House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Parliamentary Secretary to the Treasurer, the Hon David Bradbury MP)

General outline and financial impact

General outline

The former Chairman of the Financial Reporting Council (FRC) released Treasury's consultation paper Audit quality in Australia : A strategic review on 5 March 2010 for a two month consultation period.

Stakeholders have responded positively to Treasury's paper and to the consultative process that Treasury has undertaken. Stakeholders have recognised the timeliness of the paper because:

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the global financial crisis presented new complexities, risks and uncertainties for auditors (such as the opinion an auditor must make whether it is appropriate for the financial statements to have been prepared on a 'going concern' basis and the uncertainties around valuation during periods of market stress). Treasury's paper provided an opportunity to examine the impact of the uncertain economic environment on audit quality in Australia, including a 'stress test' on the robustness of the audit regulation framework and the performance of the audit profession; and

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it is more than six years since the major audit reforms were introduced by the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (the CLERP 9 Act) and the Treasury paper provided an opportunity to make a measured assessment whether Australia's audit regulation framework remains in line with best international standards and is consistent with recent international trends in relation to auditor oversight.

The methodology adopted in the Treasury paper was to identify the key drivers of audit quality in Australia and assess whether any measures should be taken to address any real or perceived threats to these drivers of audit quality.

The overall conclusion in Treasury's paper is that Australia's audit regulation framework is robust and stable, that the framework is in line with international best practice and that no fundamental changes to the framework are required.

Treasury's paper also recognised that Australia's financial reporting and audit regulation framework operates within a dynamic environment. In this context, Treasury's paper has identified a significant number of important policy issues that warrant consideration by the Government and key stakeholders who have an interest in auditing.

Treasury completed its consultations with key stakeholders by holding roundtable discussions with stakeholders in Sydney on 2 November 2010 and in Melbourne on 3 November 2010.

A number of important legislative proposals were identified during the consultative process. The Government consulted on the draft Corporations Legislation Amendment (Audit Enhancement) Bill 2011, which was released for public consultation on 30 September 2011.

The Bill implements the legislative proposals, which are explained below, arising from the consultative process.

Auditor rotation requirements

The Bill retains the five year mandatory auditor rotation period but introduces more flexibility to allow the directors of a listed company or listed registered scheme to extend the rotation period for up to two years provided the directors comply with specified requirements designed to protect auditor independence and maintain the quality of the audit.

If the directors grant approval for one financial year, they may, before the end of that year, grant approval for an additional year.

If a listed company or listed registered scheme has an audit committee, the directors must not grant approval to an extension of the rotation period unless it has been recommended by the audit committee.

The audit committee's recommendation to the directors to grant approval for an extension is subject to the following requirements:

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the recommendation must be endorsed by a resolution passed by the members of the audit committee;

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the recommendation must state that the audit committee is satisfied that the approval:

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is consistent with maintaining the quality of the audit provided to the company or scheme;

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would not give rise to a conflict of interest situation as define. d in section 324CD of the Corporations Act 2001 (the Corporations Act); and

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the recommendation must be in writing and given to the directors, giving the reasons why the audit committee is satisfied that the extension is consistent with maintaining the quality of the audit and that it will not give rise to a conflict of interest situation.

The directors are not required to grant an approval merely because the audit committee has recommended that an approval be granted.

Where a listed company or listed scheme does not have an audit committee, the directors may grant an approval to extend the rotation period provided the directors are satisfied that the extension is consistent with maintaining the quality of the audit and that it will not give rise to a conflict of interest situation.

The directors must not grant an approval to extend the rotation period unless the individual auditor subject to the rotation requirement agrees in writing to the extension.

Within 14 days of granting the approval, the directors are required to:

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lodge a copy of the resolution granting the approval with the Australian Securities and Investments Commission (ASIC); and

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give a copy of the resolution to the individual auditor who is subject to the extension of the rotation requirement or where the auditor acts on behalf of an audit firm or audit company, to the firm or company.

Where the directors have granted an approval for the extension of the rotation period, the annual directors' report must include details of, and reasons for, the approval.

Date of effect : The 28th day after Royal Assent.

Proposal announced : Treasury consultation paper Audit quality in Australia : A strategic review released on 5 March 2010.

Financial impact : Nil.

Human rights implications : These amendments do not raise any human rights issues. See Statement of Compatibility with Human Rights - Chapter 7, paragraphs 7.4 to 7.6.

Compliance cost impact : The amendments may reduce the compliance costs for audit firms in managing their audit partner rotation systems.

Summary of regulation impact statement

Regulation impact on business

Impact : The auditor rotation measures will impact on listed companies and listed registered schemes and the auditors who provide audits for those listed entities.

Main points :

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The main problem to be addressed is that a number of key stakeholders consider that the five year rotation period is too short and could be increased to seven years in line with the rotation period adopted by the European Union (EU) Statutory Audit Directive and the Code of Ethics for Professional Accountants adopted by the International Federation of Accountants (IFAC).

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It is argued that where audit partners are compelled to rotate off from an audit after five years, this requirement poses a risk that it may have a detrimental impact on audit quality because of the premature loss of expertise and knowledge about the audit and the audit client.

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There is strong stakeholder support for retaining the five year mandatory rotation period (keeping Australia in line with the mandatory rotation period in Canada, China, South Africa, the UK and the US) but giving the audit committee (or the directors where there is no audit committee) the power to extend the rotation period by a further two years, subject to safeguards to protect audit quality and auditor independence. The UK Financial Reporting Council (UKFRC) has recently introduced a similar approach.

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The main objective of the auditor rotation measures is to enhance audit quality without compromising auditor independence.

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The measures will reduce the regulatory burden for audit firms in managing their audit partner rotation systems given the geographic spread of listed entities in Australia and the limited pool of audit partners with relevant industry experience.

Annual transparency reports

The Bill introduces a requirement for the publication of an annual transparency report by firms conducting audits of ten or more Australian entities of the following categories: listed companies, listed registered schemes, authorised deposit-taking institutions (ADIs) and insurance companies.

The broad objective of the requirement is to improve audit quality by enhancing the transparency of audit firms. As Australia's larger audit firms are usually structured as partnerships, minimal information about their ownership, governance, business structure and activities is publicly available. Requiring audit firms to publish a transparency report will assist in addressing this situation by ensuring factual information about firms performing significant audits is available to existing and potential clients.

Introduction of a requirement for Australian audit firms to publish transparency reports will assist in bringing Australia into line with developments in Europe and North America in relation to the publication of transparency reports by such firms.

Date of effect : The 28th day after Royal Assent.

Proposal announced : Treasury consultation paper Audit quality in Australia : A strategic review released on 5 March 2010.

Financial impact : Nil.

Human rights implications : These amendments do not raise any human rights issues. See Statement of Compatibility with Human Rights - Chapter 7, paragraphs 7.4 to 7.6.

Compliance cost impact : Compliance costs associated with the publication of a transparency report are expected to be low because the information required would already be available to each of the firms subject to the requirement. The quantum of these costs will vary depending on the size of the firm, the structure under which the firm operates in Australia and the ability of the firm to draw on the resources of international associates when preparing the report.

Summary of regulation impact statement

Regulation impact on business

Impact : The introduction of a requirement to publish an annual transparency report will impact primarily on the audit firms that are required to publish that report.

Main points :

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There is broad stakeholder support for the introduction of a transparency reporting requirement based on the requirements of the EU's Article 40.

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The Australian requirement should apply only to auditors of listed and other public interest entities (such as ADIs and insurance companies subject to prudential supervision by the Australian Prudential Regulation Authority).

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The obligation to publish a transparency report should be triggered where an Australian audit firm audits not less than ten listed or other public interest entities.

Auditor independence functions

The Bill streamlines the auditor independence work of ASIC and the FRC by removing the existing auditor independence function from the FRC and, in its place, giving the FRC a role of providing the Minister and the professional accounting bodies strategic policy advice and reports in relation to the quality of audits conducted by Australian auditors.

The FRC's revised functions include giving the Minister and the professional accounting bodies strategic policy advice and reports in relation to the systems and processes used by: Australian auditors to comply with relevant legislative and professional requirements; and professional accounting bodies for planning and performing quality assurance reviews of audit work undertaken by such auditors.

In conjunction with these changes:

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the FRC will be relieved of the requirement to prepare an annual report on the performance of its auditor independence functions. Particulars of any strategic policy advice and reports provided by the FRC as part of its revised functions will be included in the annual report to the Minister on the operations of the FRC; and

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the FRC's information gathering powers will be limited to obtaining information from the professional accounting bodies.

Date of effect : The day of Royal Assent.

Proposal announced : Treasury consultation paper Audit quality in Australia : A strategic review released on 5 March 2010.

Financial impact : Nil.

Human rights implications : These amendments do not raise any human rights issues. See Statement of Compatibility with Human Rights - Chapter 7, paragraphs 7.4 to 7.6.

Compliance cost impact : The amendments are expected to reduce the administrative costs currently incurred by the FRC in carrying out the auditor independence functions. Costs incurred by stakeholder bodies in respect of meetings with the FRC may also be reduced.

Summary of regulation impact statement

Regulation impact on business

Impact : The changes to the FRC's auditor independence functions will impact primarily on the Government and regulators (particularly ASIC and FRC). Some stakeholders, such as audit firms, are expected to experience a reduction in the level of burden the current arrangements place on them.

Main points :

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There is strong stakeholder support for streamlining the auditor independence work of ASIC and the FRC by removing the existing auditor independence function from the FRC and giving the FRC a strategic policy advisory role in relation to audit quality.

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Stakeholders considered that making this change would remove the duplication between the 'operational' nature of the FRC's existing function and ASIC's audit inspection program.

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Giving the FRC a strategic policy advisory function would benefit the Government in that it would be able to draw on the depth and diversity of expertise within the FRC.

Audit deficiency notifications and reports

ASIC is the key regulator under the Corporations Act and has responsibility for the surveillance, investigation and enforcement of the financial reporting requirements of the Corporations Act, including the enforcement of auditor independence and audit quality requirements. The scope of ASIC's audit inspection powers was enhanced by the Australian Securities and Investments Commission Amendment (Audit Inspection) Act 2007 . The amendments introduced by this Act ensured that ASIC's audit inspection and information gathering powers were brought into line with corresponding powers granted to key overseas audit regulators.

The objective of ASIC's audit inspection program is to promote high quality external audits of financial reports of listed and other public interest entities in Australia so that users can have greater confidence in financial reports. ASIC publishes its generic public inspection reports periodically to better inform all firms, the investing public, companies, audit committees and other interested stakeholders of findings and areas of focus.

After each inspection, ASIC issues the firm with a confidential inspection report and the firm responds as to how it will deal with the issues that ASIC has identified. ASIC then revisits the firm, generally after around 12 months, to gauge the extent to which the firm has taken remedial action.

Although there is no legal obligation to report publicly, ASIC's usual practice is to publish on the ASIC website, a public report which sets out key themes and issues identified by ASIC's audit inspection program during the preceding inspection period (which may be up to 15 months). These public reports are prepared on an aggregated basis across firms and are intended to inform stakeholders of systemic themes and issues with the objective of contributing to better audit quality by all firms. These public reports do not attribute specific matters to any firm or audit client of a firm. Section 127 of the ASIC Act prevents ASIC from issuing public individual firm reports without the consent of the audit firm concerned.

During the course of the preparation of Treasury's audit quality paper, ASIC informed Treasury that in a number of important overseas jurisdictions, the independent audit regulator is permitted to make public disclosure about defects in an individual audit firm's quality control systems, subject to appropriate natural justice protections.

In the US, the PCAOB is required by the Sarbanes Oxley Act to produce public inspection reports, although portions of the complete report are omitted to comply with confidentiality requirements in the Act. The Sarbanes Oxley Act provides a framework for a remedial process whereby firms have 12 months to remedy defects in their quality control systems to prevent these defects being made public.

In the UK, the Audit Inspection Unit, part of the UKFRC's Professional Oversight Board, issues a confidential report to the audit firm inspected. In addition to the confidential report, the Audit Inspection Unit publishes both an annual overview report on its audit inspection activities and a high level public report on the inspection of an individual audit firm, detailing findings from reviews of individual audits (without client names) concerning failures to comply with auditing standards or good practice. Criticism (if relevant) of the audit firm's quality control policies and procedures is also made public. Specific reports are also issued to engagement partners of deficiencies in the file reviewed with an expectation that this is shared with the relevant client audit committee or board of directors.

In Canada, the Canadian Public Accountability Board (CPAB), produces private reports of findings and recommendations to the individual firms inspected. Failure to implement one or more recommendations to CPAB's satisfaction within a prescribed timeframe (generally six months) may result in CPAB making public the relevant portions of the inspection report.

Treasury discussed the various options for ASIC public reporting on individual audit firms with stakeholders during the consultation process on Treasury's audit quality paper. The majority consensus among stakeholders was to support a reporting model along the lines of the more restrictive Canadian approach. This approach would allow ASIC to issue a public report on an individual audit firm only after the firm had failed to take remedial action to address an audit defect identified by ASIC within a prescribed time frame. The following reasons were advanced in favour of this reporting model:

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it should be a significant driver of audit quality because it would provide a strong incentive for an audit firm to take remedial action to address an audit deficiency identified by ASIC in order to avoid the publication of an adverse public report by ASIC;

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this reporting model would be able to operate in a timely manner;

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it should not impose any significant additional financial/resource burdens on either ASIC or the audit firms; and

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the model could incorporate adequate time for remediation processes by an audit firm.

The amendments in Schedule 2, Part 2 of the Bill have adopted the more restrictive approach under the Canadian public reporting model. ASIC is given the power to issue an audit deficiency report in relation to specified failures by the audit firm that ASIC has identified during the exercise of its statutory audit functions and reasonably believes indicates a significant weakness in either the Australian auditor's quality control system or the conduct of the audit, and may be detrimental to the overall quality of the audit. A specified failure is:

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a failure by the auditor to comply with the auditing standards;

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a failure by the auditor to comply with the auditor independence requirements in the Corporations Act;

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a failure by the auditor to comply with any applicable code of professional conduct; or

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a failure by the auditor to comply with the provisions of the Corporations Act dealing with the conduct of audits.

ASIC is required to notify the auditor of the identified audit deficiency and to set out any remedial action that ASIC thinks necessary to remedy the deficiency. ASIC must also invite the auditor to make written submissions to ASIC, within six months, about the deficiency and any remedial action taken or proposed to be taken to remedy the deficiency.

At any time after the end of the six month period, ASIC may prepare an audit deficiency report if ASIC is satisfied that the Australian auditor has not taken appropriate remedial action to remedy the identified audit deficiency. Before preparing the report, ASIC must take into account any submissions received from the auditor and whether or not the auditor has taken any remedial action to remedy the deficiency.

ASIC may, if it considers it appropriate to do so, publish the report on the ASIC website. Before ASIC publishes an audit deficiency report on its website, it must give a copy of the report to the Australian auditor to which it relates and invite the Australian auditor to give ASIC comments on the report within 21 days. The comments must be published in a separate part of the report.

Date of effect : The day of Royal Assent.

Proposal announced : Treasury consultation paper Audit quality in Australia : A strategic review released on 5 March 2010.

Financial impact : Nil.

Human rights implications : These amendments raise a human rights issue. See Statement of Compatibility with Human Rights - Chapter 7, paragraphs 7.4 to 7.6.

Compliance cost impact : The amendments should not impose any significant additional costs on either ASIC or Australian auditors.

Summary of regulation impact statement

Regulation impact on business

Impact : The audit notification and report measures will impact on ASIC and Australian auditors that fail to remedy an audit deficiency identified by ASIC after six months from notification by ASIC.

Main points :

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ASIC is currently prohibited from publishing information about an audit deficiency in relation to an individual audit firm because of the confidentiality restrictions in section 127 of the ASIC Act.

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Audit oversight regulators in a number of key overseas jurisdictions have been given the power to publish reports on individual audit firms.

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After consultation with stakeholders, there was a majority consensus that it would be appropriate for Australia to adopt a restrictive reporting model based on the approach undertaken in Canada by the CPAB.

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This reporting model gives ASIC the power to prepare and publish a report on an individual audit firm where the firm has failed to take steps to satisfactorily address an audit deficiency identified by ASIC within six months of notification by ASIC.

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The reporting model provides a strong incentive for an audit firm to take appropriate remedial action without imposing any significant additional costs on either ASIC or the audit firm.

Communications with corporations, registered schemes and disclosing entities

During the consultation process on Treasury's audit quality paper, ASIC proposed that it should be able to communicate directly with the audited body (and particularly the entity's audit committee) in relation to significant matters which it identifies during the course of the exercise of ASIC's statutory functions in relation to an audit.

A significant matter could relate to a matter concerning the audit client's accounting or disclosure practices or to the conduct of the audit by the audit firm. ASIC has explained that it was placed in a difficult position where it became aware of significant matters affecting the audit of a company during the inspection or surveillance of an audit firm and yet it was unable to disclose this to the audited body or its audit committee. ASIC is prevented from making such disclosures to the audited body or its audit committee without the audit firm's consent because of the confidentiality requirements in section 127 of the ASIC Act.

The amendments allow ASIC to disclose information to the directors, the audit committee or a senior manager of a company, responsible entity or disclosing entity concerning the conduct of the audit or compliance by the audited body with the requirements in Chapter 2M to prepare financial statements and reports, or with the continuous disclosure requirements of sections 674 and 675 of the Corporations Act. The information that is authorised to be disclosed must have been obtained by ASIC in the course of the exercise of its functions and powers in relation to audit. ASIC must not disclose information about how an audit was conducted by an Australian auditor unless they notify the Australian auditor of the proposed disclosure at least seven days prior to disclosing the information.

Date of effect : The day of Royal Assent.

Proposal announced : Treasury consultation paper Audit quality in Australia : A strategic review released on 5 March 2010.

Financial impact : Nil.

Human rights implications : These amendments do not raise any human rights issues. See Statement of Compatibility with Human Rights - Chapter 7, paragraphs 7.4 to 7.6.

Compliance cost impact : The amendments should not impose any significant additional costs on ASIC, audited bodies or Australian auditors.

Summary of regulation impact statement

Regulation impact on business

Impact : The measures will impact on ASIC, audited bodies (and their audit committees) and Australian auditors.

Main points :

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ASIC is unable at present to provide information to an audit committee (or the company) that would assist the directors in fulfilling their responsibilities in relation to the preparation of the company's financial statements and the audit of those financial statements.

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There is the risk that ASIC's inability to communicate quickly to the audited body (or its audit committee) about defects in either the conduct of the audit or matters relating to the company's accounting or disclosure practices inhibits the audited body and the board of directors from fulfilling their obligations.