0969 audit model
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0969 audit model


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AN ASSESSMENT OF THE POSSIBLE APPLICATION OF THE PUBLIC SECTOR AUDIT MODEL TO THE UK PRIVATE SECTOR September 2002 The Chartered Institute of Public Finance and Accountancy (CIPFA) is one of the leading professional accountancy bodies in the UK and the only one which specialises in the public sector. It is responsible for the education and training of professional accountants and for their regulation through the setting and monitoring of professional standards. Uniquely among the professional accountancy bodies in the UK, CIPFA has responsibility for setting accounting standards for a significant part of the economy, namely local government. CIPFA’s members work (often at the most senior level) in public service bodies, in the national audit agencies and major accountancy firms. They are respected throughout for their high technical and ethical standards, and professional integrity. CIPFA also provides a range of high quality advisory, information and training and consultancy services to public service organisations. As such, CIPFA is the leading independent commentator on managing and accounting for public money. contact: Vernon Soare Policy and Technical Director CIPFA 3 Robert Street London, WC2N 6RL Tel: 020 7543 5676 e-mail vernon.soare@cipfa.org Tech1/General/0969 AN ASSESSMENT OF THE POSSIBLE APPLICATION OF THE PUBLIC SECTOR AUDIT MODEL TO THE UK ...



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September 2002
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                              contact:      Tel: e-mail
Vernon Soare Policy and Technical Director CIPFA 3 Robert Street London, WC2N 6RL  020 7543 5676 vernon.soare@cipfa.org 
AN ASSESSMENT OF THE POSSIBLE APPLICATION OF THE PUBLIC SECTOR AUDIT MODEL TO THE UK PRIVATE SECTOR Contents Page 1 BACKGROUND 1 2 SUMMARY AND CONCLUSIONS 2 3 THE PUBLIC SECTOR AUDIT MODEL 4 The Model 4 Characteristics of the Model 5 Audit appointments and rotation 5 Limitation on non-audit services 6 Scope of audits 6 Audit procedures 7 Audit advice and guidance 7 Relationships with audited bodies 7 Audit reporting 7 Quality control 7 Audit fees 7  POSSIBLE APPLICATION OF PUBLIC SECTOR MODEL TO THE UK PRIVATE SECTOR 8 General 8 Issues for consideration 8 The wider scope of audit 9 The availability of a central body 10 The legal right to obtain information 10 The ability to report publicly 10 The wider scope of quality control 11 A framework for charging fees 11  5 MAIN ISSUES FOR CONSIDERATION 12 Overview 12 Audit appointments 12 Rotation of auditors 14 Limitation on non-audit services 15  6 OTHER GOVERNANCE MATTERS 15 Chief Financial Officer 15 Internal Audit 16  APPENDIX A 17   
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BACKGROUND This paper is written at the request of the Accountancy Foundation’s Review Board. It examines and discusses the possible application of aspects of the public sector audit model within the UK private sector as a response to perceived weaknesses in the audit process which have resulted in significant high-profile corporate failures, primarily in the United States. It is not written to promote or recommend the public sector audit model, but to air some of the considerations as a contribution to the wider public debate on the issues. It is not the object of this paper to reassess the role of audit in relation to corporate failures. This has been widely covered in the financial press and more particularly in the submissions to the House of Commons Treasury Committee on the Financial Regulation of Public Limited Companies. A summary of the more widely reported weaknesses which may have contributed to corporate failure are set out below as a background to the discussion. However there is not, as yet, an authoritative analysis of the real problems which contributed to the corporate failure mentioned above. Such weaknesses mentioned below are those perceived by commentators and not necessarily those which need to be addressed by the audit profession in the UK or the USA.  The catalogue of perceived weaknesses can be broadly divided into two categories, those which relate to the audit process and other. In turn the audit related issues could be divided into those which relate to independence and those which relate to the performance of the audit. The main perceived weakness in relation to independence is that auditors may become too close to their audit clients resulting in cosy relationships in which auditors do not challenge accounting practices and financial reporting with sufficient rigour. This perceived lack of independence may arise through audit appointments being effectively made by management, and seldom changed  audit fees in practice agreed by management   the supply of non-audit services, the nature of which may conflict with the requirements of audit and the level of which may make the audit firm, its office or its partners financially reliant on the client  audit partners and staff becoming over familiar with client management through long periods of working together  frequent job moves of partners and audit staff to clients. Some weaknesses referred to by commentators related to the performance of the audit include: failures by auditors fully to understand the business and ‘profit drivers’ of their clients or the effect of their corporate structures  the risk-based approach to audit leading to reduced audit coverage of client entities and activities  Tech1/General/0969
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the inability of auditors to report or discuss concerns with a body outside their client’s board or management, for example, with shareholders or an oversight board.  Other weaknesses mentioned by commentators which do not relate to the audit process include   failures of governance, including especially the role of non-executive directors the competence of business analysts and the financial press in understanding the businesses on which they comment the effective disenfranchisement of shareholders in obtaining knowledge about a company’s activities the difficulty in interpreting accounting standards, especially the rules-based  standards applicable in the United States. These matters are not considered further in this paper. SUMMARY AND CONCLUSIONS While there is no one defined public audit model in the UK, the approach to external audit by the four UK national audit agencies (Audit Commission, Audit Scotland, National Audit Office and the Northern Ireland Audit Office) shares common features. The agencies appoint auditors to public bodies independently of the management or elected or appointed members of those bodies  regularly review audit appointments and rotate audit firms at intervals  regulate the provision of non-audit services to public bodies by the firms that provide the statutory audit  operate a fee regime for auditors  specify an audit that is wider in scope than the audit under the Companies Act  make the results of audits available to the public and to democratically elected representatives. This report suggests that the following aspects of the public audit model merit further consideration to assist the effectiveness of private sector audit. There would be practical and sometimes legal considerations to be considered and these are outlined in the relevant section in the main report the establishment of a central body to which auditors can turn for authoritative advice on legal, accounting or audit related matters or to which significant suspicions or concerns could be reported (4.14)
 2.3   2.4  
co-operation and exchange of information between auditors during audits and the in depth exchange of working papers and audit knowledge on change of auditors (4.15)  a statutory right for auditors to obtain information relevant to their audits from any source (4.17)  a more ‘public’ approach to audit reporting, whereby the audit committee reports in the company’s annual report on how the company has responded to the auditor’s findings and recommendations (4.21)  publication of the results of independent audit quality control reviews to inform the appointments made by audit committees (4.24)  permission to exceed a threshold value for non-audit services to be obtained from the audit committee (5.18). Two other suggestions that have their roots in general public sector financial practice rather than the public audit model specifically may also be of help a legal requirement for companies to appointment a Chief Financial Officer, who is a qualified member of a recognised accountancy institute (6.3)  a mandatory requirement for companies to have an internal audit function, the size and scope of work to be determined by the audit committee (6.5) The following features of the public audit model, or other associated points, while they might bring benefits to the private sector, are not judged to be practical for implementation at the present time. The main reasons are the potential costs; the relative lack of supply of audit firms caused by the reduction to the ‘Big Four’; the problems of assembling the necessary intelligence and skills outside of audit firms; the potential for litigation or for a combination of these reasons a state body carrying out the audit of private sector companies as an ‘auditor of last resort’ (4.8)  the inclusion of a duty on auditors to review the ‘proper conduct’ of company directors (4.12)  public reporting of audit findings (4.20)   an audit fees framework (4.26)  audit appointments made by a central body (5.10)  mandatory rotation of audit firms (5.14). It is recognised that the adoption of any of the suggestions made in this paper leading to a more open audit regime could only be taken after due consultation and consideration, in
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particular of the need to avoid potential litigation, the effect on the UK corporate governance model and concerns about state intervention. THE PUBLIC SECTOR AUDIT MODEL The Model This section seeks to explain what the public sector audit model is and how it works in practice. From the outset it must be realised that there is no one defined ‘public sector audit model’ and that the various parts of the public sector operate under different legislation and different regulatory regimes. There are four national audit agencies in the UK, these being the National Audit Office (NAO), Northern Ireland Audit Office (NIAO), Audit Commission and Audit Scotland. These agencies are responsible for the audits of central government (including executive agencies, trading funds and NDPBs), local government and the health service. Separate audit arrangements are in place for education institutions and registered social landlords (formerly housing associations), although Audit Scotland covers substantially all public sector entities. The NAO also supports the Auditor General for Wales. The four national agencies co-operate in the development of common audit practices across the public sector, notably in the issue by the Auditing Practices Board (APB) of Practice Note 10 (PN10) Revised on ‘Audit of Financial Statements of Public Sector Entities in the United Kingdom’ and in the establishment of the Public Audit Forum (PAF) in 1998. The PAF has issued a series of reports on public sector audit topics including ‘The Principles of Public Audit’, these principles being the independence of public sector auditors from the organisation being audited  the wide scope of public audit, that is covering the audit of financial statements, regularity (or legality), propriety (or probity) and value for money  the ability of public auditors to make the results of their audits available to the public and to democratically elected representatives.  The ways in which the four national audit agencies operate depend to a large extent on their governing legislation. In very broad terms it can be said that NAO and NIAO operate in a similar manner while the Audit Commission and Audit Scotland also share many similar characteristics. For the purposes of this paper it is probably the Audit Commission/Audit Scotland model, particularly in relation to audit appointments and rotation of auditors, which is most relevant. This model is particularly interesting in that it encompasses all of the following roles  the appointment of auditors and, from time to time, the rotation of auditors (although substantially reliant on an in-house arm).  specification of the audit through, for example, a code of practice  the provision of additional technical guidance through bulletins and courses and through acting as a helpline for problems arising on audits  the quality control of audits, which in turn can influence appointments Tech1/General/0969 4  
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  3.6  3.7  3.8
 the establishment of a fee regime for auditors.  The Characteristics The following text sets out the main characteristics of public sector audit, with the caveats given above, over these headings  Audit appointments and rotation of auditors  Limitation on non-audit services Scope of audits Audit procedures Audit advice and guidance Relationships with audited bodies Audit reporting Quality control Audit fees Audit Appointments and Rotation of Auditors  The key feature of public service audit by the NAO, the NIAO, the Audit Commission and Audit Scotland is the independence of auditors from the organisations they audit. Substantially all public service bodies do not appoint their own auditors. In the central government sector, entities are either audited by the NAO or NIAO, which are independent bodies established by law and, through the Comptroller and Auditor General, answerable to Parliament and the Assembly respectively, or in some cases auditors are appointed by Parliament or by the Secretary of State of the sponsoring government department. NAO sub-contracts a proportion of its audits to external audit firms through a competitive tendering process. In the local government and health sectors in England and Wales, the Audit Commission appoints auditors to all entities, chosen either from its own in-house audit arm or external audit firms. In Scotland, the Accounts Commission and the Auditor General appoint auditors to substantially all public sector entities, including central government and local government. In-house audit arms currently audit approximately 67% of entities in England/Wales and 65% in Scotland. Appointments are made based on performance, local expertise and, infrequently, presentations by audit firms on competence and capability. Appointments are made for periods of at least five years and reviewed, but not necessarily changed, at the end of that period. In practice, because of the majority position held by the Audit Commission’s in-house arm, and the limited number of firms’ centres, changes in appointments are relatively infrequent in England and Wales. The Audit Commission has however recently introduced ‘framework contracts’ that seek to ensure at least two audit suppliers in addition to the in-house arm are available throughout England and Wales, providing the potential for rotation. In Scotland regular rotation of auditors is an established policy and changes are made more frequently.  3.9 In view of the importance of continuity and the transfer of audit knowledge between auditors, there is a requirement for outgoing auditors to provide their successors with all the information they require. This aspect of the public sector audit model is specifically referred to in SAS 450. Tech1/General/0969 5  
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In common with ethical guidance from the International Federation of Accountants (IFAC), the Audit Commission and NAO require the rotation of the audit partner, or equivalent, at least every seven years. In addition, the Audit Commission requires the rotation of the audit manager and that firms notify changes of senior personnel on local authority and health audit teams to the Audit Commission. Similar provisions apply in Scotland. Limitation on non-audit Services The overriding principle for auditors carrying out non-audit work in the public sector is that this should in no way run the risk of either impairing auditor independence or giving a public perception that independence has been impaired. In the case of the Audit Commission appointed auditors, once this condition is satisfied, all non-audit work over a £25,000 annual threshold (or 20% of the audit fee if greater) must in addition be approved by the Audit Commission. Similarly, appointed auditors and subcontractors must obtain approval from the NAO or Audit Scotland as appropriate for any non-audit work. In practice this means that little or no such work is carried out. However, firms working for the Audit Commission and Audit Scotland are free to offer non-audit services to public sector bodies which they do not audit. Apart from issues of the perception of independence, a further consideration in the Audit Commission’s limitation on non-audit services of a consultancy nature is the requirement for auditors to include a review of arrangements for securing value for money (VFM) within the audit (generally based on nationally researched topics). Scope of Audits  The exact scope of audits in the public sector depends on the particular sector but is considerably wider than the audit of financial statements alone: in the central government and health service sectors auditors are required to report on the ‘regularity’ of transactions, that is that they are in accordance with the authority (legislation or other) which governs them. In local government auditors review the arrangements for ensuring legality and concentrate on possible breaches of legality in vulnerable areas  public audit also includes examinations of the economy, efficiency and effectiveness in the use of public resources, including the evaluation of service quality and the measurement of performance (value for money audit) In local government and the health service auditors generally review value for money in the provision of services, based on nationally researched subject areas. In central government auditors also have a VFM responsibility, but work is based on the nature of activities and the likely risk   health, central and local government, auditors review the proper co duct of in n management and employers, including arrangements for propriety, detection of fraud and prevention of corruption.  in certain sectors auditors are required to review and report on performance indicators or the achievement of financial or other targets.
Audit Procedures   3.14 All auditors in the public sector carry out audits in accordance with APB Auditing Standards, adapted where necessary for the particular circumstances of the sector. In addition, auditors appointed by the Audit Commission and Audit Scotland are required to follow an audit code of practice, which for England and Wales is approved by Parliament every five years. The codes endorse APB standards but additionally describe procedures to cover aspects of the wider audit.  Audit Advice and Guidance   3.15 Each audit agency provides guidance to all auditors operating under its regime in the form of manuals, technical advice notes and helplines on specific legal, audit and accounting problems. This is in addition to the technical departments of each audit organisation, whether in-house or external.  Relationships with Audited Bodies   3.16 Auditors’ main contact will be with the management of the audited body. There will also be a direct relationship with the audit committee, if any, which would be composed of board members, and with elected members in local government. Auditors may also have direct contact with sponsor departments on matters of reporting, or other significant matters of concern.   Audit Reporting   3.17 Auditors report the results of audits in a variety of ways. The audit opinion on financial statements is based on APB’s SAS 600 and management letters are written in accordance with SAS 610, though their content is likely to be wider than observations relating to the audit of financial statements. In addition auditors issue reports to the public (in local government and health) and parliaments or assemblies (in central government) particularly where there are breaches or potential breaches of legislation and significant waste or risk to public money.   Quality Control   3.18 The work of all auditors is subject to quality control. The NAO’s financial audit work is subject to review by the Joint Monitoring Unit (JMU). The Audit Commission carries out its own programme of quality control, as does Audit Scotland, using teams comprising head office staff and auditors, and covers all aspects of audit work, including on-site discussions on audit quality with management and (board) members.  Audit Fees   3.19 The NAO sets audit fees for its externally contracted auditors. Under the Audit Commission regime, broad fee rates are set centrally though auditors have a degree of flexibility in their application. The Commission monitors fee levels for all auditors, where in-house or external, by reference to the size and complexity of audited bodies.