30 September 2005

Dear Sir

AUDITING PROFESSION BILL

In response to the request for written representations to be made on the Auditing Profession Bill, our submission is presented below for your consideration.

We wholeheartedly welcome the publication of the draft act for public comment. In particular we support the following objectives of the proposed amending legislation:
The implementation of standards that are comparable with international standards, and
Providing for effective oversight of the auditing profession,
in a way which endeavours to make a positive contribution along with the various other measures being taken to restore confidence in reported financial information and the audits thereof.

While there are many aspects in the draft act that we fully support, there are various issues that we believe should be reconsidered or amended.

Our recommendations are respectfully set out below for your consideration.

1. Composition of Independent Regulatory Board for Auditors (IRBA)

The bill, in section 11, states that the Minister is to appoint the members of the IRBA and that not more than 40% of the IRBA are to be registered auditors. The Board of the present Public Accountants’ and Auditors’ Board (PAAB) is also appointed by the Minister, with no specified maximum proportion of registered auditors.

While we accept that in the current environment regarding governance issues that it needs to be seen that registered auditors are not regulating themselves, we have the following concerns:
The bill proposes a maximum number of registered auditors on the IRBA, but no minimum number. In theory the IRBA could then have no registered auditors as members, which we believe is unacceptable. The auditing profession is increasingly adopting international standards and practices and we therefore believe the IRBA should include those who are knowledgeable about these standards and practices. These are likely to be registered auditors preferably with a number of years’practical experience and are knowledgeable of current and developing international standards. We believe the IRBA needs to take care not to introduce requirements that are not in line with international requirements without extremely good reasons properly considered. Therefore we recommend that the IRBA should include a minimum number of registered auditors so that they can comment on the practicality, effect and advisability of introducing any requirements that differ from international practices.

The ethics and auditing standards committees make allowance for a minimum number of registered auditors to be members, yet the disciplinary committee does not. Whilst we support the need for the majority of the members to the disciplinary committee to be non-registered auditors, we believe it is important that the committee includes at least one registered auditor. We propose therefore that the Act be amended to make provision for this "minimum clause" to be included into the Act.

The success of the IRBA is dependent on the performance of the individuals on the Board and the sub-committees. We therefore believe that there should be a regular assessment of the contribution made by the various members of the IRBA and its committees and that this should be taken into account in determining whether a person should remain as a member. Consideration should be given to stating in the bill that the Minister should reconsider the composition of the IRBA on a regular basis, rather than this being optional as provided for in section 12(4).

2. International recognition of IRBA

We note that section 25 of the Bill which deals with funding has been amended to make reference to parliament contributing monies to fund the IRBA. We support this change being made to the previous draft of the Bill, but note that section 25 still refers to auditors paying prescribed fees. While this is consistent with how the PAAB is currently financed, it is likely to become the source of controversy in the future when one considers whether the IRBA is independent as we are increasingly required to follow international standards and practices. We understand that, some overseas regulators are of the opinion that for a local regulator to be seen to be independent of the auditing profession it should not be financed by the auditing profession.

Where this becomes particularly important is in audits of multinational companies that might be listed on more than one stock exchange. In such an instance more than one regulator might cover the audit of these groups. These regulators might only accept that the audit of certain foreign operations are being governed acceptably if they are satisfied with the standing of the local audit regulator, which includes their independence from the local auditing profession. In the absence of such recognition of other regulators some audit firms might be subject to oversight by more than one regulator, which is not desirable.

We believe therefore that the IRBA should be seeking international recognition as an independent regulator, and should ensure that any financing by the profession does not mitigate against or prevent such recognition.

3. Independence

Two-year independence requirement

Section 44(5) states that "A registered auditor may not conduct the audit services of any financial statements of an entity, whether as an individual registered auditor or as a member of a firm, if, at any time during a period to which those financial statements relate or at any time during the two years ending at the beginning of that period the registered auditor has or had conflict of interest in respect of that entity as prescribed by the Regulatory Board."

We believe the proposal that a registered auditor may not audit the financial statements of an entity if the auditor or the auditor’s firm has had a conflict of interest in respect of that entity in the previous two years is neither practical nor necessary.

For example, this requirement is likely to cover the following situations:
Entities the auditor is requested to audit by the shareholders where we are conflicted because of circumstances in the two years prior to audit
Being requested to audit local subsidiaries of entities as a result of a change of auditors by the overseas holding company
Entities acquired by existing audit clients
Entities in which an auditor held an interest prior to becoming a partner in an audit firm.

In the above situations an auditor is unlikely to know whether there is going to be a change in auditor and accordingly to expect an auditor to not have any financial interest, which would be expected to be included in conflicts of interest, in all potential future audit clients is impractical. Practically it might mean that auditors cannot have any financial interests in any entity because of the possibility that they might be required to audit that entity in the future.

This proposed limitation could lead perhaps to a situation in which an organization can not change their auditors because all other firms with the required experience and resources are conflicted from doing so.

We believe it is more practical to require an auditor to dispose of any financial interest the auditor has in an entity before being able to accept the appointment as auditor of that entity. This is respectfully considered to be adequate to ensure the auditor acts independently in conducting the auditor’s work.

Based on the wording of the bill it is also unclear as to what the IRBA will prescribe as being a conflict of interest, and hence we consider it unreasonable to expect auditors to already comply with requirements that will only be determined in the future by the IRBA, seeing that there is no transitional exemption from complying with this requirement.

4. Reportable irregularities

Comparison with present requirements

Section 45 of the draft bill is designed to replace the existing section in the Public Accountants’ and Auditors’ Act dealing with material irregularities. It is debatable how successful this requirement of the PAA Act has been in dealing effectively with such irregularities as had perhaps been intended by the legislation.

We question whether the new proposed requirement will be any more effective. In fact, the effect of the proposed section is such that it will result in an increase in reporting, both to the IRBA and to appropriate regulators and result in audit clients’ directors and staff being inclined to not disclose information to the auditor during the course of the auditor’s work.

Materiality

The proposals are more onerous than the current requirements which only relate to material irregularities, as, in the requirement to report fraudulent acts, theft or dishonesty, there is no reference to materiality at all.

Even when the bill makes reference to ‘material’ it will be difficult to apply in practice. For example the definition of reportable irregularity makes reference to an issue being material to ‘any partner, member, shareholder, creditor or client of the entity’ and thus requires materiality to be viewed from the perspective of these parties. Without knowing who these parties are,, their particular circumstances and what might or might not be material to them it is not possible to determine whether an issue is likely to be regarded by them as being material or not. One shareholder might regard the value of 100 shares as being material, whereas to another shareholder it might be the value of 1 000 000 shares. Accordingly we do not believe that the requirements of the bill are capable of being interpreted in a consistent manner, except if all irregularities are reported.

Therefore we believe that reportable irregularities should only apply to material issues and that materiality should be considered in light of what is regarded as being material to the entity concerned.

Reporting requirements

The bill allows a registered auditor to send a report to the IRBA regarding reporting irregularities even before the management board of the entity is informed. We are concerned that the bill could result in entities objecting that auditors could be reporting unsubstantiated contentions to external parties. As stated above in our comments on materiality above many such issues could be reported. The IRBA only has responsibility to pass on reports to appropriate regulators after a further report is received within the 30 day period, which further calls into question the need to report these issues to the IRBA before the management board had had an opportunity to respond to the issues reported to them.


Other important interpretational concerns

There is no widely accepted definition of what "dishonesty" or "breach of fiduciary duty" comprises. Dishonesty could include matters that would be considered by some to be a breach of "ethics" or possibly of "fair business practice". Are such breaches of ethics or fair business practices "dishonest"? For example, an entity might be applying for an increase in selling prices in excess of inflationary cost pressures. Is this dishonest, and therefore a reportable irregularity? Some might say this is an instance of dishonesty. Others would say not.

In addition, is it a breach of fiduciary duty when the directors declare a dividend but have to borrow to fund the dividend, in a situation where the holding company told the directors to declare the dividend, and where this might lead to a modest increase in gearing?

We are concerned with the lack of clarity in how this section should be applied, particularly as in terms of section 52 of the bill an auditor could be sentenced to a term of imprisonment of up to ten years for making a false report.

We would also like to point out that internationally, registered auditors are not trained as lawyers nor are they fully conversant with all matters of law. Or is it the intention of the IRBA that every registered auditor should be so trained and conversant so that in the event that the auditor should come across a breach of any one of the large number of complex laws in our country that the auditor would be in a position to identify all such irregularities?. We would ask whether this was the original intention of the legislation when it was originally passed?

We appeal to the legislature to make the meaning of section 45 crystal clear because of the potential extremely serious consequences for auditors of unintentionally not complying with this section, failing which it should be removed from the act.

Recommendation

We strongly believe section 45 should be reconsidered:
We believe the current section 20 requirement of the PAA Act should not be retained since the current requirements have not appeared to be effective in the past and the new section 45 would appear to promise to be equally ineffective. At the same time this proposed section presents considerable risk of prosecution for individual auditors who might unknowingly not comply with its complex provisions.
Whether reportable irregularities should be reported before the management board has had an opportunity to respond to the auditor’s report
Which type of offences should be regarded as reportable irregularities, including requiring offences only to relate to issues that are material to the entity concerned
Providing clarity as to what constitutes reportable irregularities so that it will be applied consistently by auditors

5. Practice issues

Multi-disciplinary practices

We are disappointed that the bill does not make provision for multi-disciplinary practices. As business has become more complex, some audit firms have employed ‘partner-equivalent’ persons to enable them to audit such entities. This includes persons with expertise in areas such as tax, information technology and actuarial science. These persons might not be registered auditors but for example be experts in other fields such as tax law, actuarial science etc.

We believe that serious consideration should be given to providing for multi-disciplinary practices in future legislation, subject to the majority of the partners being registered auditors.


6. Determination of liability

Liability of auditors

Public indemnity insurance is a major area of cost to audit firms. In some cases it can be difficult or very expensive to obtain insurance cover for certain levels. One of the reasons for this is that when a company fails aggrieved parties might look to the auditor of the company to reimburse them for their losses.

While auditors accept that they should be held responsible for their actions, the law, as it stands at present, provides for joint and several liability. Accordingly an auditor could be required to pay for the full loss even if they are only to blame to a very small extent. As investors know that auditors carry professional indemnity insurance, they are more likely to sue an auditor, who might be able to recover their losses, than the parties who are the main reason for the losses suffered. Auditors can also suffer by having to spend an inordinate amount of time defending their actions.

This position is regarded as being unfair on the auditor in many situations. Accordingly auditors have believed for many years that liability should be determined in such a way that the auditor is only responsible for the proportion of the loss or damage that can be ascribed to the auditor based on the relative degree of fault. We believe that the legislation should therefore make specific provision for the determination of the auditor’s liability.

The bill, in section 58 does refer to the Apportionment of Damages Act. The reference to this Act only refers to a contract concluded with an auditor. This means that the provision does not extend to other parties who might rely on an audit report or to a shareholder who has no contract with an auditor, which leaves the auditor to the mercy of common law principles of apportionment of liability. We believe that the Apportionment of Damages Act should apply to all parties who might want to sue an auditor.

We also believe the legislation should consider providing for limited liability partnerships, which are catered for in the United Kingdom and the United States of America. Such a partnership protects partners (not responsible for a failed audit ) personally, but not their firm, from possible sequestration if the firm or one of the other partners is being sued. At present a partner could be sequestrated even if they had no involvement in an audit that lead to action being taken against the partner’s firm. There is a need to attract suitably qualified people into the profession without them being too unduly exposed to possible financial risks and limited liability partnerships is one suggestion to deal with this issue.

Finally we believe that the extremely punitive possible maximum penalty of ten years imprisonment should be reconsidered in the light of the following
The auditor is unable to limit his liability and is therefore exposed to unlimited financial penalties
The ability of the IRBA to remove a registered auditor’s accreditation if an offence warrants this
In the United Kingdom a similar proposed penalty of imprisonment was comprehensively debated and found to be unreasonable. We are of the opinion that the conclusion reached there was the correct one.

Liability of auditee directors and other parties

We believe that the Auditing Professions Bill should also make it an offence for directors, employees and others connected to companies to mislead or deceive auditors or to not provide material disclosures. This proposal was contained in the recommendations of the Ministerial Panel for the Review of the Draft Accountancy Profession Bill, but it seems has not been incorporated into this draft of the bill.

We do not believe it appropriate for changes to be made to the regulation of auditors, if the necessary changes applicable to other role players in audits are not dealt with.

7. Power to make rules and issue standards

Section 10 of the draft bill bestows the power on the IRBA to make rules. Further it is noted that there is no mention in the bill of the committee for auditing standards having the power to adopt or issue standards. Consequently it appears the IRBA will need to approve the adoption of international standards or local interpretation standards or guidance as proposed by the committee for auditing standards.

Considering the IRBA will only be required to meet twice a year and the fact that they need to issue a draft proposal of the rule or standard in the government gazette for public comment before they can pass a rule, we envisage that it could take a significant period of time, in many instances more than a year, to issue standards. This does not seem practical at all as there will be situations where it would be in the public interest that changes are made timeously. The international practice is for the body who discusses the standard, being in this instance the standard setting committee, to issue the standard as well. We recommend the bill be amended to allow for a similar process to be adopted in South Africa.

8. Prescribed audit procedures

Section 44 of the bill prescribes specific audit procedures that the auditor will need to undertake when conducting an audit. We question whether there is any longer the need for the act itself to include only some audit procedures when in fact extensive guidance is tabled in the auditing standards themselves.

Not only do we believe it is inappropriate for the act to include some and not all audit procedures, but we are also very much concerned that there is no reference to materiality. This could result in inappropriately extensive and costly additional audit requirements in excess of internationally accepted standards.

To illustrate section 44(2) makes reference to the need for the registered auditor to satisfy himself or herself of the existence of all assets and liabilities. Without the criterion of "materiality" being included in this section of the bill, this would require verification of all assets and liabilities irrespective of the balance.


9. Other considerations

We note that the bill makes no reference to whether the IRBA meetings or sessions will be closed or open to the public. We encourage these sessions being made open to the public

The draft act’s definition of "audit" differs significantly from the definition provided by the International Federation of Accountants (IFAC), the international body which sets auditing standards which are now followed widely in the world today. In the interest of reducing the risk of misinterpretation and confusion we strongly recommend that the bill be amended to align its definition to IFAC’s definition which refers to "reasonable" assurance versus "high" level of assurance particularly if the IRBA is to require our registered auditors to comply with International Standards of Auditing as issued by IFAC and which standards have been drafted with the provision of "reasonable" assurance in mind..

Section 47(1)(b) states that despite the generality of paragraph (a), the Regulatory Board, or any person authorized by it, must at least annually inspect or review the practice of a firm registered as a public interest company. This does not seem to make sense, as audit firms by law cannot be public interest companies. We question whether the intention of this section was not to make reference to audit firms which act as auditors of public interest companies being subjected to annual review?

In reading section 32 it appears that the Auditor General (AG) does not have to be an accredited member of the profession while being allowed to perform external audits of public interest entities. In conjunction with this section 41 does not indicate clearly whether the auditor general is also accountable under the Act as is other registered auditors and to what extent the AG is liable for professional conduct and quality and risk management on all audits. We believe that in view of the fact that the Auditor General conducts audits of public interest entities the AG should be subjected to the same accreditation and responsibility rules as any other registered auditor under sections 32 and 41 (specifically refer to section 41(2)(b) as compared to 41(3)(c)). We do not believe that the requirements should be any different for the AG.


10. Errors within the draft

We noted the following apparent errors in the current draft.
Section 7(1)(b) makes reference to section 38 when it’s meant to make reference to section 37.
Section 21(1) the word "consists" should be "consist"
Section 34 makes reference to section 34 when it’s meant to make reference to section 33.
Section 45(4) makes reference to section (b)(i)(cc) of subsection 3 when it should in fact refer to (c)(i)(cc) of subsection 3.

Conclusion

If you would like to discuss any of the above comments with us or require clarity on any of the issues raised, please do not hesitate to contact our Professional Practice Director , Mike Bourne, at Ernst & Young, PO Box 656, Cape Town, 8000 or alternatively on telephone (021) 443-0200 ,mobile telephone 082 6030772, fax (021) 425-4523 or e-mail [email protected].

Yours faithfully




ERNST & YOUNG