int. j. audit.8: 117–138 (2004) the reform of the uk’s

The Reform of the UK’s AuditorIndependence Framework after theEnron Collapse: An Example ofEvidence-based Policy Making

Stella Fearnley1 and Vivien Beattie2

1University of Portsmouth Business School2University of Glasgow

Following the collapse of Enron, the UK government set up ahigh level group of regulators and ministers to co-ordinate a review of the UK regulatory framework, including the keyarea of auditor independence. The Accountancy FoundationReview Board (Review Board), which was at the timeresponsible for the independent oversight of the UKaccountancy professional bodies, took the leading role in theauditor independence review.

A programme of research was set up by the Review Boardand studies were provided by other bodies. The results of theresearch were compiled into a paper which underpinned theReview Board’s recommendations for change. This was fedinto the government review process. In this paper, the researchis summarised and the Review Board’s evidence-basedrecommendations are presented and compared with thegovernment’s final position. Few differences are found.Insights are provided into the nature of the regulatory reformprocess and the quality of the evidence which underpinned it.

Key words: Auditor independence, UK government, post-Enronreform, accountancy profession oversight.

International Journal of AuditingInt. J. Audit. 8: 117–138 (2004)

ISSN 1090–6738© Blackwell Publishing Ltd 2004. Published by Blackwell Publishing, 9600 GarsingtonRoad, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

Correspondence to: Department of Accounting, Law andManagement Science, University of Portsmouth Business School,Richmond Building, Portland Street, Portsmouth PO1 3DE. E-mail: [email protected]

SUMMARY

Following the collapse of Enron, the UKgovernment set up the Co-ordinating Group onAudit and Accounting Issues (CGAA), a high levelgroup of regulators and ministers. The CGAA was

responsible for leading the review of the regulatoryframework, including the key area of auditorindependence, and for making recommendationsfor change. Both the chairman and the director of the Accountancy Foundation Review Board(Review Board), which was at the time responsiblefor the independent oversight of the UKaccountancy professional bodies, were members ofthe CGAA.

In order to ensure that the policy discussions onthe subject of auditor independence were properly

informed, the Review Board commissioned aprogramme of research from leading academicsand market research bodies. Other interestedparties also prepared or commissioned furtherstudies which were made available to the Board.Based on the findings of the research, the Enronconcerns and a review of the UK regulatoryframework for auditor independence, a series ofrecommendations for the enhancement of auditorindependence were developed by the ReviewBoard. These recommendations and the evidencewhich underpinned them were fed into theCGAA’s decision-making process.

This paper has two objectives. The first objectiveis to provide, for academic readership, a summaryof the research considered by the Review Board, together with the Review Board’s recom-mendations for change to the UK auditor inde-pendence regime and the evidence which underpinned them. The second objective is tocompare the auditor independence recom-mendations in the CGAA’s final report with theReview Board’s recommendations in order toevaluate the extent to which the Review Board’sevidence-based research supported public policydevelopment in this area.

Few differences are found between the ReviewBoard’s recommendations and the CGAA’s finalrecommendations. The three principal forms of the CGAA’s recommendations are found to beincreased transparency and disclosure by auditfirms about quality control; increased transparencyand disclosure by companies about the activities ofthe audit committee; and enhanced disclosure ofthe breakdown of non-audit services. These areregulatory mechanisms which are generally lowcost. A further key change is the rationalisation ofthe regime for auditor independence under theAuditing Practices Board. The most significantdifference between the Review Board’srecommendations and the final reforms is theestablishment of a new audit monitoring unit,outside the control of the UK accountancy bodies,to inspect listed and public interest audits. Thiswill be under the control of the successor body tothe Review Board (The Professional OversightBoard for Accountancy (POBA)). The POBA willbecome part of the Financial Reporting Council(FRC), following the transfer of the AccountancyFoundation’s key activities to the FRC.

Valuable insights are also provided into thenature of the sources of input to the UK’s post-Enron reform programme for auditor

independence. The policy making procedure isseen to be essentially evidence-based, withconsiderable reliance being placed on the results ofacademic research.

INTRODUCTION

The collapse of Enron, in November 2001, followedby the demise of Andersen (SEC, 2002) and theWorldcom scandal provided evidence of systemicfailure in the US regulatory framework forfinancial reporting, and raised widespread beliefsthat Andersen had compromised its independenceas auditors.

The ensuing crisis of confidence in financialreporting and auditing spread to other countries,including the UK. Although there had been nocomparable failures in the UK, where theregulatory framework has been claimed to be morerobust (Hinks, 2002), public reassurance wasneeded. The UK government rapidly instigatedreviews of key aspects of the UK regulatoryframework. The process was led by the Co-ordinating Group on Audit and Accounting Issues (CGAA) which was set up in February 2002by the Secretary of State for Trade and Industryand the Chancellor of the Exchequer and wasjointly chaired by two ministers.1 The review waswide-ranging and focused on financial reporting,auditing, corporate governance and the structureof the regulatory framework for audit and theaccountancy profession.2

A key concern for the CGAA was the adequacyof the UK framework for auditor independence. A combination of circumstances which couldundermine independence led to harsh criticism ofAndersen. These were: (i) the firm was earningmore from non-audit services provision than fromthe audit ($25m from audit and $27m from non-audit services) and non-audit services includedassisting the company to devise accountingschemes compliant with US GAAP, which had theobjective of keeping liabilities off the balancesheet;3 (ii) Enron had been the partner’s only clientfor some years and was the principal client of thefirm’s Houston office, thus the office and thepartner were economically dependent on retainingthe client; and (iii) a number of ex-Andersen staffworked for Enron and the relationship wasbelieved to be too cosy. There were also concernsabout how the firm managed its internal qualitycontrol4 and its partner incentive mechanisms. Inthe US these issues and others associated with the

118 S. Fearnley and V. Beattie

© Blackwell Publishing Ltd 2004 Int. J. Audit. 8: 117–138 (2004)

systemic failure are being addressed through theprovisions of the Sarbanes-Oxley Act, which washastily passed in July 2002 to restore confidence inthe US market (Sarbanes-Oxley Act, 2002).

In the UK the principal concerns in the publicdomain focused on calls for the rotation of auditfirms and for the banning of non-audit serviceprovision by incumbent auditors. Apart from aplethora of press comment, these issues were alsoraised by the House of Commons TreasuryCommittee (2002) and the chairman of theFinancial Services Authority (Accountancy Age,2002).

At the time of the Enron collapse, theAccountancy Foundation Review Board (ReviewBoard), which came into operation in 2001, wasresponsible for oversight of the accountancyprofession in the UK (Accountancy Foundation,2002), including auditor independence.5 TheReview Board therefore took the leading role inproviding input to the auditor independencereview.6 Both the chairman and the director of theReview Board were members of the CGAA.Although time was limited,7 the chairman and theReview Board were anxious to ensure that anydecisions made by the CGAA about auditorindependence should be evidence-based. Thedirector was asked to establish a researchprogramme to meet the principal concerns,focusing particularly on auditor rotation and theprovision of non-audit services by incumbentauditors. Although there was little in the UK publicdebate about the other Enron concerns namely:audit quality control; partner reward structures;high levels of economic dependence (leading tofear of losing the client); and audit firm staff joiningclients, these issues were of concern to the ReviewBoard. The director, on behalf of the Review Board,commissioned research from leading academicsand market researchers. Further studies werecarried out in house. Other bodies also prepared or commissioned studies which were provided tothe Review Board and to other interested parties.When all the research studies had been received, a further study was commissioned whichconsolidated the Enron concerns and the results ofthe research programme (and other relevantliterature). The extant UK framework for auditorindependence was reviewed in the light of theconcerns and the research findings, and from thisevidence recommendations for change weremade.8 The results of the research and therecommendations were then submitted to the

DTI9 and fed into the CGAA’s decision-makingprocess.

This paper has two objectives. The first objectiveis to provide, for academic readership, the ReviewBoard’s recommendations for change to the UKauditor independence regime and the evidencewhich underpinned them. The second objective is to compare the auditor independencerecommendations in the CGAA’s final report,which have been accepted by the government,with the Review Board’s recommendations inorder to evaluate the extent to which the ReviewBoard’s evidence-based research underpinnedpublic policy in this area.

The remainder of this paper is divided into foursections. The following section summarises thefindings of the research commissioned by, orprovided to, the Review Board during 2002. Thenthe Review Board’s proposals for change arecompared to the proposals in the CGAA’s finalreport and the other related reports brought out atthe same time.10 Conclusions are drawn in the finalsection.

RESEARCH COMMISSIONED BY, ORPROVIDED TO, THE REVIEW BOARDDURING 2002 RELATING TO AUDITOR INDEPENDENCE

The programme of research which underpinned theReview Board’s independence recommendations is shown in Table 1. The programme covers thefollowing topics: non-audit services; auditorrotation and competitive tendering; auditorchanges; attitudinal surveys; differences betweenthe public and private sectors; and the summarypaper referred to above. As can be seen from thetable, six of the ten studies were provided byindependent academics. The Review Board wasparticularly interested in obtaining literaturereviews and other research in the two key areas ofnon-audit services and rotation.

The results of the academic research and otherevidence obtained by the Review Board ispresented under the following headings:definitions of auditor independence; non-auditservices and auditor independence; auditorchanges; auditor rotation and competitivetendering; activities of the audit committee; issuesfrom the comparison of practices in the public and private sectors; and the review of the UKregulatory framework for auditor independence in 2002.


The Reform of the UK’s Auditor Independence Framework after the Enron Collapse 119

Definitions of auditor independence

Beattie and Fearnley provide a summary ofdefinitions of independence from the regulatoryframeworks of Australia (ICAA, 2002), UK(CAJEC, 1996), SEC (2000), Ontario (ICAO, 2002),IFAC (2001) and the EC Recommendation (EC,2002). All the statements make a distinctionbetween independence in fact and independencein appearance. The frameworks use the termindependence of mind when referring toindependence in fact and the term objectivity isgenerally preferred to independence. There isconsensus that objectivity is a state of mind whichis free of influences that compromise judgment and which has regard to all considerations relevant to the task, but no other. SEC (2000)recognises that such objectivity is difficult to prove

except in unusual circumstances and is usuallydemonstrated by circumstantial evidence.

There is also general consensus on thedefinitions of independence in appearance. Thedefinitions focus on the avoidance by the auditorof circumstances where a reasonable and informedthird party (or public perception) would questionthe auditor’s ability to act objectively. Interestingly,IFAC (2001) contains an expectation that thereasonable and informed third party should have‘knowledge of all relevant information, includingany safeguards applied’. SEC (2000) is slightlydifferent in restricting the third party to a‘reasonable investor with knowledge of all relevantfacts and circumstances’.

Fearnley considers the two key attributes ofaudit quality which are necessary to avoid auditfailure: competence and independence.



Table 1: Summary of research commissioned by, or provided to, the Review Board

Topic Title of study Authors Sponsor

Non audit 1. Auditor independence and non-audit services: Beattie and ICAEWservices a literature review Fearnley

2. The provision of non-audit services to audit Canning and RB1clients: independence and other issues Gwilliam(a discussion paper)

Auditor 1. Mandatory rotation of audit firms Not named ICAEWrotation 2. Mandatory auditor rotation: a summary Moizer and ICAEW &

Mohamed RB23. The impact of mandatory audit rotation on Dallachio and ECG

audit quality and on audit pricing: the case Viganoof Italy

Auditor UK listed company auditor changes in the 1990s Moizer, Porter ICAEW &changes and Mohamed RB3Attitudinal 1. A survey into the attitudes of audit clients, Mori RB4surveys auditors and institutional investors towards

audit issues2. Face to face interviews with auditors, audit Not named RB5

clients and institutional shareholdersPublic and An assessment of the possible application of the Not named CIPFAprivate sector public sector audit model to the UK private

sectorSummary and Auditor Independence: the way forward in the Fearnley RB5recommendations UK

Key to sponsors: ICAEW – Institute of Chartered Accountants in England and Wales; RB – Review Board;ECG – European Contact Group (a body representing larger audit firms in Europe); CIPFA – CharteredInstitute of Public Finance and Accountancy.

Key to academic authors: Beattie: University of Glasgow; Fearnley: University of Portsmouth BusinessSchool; Canning: Dublin City University; Gwilliam: London School of Economics and Political Science andUniversity of Wales, Aberystwyth; Moizer and Mohamed: University of Leeds; Dallachio and Vigano: SDAUniversita Bocconi; Porter: University of Wellington.

Competence means that errors, omissions andmisstatements will be identified. Independencemeans that the auditor will ensure thatmanagement puts the problems right or, failingthat, will qualify the audit report. She cites theremarkably prophetic seminal work by De Angelo(1981) who shows that an auditor whocompromises quality in order to retain one clientrisks reputation damage which may lead to loss ofincome from other clients.

Fearnley further considers independence in fact and independence in appearance, showingdiagrammatically how the two interrelate in thecase of an unexpected corporate collapse whichcasts doubt on the quality of the audit.

As can be seen from Figure 1, the appearance ofan independence failure is enough to undermineconfidence in audit and financial reporting. Primafacie evidence of lack of independence in factfurther undermines confidence. This emphasisesthe importance of independence in appearancebecause independent behaviour (i.e. independencein fact) is unobservable.

Fearnley cites recent relevant UK research,particularly the Beattie et al. (1999) study. Bysurveying UK finance directors, audit partners andfinancial journalists, they find that the key factorsbelieved to threaten independence in the UK are:overall economic significance and status of theclient to the partner, where personal incomedepends on client retention; overall economicsignificance and status of the client to the office and the firm; level of non-audit services (100% ofthe fee is seen as being significantly more of athreat than 50%11); and directors’ de facto control ofthe audit appointment and the fee. The mostinfluential factors enhancing independence are:audit committee with independent directors;rotation of partners; firm’s quality control; theenforcement and penalty regime (the risk of loss of licence to audit and the risk of a FinancialReporting Review Panel12 investigation rankhighly); and protection from removal from office. Interestingly, the threats listed above arereflected in the criticism of Andersen in the Enroncase.



Independence in fact Independence inappearance

Prima facie evidence of Suspicion/belief thatauditor independence failure –

independence impaired –

independence in fact compromised independence inappearancecompromised

Unexpectedcorporate

collapse castsdoubt on auditor

independence

Loss of confidence in audit

Loss of confidence in financial reporting destabilises markets

Figure 1: Relationship between independence in fact and independence in appearance

Fearnley also refers to UK and other countrystudies which recognise the significant influencethat the ethical development of the individualaudit partner and the ethical culture within a firmhave on independent behaviour (Beattie et al., 2001;Kleinman & Palmon, 2001). These influences andsafeguards on independence in fact are presentedin Figure 2.

Figure 2 shows that: (i) an ethical company withgood corporate governance will not attempt to

undermine auditor independence; (ii) a partnerwith high ethical standards will not give in topressure; (iii) a partner with lower ethicalstandards will consider the strength of theregulatory framework, peer group pressure andthe risks and personal penalties of getting caughtbefore compromising independence; and (iv) aninappropriate in-firm reward structure is anincentive to take risks. The final backstop is thefirm’s internal quality control and the external



Influences Safeguards No independencefailure failure

Yes

No

Yes

No

Yes

No

Yes

No

Good corporate governance

Ethicalcompany

Partner has high ethical standards Ethicalfirm

& careful partner selection

Partner’s perception of risks

and penalties ofgetting caught isgreater than short term benefits of a

breach

Firm’sculture & rewards

Effectiveness of regulatoryframework & enforcement

Firm’s internalcontrols &

other externalmonitoring

procedures are effective

Firm’scompliance & riskmanagement procedures

Effectiveness of regulatorymonitoring ofindependencecompliance

Independencefailure

(all safeguards fail)

Unethical company puts pressureon partner

No independence failure

(at least onesafeguard works)

Figure 2: Chart of independence in fact

monitoring procedures. Fearnley points out thatvery little is known about how the external auditormonitoring process works and how firmsthemselves establish and maintain ethicalstandards and quality control.

Non-audit services and auditorindependence

In addition to the two studies which specificallyfocus on non-audit services and independence(Beattie and Fearnley; Canning and Gwilliam)three other studies (Mori; RB5; CIPFA) addressaspects of the subject. The findings fall into fiveareas: fees and disclosure; perceived and actualthreats to independence; the advantages anddisadvantages of auditors providing non-auditservices; international variations in regulatorypolicy; and the role of the audit committee inapproving non-audit services.

Beattie and Fearnley report that by 2001 the level of non-audit services fees paid by the largestUK companies far exceeded the level of the audit fee. The ratio of non-audit to audit fees paidto the incumbent auditor rose from 98% in 1996 to300% in 2001.13 There was no requirement todisclose the breakdown of the composition of thefee between service types. Canning and Gwilliamand RB5 suggest more disclosure of the types ofnon-audit services undertaken by audit firmsrather than a prescribed limit on the cost of thoseservices. The Mori study finds belief that audit feeshave been driven down because the audit servicehas become a loss leader for firms as it providesaccess to the more lucrative non-audit servicesmarket.

In considering the impact of non-audit serviceson auditor independence, Beattie and Fearnleypoint out that where audit and non-audit servicesare provided to the same company, two differentcontractual relationships exist. The non-auditservices contractual relationship is with thecompany (as is the case with any other serviceprovider) while the audit contractual relationship,though also with the company, requires in additionthat the auditor owes a duty of care to theshareholders. Moreover, the audit is subject toregulatory oversight. However, the audit firm andthe directors may perceive the purchase of audit inthe same light as that of any other service and maynot distinguish between audit and non-auditservices, particularly in respect of services whichare linked to the annual reporting round.

Beattie and Fearnley find that the provision ofnon-audit services presents wide-ranging threatsto independence, encompassing attributes of fourof the five threats14 identified in the UKindependence framework. These are: self-interest –fear of losing the client and the subsequent loss ofincome and status; self review – auditing one’sown work or failing to review a previous defectivedecision; advocacy – taking an extreme position inacting on behalf of, or advising a client (possibly tothe detriment of investors); and familiarity –becoming too close to the client and identifying tooclosely with management objectives. Three studiesindicate beliefs that the provision of non-auditservices undermines the appearance of auditor independence (Beattie and Fearnley, Canning and Gwilliam, and Mori). Mori identifies concernsthat independence may be compromised by theaudit firm’s desire to retain access to the morelucrative non-audit services and concerns thatpartners’ income and promotion prospects may be linked to the level of non-audit servicesprovided to audit clients. However neither Beattieand Fearnley nor Canning and Gwilliam findconclusive evidence from academic research thatnon-audit services provision undermines inde-pendence in fact, although it is recognised that thisis difficult to measure as the audit process itself isnot publicly observable, nor are the procedures forquality control and ethical standards within thefirms.

Beattie and Fearnley summarise studies thatshow there are efficiencies in the joint provision of audit and non-audit services arising fromknowledge spillovers and contractual economiesof scope. They find little evidence that jointprovision reduces cost but there is evidence thatrestrictions on joint provision would increase costsfor companies and audit firms. Canning andGwilliam take the view that if the quality of auditper se is more important to the workings of capitalmarkets than the joint provision of audit and non-audit services, then the benefits of joint provisionhave to be unequivocally demonstrated.

Regulatory frameworks15 are found by Beattieand Fearnley to differ in terms of the permissibilityand disclosure requirements for non-auditservices. Related to this, Canning and Gwilliambelieve that categorisation of permitted and non-permitted services in line with the SEC rules isfraught with difficulty.

Three studies (Mori, RB5 and CIPFA) see anenhanced role for audit committees in the approval



of non-audit services. Mori finds views that auditcommittees should be responsible for theallocation of non-audit services. RB5 argues thatthe principles for awarding non-audit servicesshould be set out in the Combined Code and thepolicy disclosed in the company’s annual report.CIPFA suggest that permission should be obtainedfrom the audit committee to exceed a thresholdvalue for non-audit services.

These studies provide clear evidence that theprovision of non-audit services, particularly at asignificant level, undermines independence inappearance and threatens the credibility of audit.The research does not point to the need for a totalban on the provision of non-audit services. Theappearance problem indicates a need for thefollowing information: more transparency abouthow firms manage the conflicts of interest thatNAS provision creates; whether audit partners arerewarded for earning NAS; and the nature of theNAS being provided. There is also evidence of adesire to see the company audit committeeapproving the provision of NAS.

Auditor changes

Moizer, Porter and Mohamed find 609 changes oflisted company auditor between 1990 and 2000,which is equivalent to an annual rate of change of 2.25%. This indicates a relatively low rate ofauditor change and, if audits were changed evenlythroughout time, it would take approximately 45years before all audits were changed. The Big Six(i.e. the top tier before the PricewaterhouseCoopersmerger and the collapse of Andersen) were theincoming auditor for 68.8% of the changes andoutgoing auditor for 55.8% of the changes. Thisshows a steady rise in the market share of the bigfirms in this sector.

Moizer et al. also find that the vast majority of companies changing auditors received anunqualified report before the change. There wererelatively few qualified reports for companies afteran auditor change and there was little differencebetween old and new audit firms in terms ofqualified reports. They conclude that it isimpossible to make any sensible inferences aboutthe reasons for an auditor change from publishedinformation, because there is either no informationat all or the information given provides no clues asto what happened. This research points to a needfor review of the auditor appointment and changeprocess.

Auditor rotation and competitive tendering

Three studies focus specifically on auditor rotation:a study prepared by the ICAEW; Moizer andMohamed’s summary of the academic literature onrotation; and a study of the Italian market byDallachio and Vigano. RB5, Mori and CIPFA alsoreport on rotation and Mori and RB5 commentbriefly on competitive tendering in the UK.

Arguments for and against auditor rotation areidentified in the studies. Moizer and Mohammedfind, on balance, that the academic literaturefavours the arguments for mandatory rotationrather than the arguments against it. Moizer andMohamed do not suggest that there will be amassive improvement in the quality of an audit, rather that there will be a net positiveimprovement, because mandatory rotation of auditappointments is likely to reduce the probability ofa large scale independence-related audit failure.The ICAEW study argues that perceived benefitsof mandatory rotation are: an improvement inaudit quality due to the avoidance of over-familiarity with the client and its management; theopportunity for a fresh approach to the audit; abetter perception of auditor independence; and thebenefits of competition.

However there is much argument againstrotation from a practical perspective. RB5, Moriand ICAEW find that the learning curve in theearly years of an audit and the implications ofrotation for audit costs, quality and the risk ofaudit failure are the most widely cited reasons for this opposition. ICAEW finds concerns aboutstart up costs for companies and audit firms andconcerns that a lack of incentive to maintainquality could arise where an audit is about tochange hands. Signals that may be given outcurrently when there is a change of auditor will belost. In addition, the small number of large auditfirms leads to lack of choice because of conflicts of interest, both at firm and partner level. Also the rules restricting firms’ partners and staff from holding financial interests in clients wouldforce partners and staff regularly to change theirinvestment portfolios, an unattractive prospect(ICAEW, RB5). As the annual rate of auditorchange in the period from 1990–2000 averaged2.25% (Moizer and Mohamed) mandatory rotationwould cause many more companies to incur thecosts and disruption of enforced change. Althoughmandatory rotation is a feature of some publicsector audit appointments,16 because of the costs



and the limited choice of firms, CIPFA does notconsider implementation of rotation in the privatesector is practical. Regulatory reviews in Australiaand the Republic of Ireland concluded that, inbalancing the arguments, the costs of mandatoryrotation outweighed the benefits (ICAEW).

Italy is currently the only EU country whererotation is mandatory. Rotation applies every nineyears with compulsory competitive tenderingevery three years. Dallachio and Vigano find thatthe mandatory audit rotation rule constitutes a potential mechanism to improve auditorindependence but they believe that it risks beingsimply a ‘theoretical’ solution to the problemwhich in practice carries significant risks. They findthat the current rule seems to have intensified pricecompetition. In the case of auditing, which isgenerally considered a public interest activity, thiscould be considered as inappropriate. This is evenmore so if growth in competitive pressure in theaudit market exceeds the ability of the governanceand professional ethics culture to cope. Theysuggest that regulators could concentrate on the following mechanisms: rotation of engagementpartners within the firm; the role of the second partner and of internal control andgovernance mechanisms in audit firms; peerreview among auditors in the firm, between auditfirms and by professional bodies; and supervisionby regulators.

Dallachio and Vigano also recommend that audit fees should never drop below the minimumfee threshold that permits audit activities to becarried out adequately, both in terms of quality andtiming, especially considering the complexity ofappointments. This is in line with a commonconviction from the professional world that thepillars for quality in professional activities (ofpublic interest) can be traced to: professionalstandards; quality control mechanisms; andminimum fees for services. They also find that, inItaly, financial markets seem more interested in thequality of the audit process than in mandatoryrotation.

RB5 and Mori show beliefs that competitivetendering has reduced audit fees, forced out wasteand made firms focus on risk. There are also beliefsthat audit quality may have suffered as a result oflower fees.

These studies show that while audit firmrotation is perceived, in theory, to enhance auditorindependence, the practical problems associatedwith its introduction are such as to make it

undesirable. The Dallachio and Vigano researchinto the experiences in Italy is particularly telling.They recommend the alternative regulatorymechanisms of partner rotation, quality controlwithin firms, peer review and regulatorysupervision.

Activities of the audit committee

Apart from involvement in the approval of NAS,the following roles for the audit committee aresupported: recommending the appointment of the auditors (Mori and RB5); the setting of theremuneration of the auditors (Mori and RB5); the review of auditor independence (Mori andRB5); the evaluation of audit effectiveness (Moriand RB5); communicating with the auditors (Moriand RB5); and a more public approach to auditreporting, whereby the audit committee reports inthe company’s annual report on how the companyhas responded to the auditors’ findings andrecommendations (CIPFA).

Issues from the comparison of practices in the public and private sectors

CIPFA suggests that, with due consideration topractical and legal problems, the followingpractices adopted in some areas of the public sector merit further consideration to assist the effectiveness of private sector audit. These are:the establishment of a central body to whichauditors can turn for authoritative advice on legal, accounting or audit related matters or towhich significant suspicions or concerns could bereported; co-operation and exchange ofinformation between auditors during audits andthe in-depth exchange of working papers andaudit knowledge on change of auditors (thissuggestion is particularly vulnerable to litigationconstraints); a legal requirement for companies toappoint a chief financial officer who is a qualifiedmember of a recognised accountancy professionalbody; a statutory right for auditors to obtaininformation relevant to their audits from anysource; and publication of the results ofindependent quality control reviews to inform theappointments made by the audit committee.

The CIPFA paper raises some different issues but that there is common ground with the otherstudies on concerns about auditor change and the transparency of firms and the regulatoryprocess.



Review of the UK regulatory framework for auditor independence in 2002

Fearnley summarises and reviews the 2002 UKauditor independence framework taking accountof the Enron concerns and the findings of theReview Board’s research programme. Inde-pendence related regulations are found to derivefrom four separate sources: the professional ethicalguidelines (including auditor independenceguidelines) which were developed by theChartered Accountants Joint Ethics Committee (the CAJEC framework, 1996);17 company law;auditing standards set by the Auditing Practices Board; and the Audit Regulations(ICAEW, 1995).18

Table 2 summarises the independence pro-`visions from the CAJEC framework, (as updatedby the 2002 EC Regulation). The frameworkidentifies a series of threats to independencetogether with the safeguards which can be put inplace to reduce the independence risk to anacceptable level. Where it is believed that theindependence risk cannot be safeguarded, theframework contains a prohibition. Also includedare two legal provisions. Section 27, CompaniesAct, 1989, prohibits certain parties from acting asauditor, and Sections 390A and B require disclosurein the company’s annual report of audit fees andNAS.

The summary of the CAJEC frameworkhighlights some deficiencies. There are no explicitsafeguards against five key independence threats.(The absence of a safeguard is shown as ‘none’ inbold type in the column headed ‘Safeguards’ inTable 2) These five threats are: the fear of losing aclient; reviewing previous judgments or decisionstaken about the performance of the audit;supporting the clients’ interest; adopting anextreme position on tax or other matters; andintimidation.

A surprising provision is that an auditor mayhave a listed company client which provides up to10% of a firm’s income. Although second partnerreviews are required where income is more than5% or where the individual office is economicallydependent on a client, this is a high level ofeconomic dependence. Also, although there is aCompanies Act requirement for the amount of NASto be disclosed, there is no requirement in the 2002framework to indicate the nature of the serviceswhich the audit firm provides. Finally, althoughthe self review threat refers to the problem of the

auditor reviewing his or her own work, thesafeguard is restricted to a limited list of prohibitedNAS. Some of the key NAS concerns are not fullyaddressed.

Table 3 summarises the provisions of theregulatory framework other than the CAJECethical guide. These provisions set out theprocedures that an audit firm is required to fol-low in order to maintain competence andindependence and are found in the AuditRegulations (ICAEW 1995), Statements of AuditingStandards and company law. Table 4 contains otherprovisions which influence auditor independenceless directly. These are related to corporategovernance, conduct of directors, reputation lossand liability.

These tables identify further deficiencies in theoverall regulatory framework. The AuditRegulations and Auditing Standards areprescriptive in their requirements for qualitycontrol within the audit firm, but do not refer to partner reward structures. More generally, thereis no requirement for firms to make anyinformation available to investors, companymanagers or other stakeholders about the auditprocess and how they maintain audit quality andindependence. Thus, apart from the firm itself,only the Recognised Supervisory Body responsiblefor the monitoring of the audit firms knows howthe firms operate in order to achieve a satisfactorylevel of independence and compliance. This isdifficult to reconcile with the generally accepteddefinitions of independence in appearance whichassume an informed investor or other user. It isunclear where they would get their informationfrom.

There are also identifiable deficiencies in the corporate governance recommendations andthe law relating to the conduct of directors. TheCombined Code is weak in its expectations that acompany audit committee will take the lead inrecommending appointment and remuneration ofauditors to the members, and will be involved inthe agreement of the NAS to be provided by theaudit firm. Company law requirements are alsolimited in their expectations of directors on changeof appointment. Whereas the auditor is required bythe CAJEC guidelines to communicate with theprevious auditor, the directors are able to withholdconsent for this communication to take place.There is also very little in company law whichrequires the directors to co-operate fully with theaudit process.19



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Int. J. Audit. 8:117–138 (2004)

The Reform

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Table 2: Summary of UK threats and safeguards ethical framework including EC Recommendation (2002)

Threats Safeguards Regulatorysource

1. Self interest or other conflict of interest1a. Financial interest in client performanceDirect or indirect financial interest in a client; Generally prohibited for partners, staff and firm. EGcontingency fees; loans; overdue fees; mutualbusiness interest with a client1b. Economic dependenceUndue dependence on a client, for firm, office No more than 10% total fees (including non-audit services) from one EGor partner, including non-audit services. listed or public interest client (15% others). Where income > 10%

for any client or 5% for listed or public interest client or where office dependent on one client, second partner, or possibly other firm review required.Disclosure of audit fees and non-audit services in company annual S.390A,B. CAreport. 1989

Low-balling. Firm must be able to demonstrate maintenance of standards. EGFear of losing a client. None. None1c. Involvement with the affairs of a clientParticipation in the affairs of a client. Auditor cannot be officer or employee of company, or partner or S.27,CA1989;

employee of such; Auditor should not have close family in company. EGPartner prohibited from joining client within 2 years. ECR

Partner or senior employee joining client. For senior employee any audit judgments made would have to be EGreviewed.

Provision of other services to audit clients. Activities normally prohibited:preparation of accounts and accounting records for public interest ECRcompanies; exercising management authority (through non-audit services); ECRrecruiting senior management; EGprovision of expert services affecting material amounts or disclosures; ECRActivities restricted:providing IT and financial information and technology systems very ECRrestricted;internal audit restricted; ECRlitigation support restricted. ECR

128S. Fearnley and V. Beattie

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Table 2: Continued

Threats Safeguards Regulatorysource

1d. Other conflicts: potential litigation; Normally prohibited. EGexcessive hospitality.2. Self review threat2a. Reviewing own work re non-audit services See 1c above for prohibitions and restrictions. ECR2b. Reviewing previous judgments or decisions None. Nonere performance of audit3. Advocacy threat3a. Supporting client’s interests None (other than judgment). EG3b. Sharpened form of advocacyRecommending or promoting shares. Prohibited. ECRLeading a corporate finance team. Prohibited. ECRAdopting extreme position on tax or other None (other than judgment). ECRmatters.4. Familiarity or trust threat4a. Being drawn by familiarity into taking Taking management decisions prohibited. EGmanagement decisions (e.g. Auditor should not act as actuary for insurance company.) EG

Ensure management takes responsibility for advice given by auditor. EG4b. Acting for a prolonged period of time Partners to be rotated every seven years and not return for two years. EC5. Intimidation threat None. None

Key: EG = ICAEW ethical guide 1.201 (issued 1997).ECR = European Commission Recommendation (2002): Statutory auditors’ independence in the EU: A set of fundamental principles.CA = Companies Act requirement.

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Table 3: Summary of detailed audit firm procedures required in the UK to maintain auditor competence and independence

Nature of procedure Source ofprocedure

1. Leadership and responsibilitiesFirms should establish and communicate quality control practices and policies; appropriate structure should be SAS 240.1established; senior audit partner (compliance partner) should take responsibility. Internal monitoring should take place AR 313–315annually.2. Acceptance and continuation of audit engagements2.1 Before accepting a new audit engagement firms should ensure that: they are competent; any threats to independence SAS 240.1

can be adequately safeguarded; they have assessed the integrity of owners, directors and management. AR 3.042.2 A registered auditor must not accept an appointment or continue as an auditor if the firm has any interest likely to AR 3.01

conflict with carrying out the audit properly.2.3 Matters should be reconsidered each year on re-appointment. SAS 240.22.4 The auditor is appointed every year by the members at the AGM. S384. CA2.5 Before accepting appointment the auditor should communicate with the existing auditor and the latter should reply 1985

promptly as to any considerations which might affect the prospective auditor’s decision whether or not to accept EG. 1.206.appointment. Appointment should not be accepted if the client withholds permission to talk to the previous auditor.

3. Leaving office3.1 If firms become aware of any factors which would have caused them to decline the appointment, they should SAS 240.3

consider whether to complete the current audit or whether to resign.3.2 An auditor should make a statement of circumstances connected with his ceasing to hold office which he considers s.394 (1) CA

should be brought to the attention of the members or creditors of the company, or, if he considers that there are no 1985.such circumstances, a statement that there are none.

3.3 A company must send to the auditor a copy of any notice of a resolution to remove the auditor from office. The s391–394a,auditors are entitled to make written representations for distribution to the members, who must be informed that CA 1985representations have been received. The company must distribute the representations before the meeting if there is time. This may also be prevented by the court if the material is defamatory. However the auditors may still make representations at the AGM.

4. Resources and quality4.1 Firms should have sufficient partners and audit staff with competencies necessary to meet their needs. Firms should SAS 240.4.

assign audit staff with the competencies necessary to perform the audit. Competencies include: understanding and SAS 240.6.experience of auditing; understanding accounting, auditing, ethical and other technical standards; specific industry AR 303knowledge; professional judgment; understanding quality control procedures and processes. Competence must be AR 308maintained. AR 302

4.2 A registered auditor must make arrangements so that all principals and employees maintain the principles of AR 311independence and confidentiality set out in the ethical statements. AR 312

4.3 Audit engagement partners should ensure that work is directed, supervised and reviewed in a manner that provides SAS.240.9reasonable assurance that the work has been performed competently. SAS 240.10


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Table 3: Continued

Nature of procedure Source ofprocedure

5. Consultation5.1 Firms should establish procedures to facilitate consultation and to ensure that sufficient resources are available to AR 3.09

enable consultation to take place in relation to difficult or contentious matters within or without the firm. The results SAS.240.7should be documented.

6. Fit and proper status of staff and partners6.1 A registered auditor must make arrangements so that each principal and anyone the firm employs to do audit work AR 3.05

is and continues to be a fit and proper person.7. Improper influence7.1 A registered auditor must make arrangements to prevent anyone who is not a responsible individual from having AR 3.06

any influence which would be likely to affect the independence or the integrity of the audit.8. Independent review8.1 Firms should ensure that an independent review of listed, public interest or high risk clients is undertaken before the SAS 240.12

audit report is issued. The review should include (among other issues): objectivity of partner and staff; effective risk analysis and planning; and judgments made.

8.2 Procedures should be in place for dealing with conflicting views between audit team members, partners and the SAS 240.13independent review partner.

9. Communication with audit committee (or others charged with governance)9.1 Auditors should communicate relevant matters relating to the audit of the financial statements to those charged SAS 610.1

with governance of the entity. Such communications should be on a sufficiently prompt basis to enable those charged with governance to take appropriate action.

9.2 At least annually . . . (for listed companies), the auditors should disclose in writing and discuss as appropriate: all SAS 610.3relationships between the audit firm and its related entities and the client entity and its related entities that may reasonably be thought to bear on the firm’s independence and the objectivity of the audit engagement partner and theaudit staff; the safeguards that are in place; and confirm in writing that, in their professional judgment, the firm is independent within the meaning of regulatory and professional requirements and the objectivity of the audit engagement partner and the audit staff is not impaired.

9.3 Auditors should communicate with those charged with governance: expected modifications of the audit report; SAS 610.5unadjusted misstatements; material weaknesses in the accounting and internal control systems identified during the audit; their views about the qualitative aspects of the entity’s accounting practices and financial reporting, matters specifically required by other Auditing Standards to be communicated to those charged with governance; and any other relevant matters relating to the audit.

9.4 Auditors should seek to obtain a written representation from those charged with governance that explains their SAS 610.6reasons for not adjusting misstatements brought to their attention by the auditors.

Key to sources of procedure:EG = Guide to Professional Ethics (2001) ICAEW.AR = Audit Regulations and Guidance (ICAEW 1995).CA = Companies Act 1985.SAS = Statement of Auditing Standards issues by the Auditing Practices Board.



Table 4: Safeguards not referred to elsewhere in the UK regulatory framework

Type of Description Sourcesafeguard

Within the 1. Duties of the audit committee should include keeping under Combined Codecompany review the scope and results of the audit and its cost effectiveness (para. D.3.2)

and the independence and objectivity of the auditors. Where the auditors also supply a substantial volume of non-audit services to the company, the committee should keep the nature and extent of such services under review, seeking to balance the maintenance and objectivity with value for money.

Within the 1. Risk of litigation. Market or possiblefirm 2. Risk of loss of reputation and loss of clients (and possible regulatory action

collapse) from corporate collapses where poor quality audit issuspected.

Within the 1. Criminal offence for directors to mislead an auditor.* Companies Actregulatory 2. Risk of being found out by Joint Monitoring Unit or Review Audit regulationsframework Possibility of losing licence or suffering reputation damage. Review Panel

*The Company Law White Paper (Modernising Company Law, 2002) includes provisions for directors to becriminally liable for failure to disclose significant information to auditors.

Proposal for change within audit firms

The research clearly indicates the need for greatertransparency from audit firms. It is impossible foran investor to be well-informed, as the definitionsof independence in appearance demand, ifessential information is not available. Specifically,the Review Board recommends that audit firmsshould disclose the following information:management structures; ethical standards; qualitycontrol procedures for audit and maintenance of independence; management of economicdependence at firm and partner level; and financialinformation about the relative profitability of auditand NAS. This would particularly enhance theappearance of independence.

Proposals for change within companies

The research indicates a need for disclosure of thebreakdown of NAS bought by the company fromits auditor, a wider role for the company auditcommittee in managing the relationship betweenthe company and the auditor, and the inclusion ina company’s annual report of a report on the auditcommittee’s activities.

The Review Board recommends that a companyaudit committee should take responsibility forleading the following activities in respect of the company’s relationship with the auditor: theannual appointment process; the adequacy of the

In addition to the deficiencies arising in specificareas of the independence framework, the aboveanalysis clearly shows that the responsibility forpromulgation of the independence regulatoryframework is fragmented with no single bodyhaving overall responsibility.

This review shows the necessity for a review ofthe current UK framework for independence inorder that key threats to independence can be moreexplicitly addressed. The independence regime isfound to be fragmented and the need fortransparency in how audit firms operate is re-emphasised. Further concerns arise about theregime for auditor re-appointment and change.

HOW THE REVIEW BOARD’SEVIDENCE-BASEDRECOMMENDATIONS COMPARE TOTHE CGAA’S FINAL REFORMS

In determining the proposals for change theReview Board considered the cost benefit andpotential effectiveness of three different forms of regulatory change: voluntary compliance and transparency; extension of the regulatoryframework; and increased enforcement. Therecommendations focus on three main sources ofsafeguard against independence threats: safe-guards within the company; safeguards within theaudit firm; and safeguards within the regulatoryframework.

for the UK auditor independence frameworkshould be vested in the Auditing Practices Board,in preference to the 2002 fragmented regime, whichis found to be deficient in several key areas, suchas fear of losing the client and intimidation.Second, the permitted level of economicdependence for one audit client should be reducedto 5% of total practice fees. Third, a wide rangingreview could be undertaken on the change ofappointment procedures, which are alsofragmented and which the research suggests may be ineffective in some areas. Fourth, the audit monitoring regime could take a widerrole in reviewing independence in firms,particularly in relation to the management ofeconomically significant clients. More compre-hensive public reporting by the monitoring unitswould also help to inform investors andstakeholders of the extent of monitoring whichalready takes place.

Changes to the UK auditor independenceframework which were introduced by thegovernment reviews

The CGAA was established in February 2002 andissued two reports. An interim report was issuedin July 2002 (CGAA, 2002) and the final report was issued in January 2003 (CGAA, 2003). Theinterim report envisaged: an enhanced role foraudit committees by developing the existingCombined Code guidance, including makingrecommendations on the appointment of auditors;further work on the acceptability of certain typesof NAS; an examination of the case for mandatoryaudit firm rotation; an extension of existingrequirements to rotate audit partners; and trans-parency of audit firms.

By the time the CGAA interim report was issued (CGAA, 2002) the research programmescommissioned by the Review Board and otherbodies were already in progress and the Council of the ICAEW had agreed to adopt the ECRecommendation (2002) on auditor independence.The EC recommendation suggests rotation of allpartners engaged with the audit every seven years,but following the issue of the CGAA interimreport, ICAEW and ICAS agreed to introduce arequirement that the audit engagement partnershould rotate every five years. Also following theCGAA interim report, two further inquiries wereset up. In September 2002, at the CGAA’s request,the FRC set up a group under Sir Robert Smith to



fee; approval of NAS; changing auditors; andensuring audit effectiveness and independencefrom the company’s point of view. A report onthese activities should be included in thecompany’s annual report.20 It is also recommendedthat more detailed disclosure is made in companyaccounts about the nature of the NAS bought bythe company.

A wider role for the audit committee wouldenhance independence in that the audit committeeprovides a buffer between the auditor and theexecutive management, and the audit committeewould also oversee independence issues from the company’s perspective. Independence inappearance would be enhanced by the disclosuresin the audit committee report and the breakdownof NAS.

Proposals for change within the regulatory framework

The research does not, on balance, support theintroduction of mandatory rotation of audit firms.There are widespread concerns about the impacton the appearance of independence caused by the provision of NAS. Other issues which emergefrom the research are: the fragmentation ofresponsibility for the regulatory regime forindependence; doubts about the effectiveness of the appointment and change process; thepermissible level of economic dependence of a firm on one client; and the effectiveness of themonitoring regime in respect of auditor inde-pendence.

The Review Board does not recommendmandatory rotation of audit firms or compulsorycompetitive tendering because of concerns aboutcost, market disruption and quality risksassociated with both.

In respect of NAS the Review Board makes tworecommendations. First, that an additionalprohibition be brought into the independenceframework that auditors should not give advice tomanagement which is detrimental to the interestsof investors. Second, that the range of permissibleNAS should be reviewed to consider thecontinuing acceptability of services where the threats to independence are high, because ofthe firm auditing its own work, acting as anadvocate for the client or getting too close tomanagement.

The Review Board makes four furtherrecommendations for change. First, responsibility

develop the existing guidance for audit committeescontained in the Combined Code, which reportedin January 2003 (FRC, 2003). Also in her oralstatement which accompanies the issue of theCGAA interim report, the Secretary of State forTrade and Industry announced an immediatereview of the regulatory arrangements for the auditing and accounting professions. Aconsultation document was issued by the DTI inOctober 2002 (DTI, 2002) and the final report (DTI,2003) was issued in January. (In addition to thesereports the review of the role and effectiveness ofnon-executive directors, set up in February 2002and led by Derek Higgs, was published in January2003 (Higgs, 2003)).

The recommended package of changes fromthese various reports is summarised in Table 5. Thetable shows the source of the recommendationsand whether the changes coincide in principle withReview Board’s recommendations. The changesare grouped into changes within companies,changes within audit firms and changes to theregulatory framework.

There are three principal differences between the Review Board’s recommendations and thegovernment reforms. The first is the disclosure byfirms of fees in excess of 5% received from any oneclient. The Review Board recommended an upperlimit of 5% for fees from any one client. The CGAAwas concerned that a prohibition could create a barrier to entry to the larger company auditmarket for firms other than the largest (CGAA,2003, p. 37).

The second difference is the decision to set up anew unit to monitor listed and public interestcompanies separate from the professional bodieswho currently operate the scheme through theJoint Monitoring Unit. The new unit will belong to the new Professional Oversight Board forAccountancy (POBA) under the FinancialReporting Council. The Review Board did not putforward this suggestion, but was not opposed to itin principle.

The DTI acknowledges that the decision to createthis new unit was influenced by some respondentsto the consultation paper on the Review of theRegulatory Regime of the Accountancy Profession(DTI, 2002), particularly the Financial ServicesAuthority, and by international developments(DTI, 2003, pp. 40–41). It is believed that thischange will put the independence of the processbeyond doubt and retain the UK’s position at the leading edge of best practice around the

world (DTI, 2003, p. 41). However, respon-sibility for the licensing and discipline of auditors remains with the accounting bodies. This is the most organisationally complex andpotentially the most costly change which thegovernment has introduced in relation to auditorindependence.

The third difference is that Review Board’srecommendations for a review of the regulatoryframework for auditor change has not beenfollowed up. (The review of the permissable non-audit services is left to the APB to address as partof its role in taking responsibility for settingstandards for auditor independence.21)

It is also interesting to note that the proposals in the CGAA report in relation to auditorindependence are compatible, in a UK context,with the proposals Volker made for the changes toAndersen’s practices in the US (see note 4).

CONCLUSION

This paper considers the impact of the Enroncollapse on the regulatory framework for auditorindependence in the UK, and describes a keyaspect of the process which led to the changes to the UK’s regulatory regime for auditorindependence. The research programme, devel-oped by the Accountancy Foundation ReviewBoard and supported by input from other bodies,identifies areas where improvements could bemade to enhance both independence in appearanceand independence in fact. Although the ReviewBoard’s recommendations were not the only inputto the reform process, it is found thatrecommendations made by the Review Board inrespect of auditor independence align closely withthe changes which were finally introduced.

Responsibility for the setting of auditorindependence standards is transferred to theAuditing Practices Board (under the FinancialReporting Council). The company audit committeeis expected to take a leading role in managing therelationship between the company and the auditor.The principal form of the changes is increasedtransparency and disclosure by audit firms,companies and regulators who monitor audit firmperformance. The decision has been taken bygovernment to encourage voluntary complianceand disclosure wherever possible in preference to more costly and interventionist strategies.However, further change is possible if thesemechanisms prove unsatisfactory.




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Table 5: Summary of government reforms for auditor independence

Responsibility Description of reform Report source Principlefor additional included inreform Review Board

suggestions

Company The terms of reference of the audit committee should include:Auditor appointmentMaking recommendations to the board in relation to the appointment of the CGAA p. 10 Yesexternal auditor and approving the remuneration and terms of engagement of the external auditor.Auditor independence and effectivenessMonitoring the external auditor’s performance, independence and objectivity CGAA p. 12 & Yestaking into consideration relevant UK professional and regulatory Smithrequirements.Non-audit servicesDeveloping and implementing policy on the engagement of the external auditor CGAA p. 34 citing Yesto supply non-audit services. SmithThe audit committee . . . in principle should not agree to the auditor providing the service if, having regard to the ethical guidance, the result is that the external auditor: audits its firm’s own work; makes management decisions for the company; is put in the role of advocate for the company; or a mutuality ofinterest is created.Listed companies should disclose in more detail in their annual report the CGAA p. 35 Yesinformation they give about non-audit services provided by their statutory auditor. (This requires legislative change.)Report on audit committee activitiesThe annual report should contain a separate section that describes the role and CGAA p. 12 Yesresponsibilities of the committee and the actions taken by the committee to discharge those responsibilities.In respect of external auditors, the report should: describe the procedures Smith pp. 33–34 Yesadopted to review the independence of the external auditors, including disclosure of the policy in provision of non-audit services and an explanation of how the policy protects auditor independence; describe the oversight of the external audit process and confirm that an assessment of the effectiveness of the external audit process was made; explain the recommendations to theboard on the appointment of the auditors and, if applicable, the process adopted to select the new auditor.

Audit firm Audit firm transparencyAudit firms with listed and public interest clients should disclose the fees CGAA pp. 11 & 37 No. RB received from a client where these exceed 5% of the firm’s total fees, and suggested make the audit committee aware of the level of economic dependence. upper limit of

fee to be 5% from one client

Audit firms should make available information on their policies, procedures CGAA pp. 11 & 13 Yesand processes for managing auditor independence within the firm, together with relevant management and reward structures, and management and financial information. Reports will initially be voluntary but will be statutory if they are judged inadequate after the first round for periodson or after 1 January 2003.

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Regulators Mandatory rotation of audit firms and compulsory re-tenderingMandatory rotation and compulsory re-tendering is not supported. CGAA p. 17 YesStandard setting for auditor independenceResponsibility for setting standards to uphold auditor independence should CGAA p. 38 Yesbe transferred to a body independent of the accountancy bodies.The Auditing Practices Board should take over the professional bodies’ DTI, p. 5 Yesresponsibility for setting standards for independence, objectivity and integrity of auditors.Non-audit servicesWhilst there is little clear support for the view that joint provision has in fact CGAA p. 28 Yescompromised auditor independence, it undoubtedly raises significant concerns as to the appearance of independence.The standard setter (i.e. the Auditing Practices Board) should further restrict the CGAA pp. 30–31 Yescircumstances in which auditors are able to supply internal audit services. The standard setter should carefully review the circumstances in which it is permissible to provide . . . valuation services, taxation services, and the design and supply of IT and financial implementation technology systems.

Regulators Economic dependence on an audit clientThe standard setter (i.e. the Auditing Practices Board) for auditor CGAA p. 19 Yesindependence should develop improved qualitative guidance for audit firms to ensure that auditors are alert to the threats to their independence arising from the fear of losing an economically significant client at the level of theaudit firm, the office or the individual partner.Enforcing auditor independence requirementsThe Unit responsible for monitoring the work of auditors with listed CGAA p. 20 Yescompany clients should annually (i) publish information on how it monitors auditor independence requirements and (ii) give aggregateinformation on the effectiveness of the management of auditor independence issues in the major firms.Ownership of the monitoring unitThe FRC should take on the functions of the Accountancy Foundation DTI p. 6 No(including the Review Board), creating a new body, referred to in this report as ‘the independent regulator.’A new audit inspection unit should take over from the professional DTI p. 41 Nobodies responsibility for monitoring the audit of those entities whose activities have the greatest potential to impact on financial and economic stability-specifically, listed companies, major charities and pension funds. It would report to the successor board to the Review Board. The new unit should put a greater emphasis on judgments taken by auditors of these companies rather than on their processes and systems.

Key to report sources:CGAA: Co-ordinating group on audit and accounting issues: Final Report to the Secretary of State for Trade and Industry and the Chancellorof the Exchequer (2003), URN 03/567, Department of Trade and Industry, London.Smith: Audit Committees: Combined Code Guidance, A report and proposed guidance by an FRC-appointed group chaired by Sir RobertSmith (2003), Financial Reporting Council, London.DTI: Review of the Regulatory Regime of the Accountancy Profession: Report to the Secretary of State for Trade and Industry (2003), URN03/589, Department of Trade and Industry, London.

The most significant difference between the Review Board’s recommendations and thegovernment’s final recommendations is theestablishment of a new audit monitoring unit toinspect listed and public interest audits. This unitwill be under the control of the successor body tothe Review Board, under the Financial ReportingCouncil, therefore the new Professional OversightBoard for Accountancy (POBA) will be responsiblefor ensuring its effectiveness. The POBA, as part ofits continuing role, will monitor the effectivenessof the changes which have been brought in and recommend additional changes whereappropriate.

This paper provides valuable insights into the nature of the sources of input to the UK’s post-Enron reform programme for auditorindependence. The Review Board’s researchprogramme, much of which was undertaken byindependent academics, was put together in a veryshort time to ensure that the UK’s government’sfinal decision making process on auditorindependence was evidence-based. The pro-gramme also provided evidence to supportgovernment instigated reviews of other aspects of the UK framework which were proceeding at the same time, particularly the Smith Report (FRC, 2003) and the Review of the RegulatoryFramework of the Accountancy profession (DTI,2003). This reform process represents an interestingexample of evidence based policy making.

ACKNOWLEDGEMENT

The authors thank Sir John Bourn, Comptroller and Auditor General of the United Kingdom andAuditor General of Wales, for his advice andsupport in the development of this paper forpublication. Sir John is Chairman of the UKProfessional Oversight Board for Accountancy andwas formerly Chairman of the AccountancyFoundation Review Board.

NOTES

1. The two Ministers were Melanie Johnson MP,Minister for Competition, Consumers andMarkets and Ruth Kelly MP, FinancialSecretary to the Treasury.

2. In addition to the CGAA Report, three othergovernment instigated reports associated with the Enron collapse were issued in January 2003. These addressed: the role of the

non-executive director (Higgs, 2003); auditcommittees (Financial Reporting Council,2003) and the structure of the regulatoryframework (DTI, 2003). In addition, the Houseof Commons Treasury Committee (2002)conducted its own inquiry.

3. The off balance sheet vehicles would not havebeen permitted under UK GAAP.

4. Before Andersen collapsed, the firm invitedPaul Volker, the former head of the US FederalReserve, to make recommendations about thefuture operation of the firm. Volker’s proposals(Arthur Andersen, 2002) were intended toreduce risk and enhance independence. Riskwould be reduced by improvement of internalquality control in the firm and stricter rules forclient acceptance and retention decisions.Independence would be enhanced by theintroduction of audit partner rotation andrestrictions on audit staff joining clients (thusavoiding cosiness). There would also berestrictions on the provision of non-auditservices and changes in the basis for auditpartner performance incentives so that auditpartners would be rewarded for good qualityauditing rather than the selling of non-auditservices.

5. The Accountancy Foundation was funded bythe UK accounting bodies and consisted of: theFoundation Board, which made appointments;the Review Board which oversaw theeducation, disciplinary and audit regulatoryactivities of the accounting bodies; the AuditingPractices Board (APB), which set UK standardsfor auditors; the Ethics Standards Board (ESB),which oversaw the ethical standard setting ofthe professional bodies; and the Investigationand Discipline Board (IDB), which investigatedmajor accounting scandals. The Review Boardwas responsible for scrutiny of the APB and theESB. At the time of writing the activities of theAccountancy Foundation, with the exception ofthe ESB, are being transferred to the FinancialReporting Council. This follows the review by the DTI of the structure of regulation of the accountancy profession (DTI, 2003). Theprocess is not yet complete. The accountancyprofessional bodies over which theAccountancy Foundation provided inde-pendent oversight constitute the ConsultativeCommittee of Accountancy Bodies (CCAB).These are: The Institute of CharteredAccountants in England and Wales (ICAEW);



The Institute of Chartered Accountants ofScotland (ICAS); The Institute of CharteredAccountants in Ireland (ICAI); The Associationof Chartered Certified Accountants (ACCA);The Chartered Institute of ManagementAccountants (CIMA); and the CharteredInstitute of Public Finance and Accountancy(CIPFA).

6. Before the CGAA made any recommendationsfor change to the independence framework,the Council of the Institute of CharteredAccountants in England and Wales (ICAEW)agreed to adopt as best practice the provisionsof the 2002 Recommendation on AuditorIndependence issued by the EuropeanCommission (EC, 2002) ‘to the extent that they cover circumstances not specificallyaddressed’ in the current UK framework.These provisions were approved by theICAEW Council in October 2002. The principaldifferences between the framework applied by the ICAEW (i.e. the Chartered AccountantsJoint Ethics Committee (CAJEC) Frame-work) and the EC recommendation are: greaterrestriction on non-audit services particularlyIT and internal audit; audit engagementpartner rotation every five years; and a ban onsenior members of an audit team joining aclient within two years of being engaged onthe client’s audit. At the time this review wascarried out the ACCA had a separate ethicsframework but this is of limited significance tothe auditors of listed companies who aremainly regulated by the ICAEW.

7. The CGAA was set up in February 2002. Aninterim report was issued in July 2002 and thefinal report in January 2003.

8. The research was summarised by ProfessorStella Fearnley of the University of PortsmouthBusiness School.

9. The DTI provided secretarial support to theCGAA.

10. See note 2 for details of the other reports.11. Interestingly the financial journalists surveyed

believed the level of non-audit services to be amuch greater threat than the finance directorsor audit partners.

12. The Financial Reporting Review Panel is theUK body which enforces company accountingcompliance. The Panel has powers to apply to the court to require restatement of non-compliant accounts if directors do not takevoluntary remedial action.

13. It is possible that this ratio may fall as a result of three of the Big Four (Price-waterhouseCoopers, Ernst and Young andKPMG) selling off their consulting practices.

14. Further details of the nature of these threats are shown in Table 2. Intimidation is the only threat which does not apply to non-auditservices.

15. The frameworks compared are: UK, SEC,Australia, Ontario, International Federation of Accountants (IFAC) and the EC Recom-mendation.

16. The audit of central government functions is not subject to the mandatory rotation ofauditors.

17. This framework was adopted by the three UKInstitutes of Chartered Accountants who areresponsible for the regulation of auditors ofvirtually all listed and public interestcompanies in the UK. The ACCA has a slightlydifferent regime.

18. The Audit Regulations are issued by the UK professional accountancy bodies which are Recognised Supervisory Bodies forregulating auditors in the UK. The regulationsreferred to above are those issued by the three Institutes of Chartered Accountants. The ACCA has a slightly different regime.

19. The recently issued Companies Bill (December,2003) proposes severe penalties for directors or company employees misleading auditors orfailing to disclose material information to them.

20. The principal body responsible for recon-sidering the role of the audit committee was Sir Robert Smith’s group which was set up by the Financial Reporting Council. TheReview Board research programme providedadditional evidence in support of the Smithrecommendations.

21. The Auditing Practices Board issued aconsultation paper in November 2003 onethical standards for auditors (APB, 2003).

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AUTHOR PROFILE

Stella Fearnley is Professor of Accounting in theDepartment of Accounting and Law, University ofPortsmouth Business School. She was an electedmember of the Council of the Institute of CharteredAccountants in England and Wales from 1992–2004and Deputy Chair of its Centre for BusinessPerformance from 1996–2004. She is now a memberof the UK’s Professional Oversight Board forAccountancy.

Vivien Beattie is Professor of Accounting in the Department of Accounting and Finance,University of Glasgow. She held the part-timeappointment of Director of Research of theInstitute of Chartered Accountants of Scotlandfrom 1997 until 2003 and is a member of the ASB’sAcademic Panel. Her main research interests areexternal audit and business reporting.



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