountants in Australia and the National Institute of Accountants); and

the major audit firms.

Conclusion and recommended option

It is desirable that a legal framework be established to enable ASIC to enter into a cooperative arrangement with the PCAOB in relation to joint audit inspections of Australian auditors that are registered with the PCAOB. Option 2 is the recommended option.

Option 2 will result in a reduction of the regulatory burden and the level of duplicated processes related to audit inspections which would be involved under Option 1.

While Option 2 does not completely eliminate the compliance costs of the US audit requirements, it represents the best possible outcome in the context of the approach adopted by the PCAOB in relation to non-US based auditors.

If Option 1 is taken, the additional compliance burden will initially be borne by auditors who will need to respond to dual inspections by ASIC and the PCAOB. Those additional costs are likely to be passed on to audit clients in the form of higher fees. Although not quantifiable at this stage, the aggregate annual costs are estimated to be substantially greater than the proposed costs of reducing the regulatory burden by giving ASIC expanded functions under Option 2. Accordingly, there is a strong expectation that the cost savings produced by Option 2 will yield a net benefit.

Implementation and Review

It is anticipated that the required legislation to enable ASIC to undertake the functions under the US-Australian Audit Regulation Programme will be introduced during the 2006 Spring sittings.

ASIC's discussions with the PCAOB are at an advanced stage. ASIC and the PCAOB would hope to be able to finalise their cooperative arrangement shortly after the enactment of the supporting legislation.

There may be an argument that the costs of implementing Option 2 should be borne by the entities that directly benefit from the reduction in the regulatory burden - either the auditors that would be subject to the inspections or the affected client companies (that is, SEC registrants and US and other overseas subsidiaries). It is not, however, proposed that they should pay additional fees in order to recover the costs of ASIC's additional activities. Although it may be possible to charge audit firms for the costs of conducting the additional inspections, this would not be consistent with current practice for ASIC monitoring/compliance functions. ASIC's running costs are paid out of general revenue through a budget appropriation. Those costs, and other costs of the national corporate regulation scheme, are notionally recovered by means of a range of fees and charges imposed on regulated entities generally. Specific regulatory activities of ASIC are generally not dependent upon receipt of revenue from specific fees and charges imposed on a particular market sector. However, the Government has announced that the cost recovery arrangements applying to ASIC are to be reviewed for the 2008-09 Budget.

The Government has decided that the operation of the joint inspection arrangement between ASIC and the PCAOB should be reviewed after the completion of the first round of triennial PCAOB inspections. The PCAOB triennial inspections of Australian audit firms will commence in 2007.

Schedule 2 - Technical amendment to auditing standard provisions

The Office of Regulation Review advised that a Regulation Impact Statement is not required in relation to the amendment in Schedule 2.

Financial impact statement

Implementation of the measures in Schedule 1 to the Bill are expected to require Commonwealth expenditure on an ongoing basis.

In the 2005-06 Budget, it was announced that the Australian Securities and Investments Commission (ASIC) would be provided with additional funding of $6.3 million over three years to support the measures in Schedule 1 to the Bill. Continued funding will be subject to review.

The amendment in Schedule 2 to the Bill has no significant financial impact on Commonwealth expenditure or revenue.