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Jacqui Smith: We have had a short debate, but the quality has been high. I assure my hon. Friend the Member for Newcastle upon Tyne, Central (Mr. Cousins) that the Government do not have a closed mind about anything that might help to improve confidence in financial reporting and the quality of audit, but I said on Second Reading that there are two approaches to audit regulation. We can either take the rules-based legislative approach adopted in the US, or we can build on the principles-based approach that we already have in the UK.
The new clause adopts a rules-based approach to the questions of non-audit services and of rotation of the auditor. In many ways, that allows me to set out more fully why the Government believe that the better route for the UK is to build on the existing principles-based approach.
There is a general consensus about what we want to achieve. We all want to be sure that auditors act with integrity, objectivity and independence. We want to guard against two specific risks: the provision of non-audit services alongside audit services, and the development of a relationship between the auditor and the company being audited that is inappropriately familiar, cosy or collusive. However, there are many other possible risks in the relationship between auditors and the companies that they audit. I shall deal with them in a moment, when I explain about the ethical standards of the Auditing Practices Board.
One of the difficulties of adopting a rules-based approach dealing with only two specific areas of the problem is that it can imply that other matters are not important. The benefit of the ethical standard is that it covers a broader area. However, we recognise the risks that were outlined by my hon. Friend the Member for Newcastle upon Tyne, Central, and we share his overall objective. We depart from him only in respect of how that objective can best be achieved.
As the hon. Member for Sutton Coldfield (Mr. Mitchell) noted, in 2002 the Government established the co-ordinating group on audit and accounting issues. That was a direct response to the events at Enron and
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later at WorldCom. One of the group's key concerns was auditor independence, and it devoted a great deal of time to looking at non-audit services and at auditor rotation in particular.
The conclusions that the group reached were firmly against imposing a ban on non-audit services or on compulsory rotation of audit firms—precisely the two measures proposed in this new clause. In its final report, the group stated that
"firm rotation is a blunt regulatory instrument, and there are a number of arguments against mandating it."
The report went on to list those arguments, some of which have been touched on in today's debate. The first problem has to do with the quality and effectiveness of audit in the years immediately after a change of auditing firm. That is especially difficult given the ever-growing complexity of large groups. In other words, there can be some benefits as well as dangers in the development of continuity and understanding.
Secondly, rotating auditing firms would impose substantial costs on business, as it would take up a lot of management time. The third factor is that there is no evidence that the rotation approach is effective. It has been tried and abandoned in Spain, for example, and the hon. Member for Sutton Coldfield pointed out that it is still in operation in Italy. Other countries that have considered the issue have all decided against it. Indeed, my hon. Friend himself highlighted the fact that despite the rigours of the Sarbanes-Oxley Act 2002, the US has not gone down that route either.
The fourth issue was the problem of being able to find large audit firms to carry out all the audits if frequent rotation were required, especially as some might be prevented from taking on the work as a result of auditor independence requirements also being introduced. As we discussed in the debate on the previous group, the market for large audits is very concentrated.
Finally, the Office of Fair Trading expressed concerns about rotation being in effect a form of compulsory retendering with one of the potential bidders excluded. That is what the group had to say about compulsory rotation of the audit firm.
My hon. Friend the Member for Newcastle upon Tyne, Central identified the alternative approach, which we have adopted—ensuring the rotation of the leading audit firm partner through the application of ethical standards. The previous rotation period was seven years, but it has now been reduced to five.
Let me deal next with what the co-ordinating group had to say about banning certain non-audit services. I will then come to what steps have been taken as a result of the group's recommendations to further auditor independence and, in particular, the role of the Auditing Practices Board. I do not oppose my hon. Friend's proposals because I think that there is no issue to address. On the contrary, we should perhaps take a broader approach to the problem than he adopts in new clause 9.
The co-ordinating group concluded that the provision of non-audit services was indeed a problem—in appearance, if not in fact—but that the solution was not to impose a ban on particular types of services being
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provided; rather, it was to re-emphasise and strengthen the key principles that were already in place in the UK, namely that auditors should not carry out work for a company that they are auditing if that would involve the auditors taking management decisions, auditing their own work, or acting as an advocate for the client. The group concluded that tougher mechanisms were needed to safeguard those principles. Specifically, it recommended that ethical standards on auditor independence should be set by an independent standard-setting body; the audit firms should be monitored frequently and by an independent monitoring unit in the case of public interest audits; the audit firms should be more transparent in publishing details about their own structures, processes and financial position; the role of the audit committee within the company should be enhanced through changes to the combined code guidance; and companies should be required to disclose more detail in their annual reports.
The last of those requirements, of course, is the subject of clause 7. In response to the point made by the hon. Member for Sevenoaks (Mr. Fallon), I can say that clause 7 also requires more transparency about the costs of non-audit services that are bought by the company.
The combined code has been expanded as a result of the excellent work of Sir Robert Smith and his group on the role of audit committees. The major firms have published more information about their own internal practices, and that is also a matter that is covered in the draft European directive on audits. The audit investigation unit is up and running as part of the newly created Professional Oversight Board for Accountancy, itself part of the newly expanded Financial Reporting Council.
Finally, and most importantly in the context of new clause 9, the Auditing Practices Board has been taken out of the control of the professional bodies, brought into the expanded Financial Reporting Council family and given responsibility for setting ethical standards for auditors on auditor independence. We now have independent standard-setting for audit standards. That covers a lot more than just the provision of non-audit services and the rotation of auditors.
There are five standards and they cover, to take some examples at random from a lengthy list, issues such as financial relationships, employment relationships, family and other personal relationships, fees, remuneration and gifts, litigation and the overall principles of integrity, independence and objectivity. They set out clearly the standards to which auditors are expected to adhere in the provision of non-audit services to a company to which they also provide audit services more broadly than could a legislative list that simply banned certain services.
I accept my hon. Friend's objectives in tabling his new clause, but I am not convinced that the solution he has chosen would work. It has been tried in the US, but we have seen nothing to change our view that lots of rules mean only lots of lawyers looking for ways to get round the rules. The new clause lists three services that it would be unacceptable for an auditor to provide for a client, but that might imply by omission that other services are acceptable. That is clearly not the case. If the rules cover long association with a company and the provision of non-audit services, why should they not cover all the other threats to auditors' integrity? There are many, as
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I have demonstrated, and we need to ensure that they are all covered. That is where standards play an important role.
To anticipate my hon. Friend's reply, I should say that just because the standards are not set in legislation, it does not mean that they have no force: they do. They are not just "guidance" or "recommendations". Auditing is a statutory function and to carry it out an auditor must be a member of a recognised supervisory body. The supervisory bodies are required by law to have rules and practices designed to ensure that audit work is carried out with integrity and without conflicts of interest. Clauses 1 and 2 require such standards for the purposes of those rules to be set by a body independent of the profession and for the recognised supervisory bodies to require the auditors registered with them to comply with those standards. Compliance with those standards is rigorously monitored and enforced. Clauses 1 and 2 increase the independence of audit monitoring and disciplinary processes by requiring that they must be carried out independently of the recognised supervisory bodies where the audits are of public interest.
I hope that I have given my hon. Friend some reassurance. I do not take the defensive approach that the hon. Member for Sutton Coldfield takes, because I share my hon. Friend's concerns that we need to ensure that a cosy relationship does not develop between auditors and the companies that they audit. We need much more clarity and transparency in respect of the value and provision of non-audit services to firms. The principles-based approach, with the additional independence and rigour brought in by the legislation, is the most appropriate way to achieve those objectives.
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