Memorandum submitted by The Auditing Practices Board
In this submission, the Auditing Practices Board describes some of the major initiatives that it has pursued with the aim of improving public confidence in the auditing process in the period since its formation in 1991.
THE ROLE AND COMPOSITION OF THE APB
1. Following a number of well publicised UK corporate failures in the late 1980s, the Auditing Practices Board (APB) was established in 1991 by the Consultative Committee of Accountancy Bodies (CCAB). The APB's objectives are to establish high standards of auditing for the United Kingdom and the Republic of Ireland; to meet the developing needs of users of financial information; and to ensure public confidence in the auditing process. From the outset, the ABP has been unique in terms of world auditing standard setters in that 50 per cent of its voting membership was made up of non-audit practitioners who represented the community of users and preparers of financial reports, academia and the public sector.
2. A new system of non-statutory regulation of the accountancy profession, approved by Government, was put in place in 2001. A key feature of the new arrangements is yet greater independence from the control or undue influence of the accountancy profession. The aim was to secure improved public confidence in the impartiality and effectiveness of the profession's systems of regulation and discipline. With its members appointed by the Accountancy Foundation and its operations monitored by the Review Board, the new APB started work in 2002. It is now established as a company owned by the Accountancy Foundation representing major users of audited financial statements (and not auditors). Under its constitution, the proportion of non-audit practitioners on the new APB has been increased from 50 to 60 per cent.
3. In addition to issuing Statements of Auditing Standards (SASs) and guidance for auditors, and consistent with its objectives, since 1991 the APB has been active in promoting public debate on the role of auditing, and in supporting corporate governance developments (including those relating to the work of the Cadbury, Hampel and Turnbull committees). Some of the key initiatives taken by the APB to stimulate public debate on the role of auditing are described in the following paragraphs. Copies of the publications referred to are attached to this submission.
"The Future Development of Auditing"
4. One of the APB's first major initiatives was to undertake a comprehensive review of the role of auditing. That led in November 1992 to the publication of a discussion paper entitled "The future development of auditing". The paper was based on research into the changing role of audit, the needs of preparers and users of accounts, the issues that needed to be addressed and the difficulties in doing so. The paper discussed the security of tenure and rotation of auditors, the provision of other services by auditors and the role of audit committees. It engendered a considerable amount of discussion both within and without the accountancy profession.
"The Audit Agenda" and "The Audit AgendaNext Steps"
5. Building on responses to "The Future Development of auditing" and other research and thinking, in December 1994 the ABP issued "The Audit Agenda". This outlined concrete proposals designed to establish a framework for the development of audit services. The results of this exerciseand the implications for the APB's future workwere reported in "The Audit Agenda-Next Steps" which set out those matters which the APB believed should be pursued, including auditor objectivity, expectations regarding the likelihood that fraud can be detected in the course of an audit and the contribution that the audit can make in a corporate governance context. By way of illustration, two new Statements of Auditing Standards resulted from this work. These related to "Quality control for audit work" (SAS 240) and "Communication of audit matters to those charged with governance"(SAS 610).
"The Auditors Code"
6. The APB was conscious that in some countries, including the United States of America, attempts were being made to safeguard auditor independence and objectivity by establishing detailed prescriptive rules. However, detailed rules of this nature can give rise to serious problems of definition, are often incomplete and can prove to be inflexible and ineffective in difficult cases. On balance, the APB considered that a more fruitful approach would be to concentrate on the fundamental principles that should govern an auditor's behaviour. The APB set out these fundamental principles in "The auditors code", issued in 1996.
"Fraud and Audit: Choices for Society"
7. In January 1995, the APB issued the UK's first Statement of Auditing Standards to address the approach to be taken by auditors when encountering actual or possible fraud by management; "Fraud and error" (SAS 110). In the period from 1995 to 1998, and with the benefit of four years experience, the APB sought to assess the effectiveness of that Statement and also undertook some research work in conjunction with the Serious Fraud Office and the Criminal Prosecution Service. The APB's preliminary conclusions were published in November 1998 in its consultation paper "Fraud and audit: choices for Society".
8. This paper explained the difficulties the APB faces as it endeavours to respond to the expectations of investors and the public (who continue to expect auditors to detect fraud) and the demands of governments and regulators (who expect the accounting profession to increase its contribution to the prevention and detection of fraud). The consultation paper also set out various changes to the audit process and to the structure of corporate governance which might be considered.
9. The overwhelming response from users, preparers, regulators and auditors to the consultation paper was that the APB should not seek to extend the scope of the audit. To increase audit costs across the board in an attempt to detect a limited number of cases of management fraud was seen as creating an unacceptable regulatory burden.
"Aggressive Earnings Management"
10. The APB issued a consultation paper on "Aggressive earnings management" in June 2001 because it was concerned that, despite the progress made during the last decade in corporate governance, accounting standards and auditing standards, the quality and reliability of financial reporting may be being undermined by increasing commercial pressures on those preparing financial statements. It is, in part, a follow on from the paper "Fraud and audit: choices for society".
11. Earnings management is not a new phenomenon. Accounting is not a precise science and there is always a range of acceptability within which companies can present their results and financial positions. The aim of the consultation paper was to alert executive directors, non-executive directors, auditors, regulators and users of financial statements to the potential threat that increased commercial and economic pressure may cause aggressive earnings management. The APB also sought views on the steps that auditors and others should take to respond to the risks of aggressive earnings management.
12. Commentators observed that aggressive earnings management is not something that can be countered by auditors alone: good corporate governance and appropriate accounting standards are prerequisites. Thus, in addition to identifying the scope for additional guidance for auditors (which the APB will be addressing), commentators suggested actions that might be taken by others including the Department of Trade and Industry, the Financial Services Authority, the Accounting Standards Board and institutional investors.
3 April 2002