House of Representatives

Explanatory Memorandum

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

Auditor rotation requirements

Outline of chapter

1.1 Part 1 of Schedule 1 to the Bill contains the amendments to the auditor rotation requirements in the Corporations Act.

1.2 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 safeguard the quality of the audit.

1.3 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.

1.4 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 defined 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.

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

1.6 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.

1.7 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.

1.8 Within 14 days of granting the approval, the directors are required to give a copy of the resolution granting the approval to:

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the Australian Securities and Investments Commission (ASIC); and

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the individual auditor who is subject to the extension of the rotation requirement.

1.9 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.

Context of amendments

1.10 The length of a relationship between senior audit personnel and an audit client presents clear risks in relation to auditor independence. Mandatory audit partner rotation requirements have been introduced in Australia and many overseas jurisdictions to address the familiarity threat arising from a long association between audit partners and the client. The Code of Ethics for Professional Accountants issued by the IFAC also contains auditor rotation requirements.

1.11 The key policy issue in determining an appropriate rotation period is to strike the right balance between auditor independence and objectivity on the one hand and the retention of knowledge and experience relating to the audit of the client on the other hand. While mandatory audit partner rotation addresses the familiarity threat, it can also involve a significant loss of knowledge held by the rotating partner about the audit client which can impact on audit quality.

1.12 The Review of the Independence of Australian Company Auditors (the Ramsay report), which was released in October 2001, recommended that there should be mandatory rotation of an audit partner responsible for the audit of a listed company after a maximum of seven years and that there should be a period of at least two years before the partner can again be involved in the audit of a client.

1.13 The CLERP 9 Act introduced a rotation period of five years in relation to the lead engagement and review partners for the audit of a listed company which brought the Australian rotation period into line with the new requirements in the UK and in the US under the Sarbanes Oxley Act. The CLERP 9 Act retained the two year time out period recommended by the Ramsay report rather than the more onerous time out period of five years adopted in the UK and US. Canada also introduced a five year rotation period with a five year time out period. China, Singapore and South Africa have adopted a five year rotation period with a two year time out period.

1.14 Treasury sought views from stakeholders on the existing rotation period in its consultation paper Audit Quality in Australia : A Strategic Review (Treasury's audit quality paper). Support in the public submissions for either the five or seven year period was evenly divided. However, a clear majority of stakeholders informed Treasury that the UK approach involving the audit committee would be an appropriate compromise and would enhance audit quality. The arguments put forward in support of this option are:

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Retention of the core rotation period of five years would keep Australia in line with the important jurisdictions such as Canada, China, South Africa, the UK and the US.

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It is appropriate that the audit committee should have the responsibility of making the decision to extend the rotation period by up to two years where it is necessary to safeguard audit quality because the role of the audit committee is to ensure the integrity of a company's financial reporting and the audit process, including the independence and objectivity of the external auditor.

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The extension of the rotation period by a further two years in appropriate circumstances should in fact enhance audit quality because it would result in the retention of an audit partner's expertise and corporate knowledge without compromising the auditor's independence.

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It would reduce the regulatory burden for audit firms in managing their audit partner rotations, given the geographic spread of listed entities in Australia and the limited pool of audit partners with relevant industry experience.

1.15 The Bill adopts the UK approach because this option provides the flexibility to enhance audit quality while safeguarding auditor independence.

Summary of new law

1.16 The amendments enable the board of directors of a listed company or a listed registered scheme to grant approval for the extension of the existing five year rotation period for up to two years subject to safeguards to protect audit quality and auditor independence.

1.17 If the listed company or listed registered scheme has an audit committee, the directors must not agree to extend the rotation period unless it has been recommended by the audit committee.

Comparison of key features of new law and current law

Detailed explanation of new law

1.18 A number of key stakeholders have made representations 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 EU Statutory Audit Directive and the IFAC Code of Ethics for Professional Accountants . 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.

1.19 While stakeholder support for either the five or seven year period was evenly divided, a clear majority of stakeholders informed Treasury that the UK approach which allows the audit committee or board of directors to extend the five year period by a further two years, would be an appropriate compromise and would enhance audit quality.

1.20 The amendments introduce some flexibility into the existing auditor rotation requirements so that the directors of a listed company or of a listed registered scheme may grant an approval for an individual to play a significant role in the audit of the company or scheme for not more than two successive financial years in addition to the five successive financial years under the existing requirements mentioned in subsection 324DA(1). [ Schedule 1, Part 1, item 6, subsections 324DAA(1 ), ( 2 ) and ( 3 )]

1.21 If the directors grant approval for one successive financial year, they may, before the end of that year, grant approval for an additional successive year. [ Schedule 1, Part 1, Item 6, subsections 324DAA(4 ) and ( 5 )]

1.22 If the company or registered scheme has an audit committee, then the directors must not grant the approval unless:

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the resolution granting the approval is in accordance with a recommendation provided by the audit committee;

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the resolution by the directors granting the approval must set out the reasons why 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 registered scheme; and

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would not give rise to a conflict of interest situation as defined in section 324CD of the Corporations Act. [ Schedule 1, Part 1 , item 6, subsection 324DAB ]

1.23 An approval granted by the directors is taken to be made in accordance with a recommendation provided by the audit committee only if:

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the approval is in fact consistent with the audit committee's recommendation;

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

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the recommendation is in writing signed by a member of the audit committee on behalf of the audit committee and given to the directors of the company or scheme;

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the recommendation states 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 defined in section 324CD of the Corporations Act. The conflict of interest situation defined in section 324CD constitutes the general standard of independence which was introduced by the CLERP 9 Act (and is similar to the general standard of independence in the rules of the US Securities and Exchange Commission (SEC)); and

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the recommendation sets out the reasons why the committee is satisfied that the extension would maintain the quality of the audit and would not give rise to a conflict of interest situation. [ Schedule 1, Part 1, item 6, subsection 324DAB(2 )]

1.24 The directors may decide against granting an extension of the rotation period notwithstanding the fact that the audit committee has recommended that an approval be granted.

1.25 Where a listed company or listed registered scheme does not have an audit committee, the directors may grant an approval to extend the rotation period:

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provided the directors are 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 defined in section 324CD of the Corporations Act; and

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the resolution of the directors granting the approval must set out the reasons why the directors are so satisfied. [ Schedule 1, Part 1, item 6, subsection 324DAB(3 )]

1.26 The directors also must not grant approval for an extension of the rotation period unless the auditor has agreed to the extension:

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in the case of an individual auditor to whom the approval relates who does not act on behalf of an audit firm or company, then the individual auditor must agree in writing to the approval being granted; and

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in the case of an individual auditor to whom the appeal relates who acts on behalf of an audit firm or audit company, then the audit firm or audit company must agree in writing to the approval being granted. [ Schedule 1, Part 1, item 6, subsection 324DAB(4 )]

1.27 If the directors extend the rotation period in reliance of an approval granted under section 324DAA, the directors' report under section 300 must include details of, and reasons for, the approval. [ Schedule 1, Part 1, item 2, subsection300(11AA )]

1.28 If the directors grant an approval to extend the rotation period, they must, within 14 days of granting the approval:

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lodge a copy of the resolution granting the approval with ASIC;

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give a copy of the resolution to:

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the individual auditor, where the auditor does not act on behalf of an audit firm or audit company; and

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the audit firm or audit company where the individual auditor to whom the approval relates, acts on behalf of the firm or company. [ Schedule 1, Part 1, item 6, section 324DAC ]

1.29 If the requirements of sections 324DAA, 324DAB and 324DAA are not complied with by the directors, then the purported grant of approval by the directors to extend the rotation period is rendered ineffective by section 324DAD. [ Schedule 1, Part 1, item 6, section 323DAD ]

1.30 If an individual auditor to which the purported approval relates relies on the purported extension that has not been properly granted by the directors, the individual auditor, a partner in the audit firm, the audit company or the directors may commit an offence under the existing sections 324DB, 324DC and 324DD if they were aware that the approval was, or that there was substantial risk that the approval was, invalid. This circumstance is excluded from the strict liability offences in sections 324DC and 324DD. Part 2.2 of the Criminal Code provides for the fault elements that must be proven for a person to be found guilty of an offence where strict liability does not apply. [ Schedule 1, Part 1, items 7A, 7B, 7C and 7D ]

1.31 The obligations contained in sections 324DB, 324DC and 324DD were introduced by the CLERP 9 Act. The obligations in sections 324DC and 324DD impose a form of collective liability and are designed to encourage a 'culture of compliance' across the whole audit firm or audit company. The provisions do contain safeguards for less blameworthy persons. For example under subsections 324DC(1) and 324DD(2) a partner or a director only commits an offence if they are aware that an individual auditor is not eligible to play a significant role in the audit of a company.

1.32 Existing subsections 324DC(2) and 324DD(3) contain strict liability offences against a partner of an audit firm or a director of an audit company but a complete defence is provided if the partner or director has reasonable grounds to believe that the audit firm or audit company had in place a quality control system that provided reasonable assurance that the firm or audit company would comply with the auditor rotation requirements. The strict offence provision and the statutory defence is designed to provide an incentive across the firm or audit company to establish effective audit quality control systems.

1.33 If the directors of a listed company or listed registered scheme fail to take all reasonable steps to comply with, or to secure compliance with, the provisions relating to the granting of an approval to extend the rotation period, they will contravene subsection 344(1) which is a civil penalty provision. If the directors contravene subsection 344(1) and there is dishonesty involved then under 344(2), the directors will commit a criminal offence. [ Schedule 1, Part 1, item 9 ]

Application and transitional provisions

1.34 There are no transitional provisions because the grant of the approval by the directors to extend the existing rotation period of five successive years must by virtue of subsection 324DAA(2) be made before the end of those five successive years or if the directors grant approval for one successive year, before the end of the first year. [ Schedule 1, Part 1, item 6, subsections 324DAA(2 ) and ( 4 )]

Consequential amendments

1.35 Section 300(1) has been amended to specify that additional information must be included in the director's report under subsection (11AA). [ Schedule 1, Part 1, item 1A ]

1.36 The heading for subsection 300(11) has been amended to refer to registered schemes as well as listed companies because the auditor rotation requirements apply to both listed companies and listed schemes. [ Schedule 1, Part 1, item 1 ]

1.37 Section 311 of the Corporations Act imposes obligations on an auditor to report to ASIC where the auditor is aware of circumstances that the auditor has reasonable grounds to suspect amount to a contravention of the Act. Subsection 311(5) is amended to pick up a cross reference to the provisions imposing requirements on directors in relation to the granting of an approval to extend the rotation period. [ Schedule 1, Part 1, item 3 ]

1.38 Paragraphs 324DA(3)(a) and (b) are amended to ensure that they also refer to the provisions relating to the granting of an approval by the directors to extend the existing rotation period. [ Schedule 1, Part 1, items 4 and 5 ]

1.39 The heading for section 344 has been amended to refer to the provisions relating to the grant of approval by the directors to extend the existing rotation period. [ Schedule 1, Part 1, item 8 ]

1.40 Section 601HG relates to the audit of a managed investment scheme's compliance plan. The cross-reference in subsection 601HG(11) is amended to refer to the provisions relating to the grant of approval by the directors to extend the existing rotation period. [ Schedule 1, Part 1, item 10 ]