Auditor Independence: Guidance on Best Practice

From 1 November 2002

NB:Words and phrases marked with an asterisk (*) are defined at the end of this guidance. Other terms used are as defined in Statement 1.201.

Introduction

1   On 12 June 2002, the Council of the Institute of Chartered Accountants in England and Wales agreed that auditors should regard the provisions of the European Commission Recommendation: 'Statutory Auditors' Independence in the EU: A set of Fundamental Principles', published on 16 May 2002, as best practice to the extent that they cover circumstances not specifically addressed in the current Statement 1.201: Integrity, Objectivity and Independence. The purpose of this supplementary statement from Council ("the best practice guidance" or "this guidance") is to highlight the additional provisions and then give guidance on how they should be implemented.

2   Since that date, the Co-ordinating Group on Audit and Accounting Issues has stated in its Interim Report to the Secretary of State for Trade and Industry and the Chancellor of the Exchequer that the requirement for rotation of the audit engagement partner* should be for at least every five years rather than every seven years as at present. Accordingly, the Council considers it appropriate to adopt this policy as part of the best practice guidance.

Status of Existing Guidance and the Best Practice Guidance

3   Statement 1.200 of the Guide to Professional Ethics: 'Introduction & Fundamental Principles', sets out a conceptual framework of fundamental principles that must be applied, and an analysis of threats and safeguards. This applies and continues to apply to all members in all of their professional and business relationships.

4   Statement 1.201 applies to members in practice in respect of audit and similar financial reporting roles.

5   Pending a full revision of that statement, scheduled for 2003, Statement 1.201 continues to apply. This best practice guidance is additional to that included in Statement 1.201 and relates to audit engagements only. Non-compliance with the best practice guidance may be taken into account by the Institute's Professional Standards Committees in any disciplinary or regulatory decisions.

Date of application and transitional arrangements

6   The decision by Council to adopt the European Commission Recommendation ("EC Recommendation") as soon as practicable, and well in advance of the formal consultation process that will take place in connection with the revision of Statement 1.201, has required a careful balance to be struck between the benefits of early adoption and the need to preserve audit quality. In the context of partner rotation, particularly for complex groups, this includes the need to allow sufficient flexibility for orderly succession planning.

7   Except where noted below, the best practice guidance applies in respect of all audit engagements relating to reporting periods commencing on or after 1 November 2002. In certain sections of the guidance below, transitional arrangements are provided appropriate to the specific circumstances described. These transitional arrangements apply pending the full revision of Statement 1.201 referred to in paragraph 5 above. Where relief is given under transitional arrangements, the potential threat to independence should nevertheless be assessed and alternative or additional safeguards put in place where necessary.

8   It may not be practicable for all of the measures to be put in place in time for the first reporting period commencing on or after 1 November 2002, where the best practice guidance involves an extension to the existing requirements of Statement 1.201. Where no specific transitional arrangements are provided to cover these circumstances, measures to comply with the guidance in these respects should be in place as soon as practicable and at the latest by the time the audit report is signed for the first period to which the best practice guidance applies.

Fundamental Requirements

9   The EC Recommendation utilises the same framework as Statement 1.201, that is objectivity and independence should be ensured by assessing and documenting, for each engagement, the actual or perceived threats to independence through self-interest, self-review, advocacy, familiarity and intimidation. Safeguards should be applied to eliminate the threats or reduce them to clearly insignificant levels. In the absence of such safeguards, the engagement should not be undertaken. The additional requirements of the EC Recommendation, which are summarised below, relate to specific circumstances that might be encountered, and specify the safeguards that should be implemented in those circumstances. In some instances, the only acceptable safeguard is to decline the work, or to remove the relevant individual from the engagement.

10 The revised independence code issued by the International Federation of Accountants ("IFAC") will be fully taken into account by the Institute in its revisions to Statement 1.201. However, the fundamental requirements and safeguards in the IFAC code are, in so far as audit engagements are concerned, similar to those of the EC Recommendation. Accordingly, compliance with the best practice guidance will substantially result in compliance with the requirements of IFAC's revised independence code.

Scope - Individuals

11 Statement 1.201 applies to the audit firm, partners and other principals*, and in certain instances to employees of the audit firm. The EC Recommendation applies, broadly, to those individuals in a position to influence the audit engagement. As the requirements of 1.201 are not withdrawn, for the purposes of complying with the best practice guidance, therefore, the provisions of Statement 1.201 and of this guidance should be taken to apply to:

a) the audit firm;

b) those individuals addressed in Statement 1.201, referred to above;

c) other persons who are directly involved in the audit engagement including:

(i) the audit principals*, audit managers and audit staff (the audit team);

(ii) professional personnel from other disciplines involved in the audit engagement (e.g. lawyers, actuaries, taxation specialists, IT-specialists, treasury management specialists);

(iii) those who provide quality control or direct oversight of the audit engagement;

d) all other persons, who form part of the chain of command* for the audit within the audit firm or within a network* of which the firm is a member;

e) all other persons within the audit firm or its network* who, owing to any other circumstances, may be in a position to exert influence on the audit.

It is the responsibility of the audit firm to ensure that the requirement for auditor independence is complied with.

12 Where provisions in this guidance refer to closely connected individuals, the definition of 'closely connected' in paragraphs 7.2 to 7.5 of Statement 1.201 should be considered to extend to parents, siblings and any dependants not already covered.

13 Close non-family relationships that entail frequent or regular social contact should also be considered in the assessment of any actual or perceived threat to independence.

Scope - Audit Firms

14 A number of the provisions in the best practice guidance refer not only to the audit firm, but also to its network*. Where the audit firm is a member of a network*, the firm should take all reasonable measures to ensure that, in so far as they are in a position to exert influence on the audit, the entities within the network* comply with the independence guidance applicable to the audit firm. Such measures could, for example, include:

(a) contractual agreements which allow the audit firm to impose independence rules on its network* member firms, their principals* and employees with regard to its particular audit clients, including inter-firm quality review procedures and external quality assurance access;

(b) providing its network* member firms with regular information on audit clients, and requiring them to provide regular information on their own business and financial relationships with audit clients;

(c) obligatory intra-firm consultation procedures in any case where there are doubts as to whether independence could be compromised by the audit client's relationship with one of the network* member firms.

Financial interests Direct

15 For the purpose of compliance with this guidance, the outright prohibition on the holding of direct financial interests in the audit client that is included in paragraphs 4.31 et seq. of Statement 1.201 should be considered to extend to interests in affiliates* of the audit client, where these are significant to either party.

16 Direct financial interests would include shares, bonds, notes, similar securities, commitments to hold such interests and derivatives directly related to such interests (for example share options, futures etc). Acceptance of pension rights and similar benefits from audit clients might also be included where, for example, these depend on future performance.

17 The requirements of Statement 1.201 in respect of financial instruments also extend to the holding of beneficial interests by indirect means, though there are exceptions in paragraphs 4.34 to 4.36 thereof. Notwithstanding the exceptions in those paragraphs, no direct financial interest which is significant to either party should be held in the audit client, by the audit firm or any person included within the scope of paragraph 11 of this guidance. A holding might be considered significant if, inter-alia, it allows or appears to allow the holder to be able to influence management decisions or when income from, or the value of, that holding is material to the holder.

Indirect

18 As with direct financial interests, the requirements of Statement 1.201 and the best practice guidance in respect of indirect financial interests in an audit client should be considered to extend to affiliates* of the audit client where the interests are significant to either party.

19 Indirect financial interests may include, for example, a beneficial holding by a person within the scope of paragraph 11 of this guidance (directly or, for example, through profit dependent policies) in non-client entities which have investments in the audit client, or significant investments in entities in which the audit client also has a significant investment.

20 The potential self-interest threat to independence may be regarded as insignificant to the independence risk if, for example, when holding indirect financial interests in the audit client:

(a) the financial interest is directly held by a third party such as an investment fund, pension fund, unit trust or an equivalent investment vehicle; and

(b) the person holding the indirect interest is not directly involved in the audit of the fund manager, nor able to influence the individual investment decisions of the fund manager.

21 Independence may also be threatened by an apparently insignificant indirect financial interest in an audit client. The level of threat will be higher, and likely to be unacceptable, if the interest is neither acquired or held on normal commercial terms nor negotiated on an arm's length basis.

General

22 Where persons considered to be closely connected by reference to paragraph 12 of this guidance are known to hold significant financial interests in the audit client, the individuals to whom they are closely connected should not serve on the audit engagement.

23 Transitional arrangements: The interaction of the above paragraphs with the exceptions included in Statement 1.201 may mean that interests acquired in the normal course of business and on normal commercial terms, which may have been permissible under Statement 1.201, may not be permissible when complying with the best practice guidance. Financial interests held at 1 November 2002 may continue to be held if they comply with the guidance in Statement 1.201 and provided that:

a) no new interest is acquired that would not be in accordance with the best practice guidance; and

b) the audit firm satisfies itself that adequate safeguards are in place to reduce the threat to acceptable levels.

Family and other relationships with management

24 Paragraph 4.23 of Statement 1.201 addresses close connections with the audit client. For the purpose of compliance with the best practice provisions, the following guidance should be observed:

(a) No person within an audit firm or network* should be assigned to any of the positions specified in paragraph 11 (c) above if he or she is closely connected to a person meeting any of the criteria under (b) below or, in the case of an audit principal*, if he or she is working in an office* where any of the other principals* in it is closely connected to a person who meets those criteria.

Appropriate safeguards should ensure that any other member of the chain of command* does not participate in any decisions that directly relate to the audit engagement if they are closely connected to a person who meets any of the criteria under (b) below, or if he or she is working in an office* where any of the principals* in it is closely connected to a person who meets these criteria.

(b) The provision in (a) applies where a closely connected person is known to:

(i) hold a senior management position with the audit client;

(ii) be in a position to exert direct influence on the preparation of the audit client's accounting records or financial statements;

(iii) have a financial interest in the audit client unless it is insignificant; or

(iv) have a business relationship with the audit client unless it is in the normal course of business and insignificant in terms of the threat it poses to the independence of the statutory auditor.

(c) Identification of the facts of a relevant individual's close personal relationship should be based upon the knowledge of the audit firm and the individual concerned. The individual is responsible for disclosing to the audit firm any relationship that might constitute an actual or perceived threat to independence.

Business relationships

25 Paragraph 4.30 of Statement 1.201 notes that a mutual business interest between the auditor and the audit client will create a self-interest threat:

a) For the purposes of compliance with the best practice guidance, business relationships, or commitments to establish such relationships, should not be entered into unless the relationship is in the normal course of business and insignificant in terms of the threat it poses to the independence of the auditor. Where applicable, and especially with regard to public interest entity clients (see paragraph 7.7 of Statement 1.201), the auditor should seek to discuss with the audit client's audit committee (or equivalent), any cases where doubt arises as to whether or not a business relationship is in the normal course of business and insignificant in relation to the auditor's independence.

b) An unacceptable threat to independence for which no adequate safeguards are available would arise if the audit firm or any of its network* member firms provided statutory audit services to:

(i) any owner of the audit firm; or

(ii) any affiliate* of such an owner where the owner may be in a position to influence any decision-making of the audit firm which affects its audit function; or

(iii) an entity where any individual who has a supervisory or managerial role in that entity may be in a position to influence any decision-making of the audit firm which affects its audit function.

26 For the purpose of complying with this guidance, relevant business relationships are those which involve a commercial or financial common interest between the audit firm or any person within the scope of paragraph 11 on the one hand and the audit client, an affiliate* of the client, or the management thereof on the other. The following are examples of such relationships that would, if significant to the auditor or conducted outside the normal course of business, cause a self-interest, advocacy or intimidation threat:

a) having a financial interest in a joint venture with the audit client, or with an owner, managing director or other individual who performs senior management functions of that client;

b) having a financial interest in a nonaudit client that has an investor or investee relationship with the audit client;

c) giving a loan to the audit client or guarantees for the audit client's risks;

d) accepting a loan from an audit client or having borrowings guaranteed by the audit client;

e) providing services to a managing director or another individual performing a senior management function of the audit client in respect of the personal interest of such individual;

f) receiving services from the audit client or its affiliates* which concern underwriting, offering, marketing or selling of securities issues by the audit firm or one of its group member firms.

Employment with the audit client

27 Paragraphs 4.26 to 4.29 of Statement 1.201 set out self-interest threats to independence arising when principals* or senior employees of the audit firm subsequently join the client, together with possible safeguards.

28 In addition, for the purposes of compliance-with the best practice guidance, the acceptance by a key audit principal* of a key management position* in his or her audit client should be considered to cause an unacceptable threat to the appearance of independence unless a period of at least two years has elapsed since the conclusion of the relevant audit .

29 Transitional arrangements: The requirements of paragraph 28 need not be applied if the key audit principal* has notified an intention to join the client prior to 1 November 2002, in accordance with paragraph 4.29 of Statement 1.201 or has entered into contractual arrangements prior to that date.

30 An unacceptable self-review threat, for which no adequate safeguards are available, would arise if a principal* or employee of an audit firm who worked with an audit client under a staff secondment assignment were given audit responsibility for any function or activity that he or she was required to perform or supervise during the staff secondment assignment.

Individuals acting for a long period of time

31 Paragraphs 4.80 to 4.83 of Statement 1.201 specify the safeguards to be put in place to counter the familiarity threat that arises where the same audit engagement partner*, or other senior personnel, act on the same audit client for a prolonged period of time. In particular, in relation to the audit of listed companies, Statement 1.201 requires the audit engagement partner* to be in charge of such an audit for no more than seven consecutive years, and not to return to the role until at least five years has passed.

32 The EC Recommendation recognises that further steps need to be taken to address the familiarity threat arising from close contact with the client at a senior level over a prolonged period. Accordingly, the best practice guidance extends the rotation requirements set out in Statement 1.201 in respect of audit engagement partners* of listed company audit clients as provided in this paragraph:

a) to all key audit principals* on the engagement;

b) to all public interest entities (see paragraph 7.7 of Statement 1.201) Further, the rotation period for the audit engagement partner* set out in Statement 1.201 is reduced from seven to five years, reflecting the position set out in the Interim Report of the Coordinating Group on Audit and Accounting Issues.

Key audit principals* (other than the audit engagement partner*) who rotate off the engagement in accordance with this paragraph may not return to the engagement until at least two years have passed. The equivalent period for the audit engagement partner* remains at five years as set out in Statement 1.201. The provisions of paragraph 4.81 providing a limited degree of flexibility over timing and 4.82 of Statement 1.201 in respect of sole-practitioners and small firms apply in respect of the best practice guidance.

Transitional arrangements

33 The requirements of paragraph 32 apply in respect of audit engagement periods commencing after 1 January 2003. a) It is recognised that care will be needed in implementing the important additional requirements of paragraph 32 in order to ensure that underlying audit quality is not impaired. Accordingly, as a transitional arrangement, where the audit engagement partner* is required by virtue of this guidance to rotate off the engagement prior to the completion of seven consecutive years service as audit engagement partner*, he/she may continue to serve in this role for a limited further period where earlier rotation would impair audit quality. This transitional arrangement is only available to extend service as audit engagement partner* beyond five years up to a maximum of seven years for engagement periods ending on or prior to 31 December 2004. b) A limited degree of flexibility over timing of the rotation of other key audit principals* may also be acceptable in circumstances where the requirements of paragraph 32 would result in disruption to existing audit engagement partner* succession planning, with a consequent adverse impact on audit quality. In these circumstances, a key audit principal* (other than the audit engagement partner*) who would otherwise have been required (or will in the transition period be required) to rotate off the engagement in accordance with the requirements of paragraph 32, may transition to serve as audit engagement partner* for five years provided that under no circumstances does he/she serve for more than ten consecutive years as a key audit principal*. As this is a transitional arrangement in the interests of maintaining audit quality through orderly partner succession, it should only be applied to key audit principals* appointed to the position of audit engagement partner* for audit engagement periods ending on or prior to 31 December 2005. The period of up to five years as audit engagement partner* will then commence following appointment under this transitional arrangement.

Non-audit services

34 The general principles in respect of the provision of non-audit services to audit clients are set out in paragraph 4.55 and 4.56 of Statement 1.201 and are unchanged by the best practice guidance: other services may only be provided where there is no involvement in the management function or management decision making of the audit client, and where actual or apparent threats to objectivity are reduced to acceptable levels by safeguards.

35 However, the best practice guidance additionally specifies particular safeguards in respect of certain non-audit services. These are detailed below.

Valuation services

36 A threats and safeguards analysis is included in paragraphs 4.65 and 4.66(a) of Statement 1.201. For the purposes of compliance with the best practice guidance, no adequate safeguards are available to counter the self-review threat that would arise from the provision of valuation services which lead to the valuation of amounts that are directly material in relation to the financial statements being audited and where the valuation involves a significant degree of subjectivity.

37 A valuation comprises the making of assumptions with regard to future developments, the application of certain methodologies and techniques, and the combination of both in order to compute a certain value, or a range of values, for an asset, a liability or for a business as a whole. The underlying assumptions of such a valuation may relate to interpretations of the present or expectations of the future, including both general developments and the consequences of certain actions taken or planned by the audit client or anybody within its close business environment. Engagements to review or to issue an opinion on valuation work performed by others, or to collect and verify data to be used in a valuation performed by others (e.g. "due diligence" work in connection with the sale or purchase of a business) are not regarded as valuation services under this principle.

Internal audit services

38 Self-review threats may arise in certain circumstances where an audit firm or an entity within a network* provides internal audit services to an audit client. This would arise, for example, where there is no clear separation between the management and control of the internal audit and the internal audit activities themselves, or if the auditor's evaluation, in an internal audit role, of the audit client's internal control system determines the nature of subsequent audit procedures.

39 To mitigate self-review threats when involved in an audit client's internal audit task the auditor should:

(a) be satisfied that the audit client's management or audit committee (or equivalent) is at all times responsible for:

(i) the overall system of internal control (i.e. the establishment and maintenance of internal controls, including the day to day controls and processes in relation to the authorisation, execution and recording of accounting transactions);

(ii) determining the scope, risk and frequency of the internal audit procedures to be performed; and

(iii) considering and acting on the findings and recommendations provided by internal audit or during the course of an audit.

If the auditor is not satisfied that this is the case, the only adequate safeguard would be for the audit firm and any entity within its network* to refuse the audit client's internal audit engagement.

(b) not accept the outcomes of internal auditing processes for statutory audit purposes without adequate review.

Design and implementation of financial information technology systems

40 The provision of services by the audit firm or an entity within its network* to an audit client that involve the design and implementation of financial information technology systems (FITS) used to generate information forming part of the audit client's financial statements may give rise to a self-review threat. The significance of the self-review threat is considered too high to permit an audit firm or one of its network* firms to provide such FITS services unless:

a) the audit client's management acknowledge in writing that they take responsibility for the overall system of internal control;

b) the auditor is satisfied that the audit client's management is not relying on the FITS work as the primary basis for determining the adequacy of its internal controls and financial reporting systems;

c) in the case of a FITS design project, the service provided involves design to specifications set by the audit client's management; and

d) the FITS services do not constitute a "turn key" project (i.e. a project that consists of software design, hardware configuration and the implementation of both), unless the audit client or its management explicitly confirms in the written acknowledgement required under (a) that they take responsibility for:

(i) the design, implementation and evaluation process, including any decision thereon; and

(ii) the operation of the system, including the data used or generated by the system.

41 These provisions shall not limit the services an audit firm or a member of its network* performs for an audit client in connection with the assessment, design, and implementation of internal accounting controls and risk management controls, provided these persons do not act as an employee or perform management functions.

42 In cases not prohibited under paragraph 40 the auditor should consider whether additional safeguards are needed to mitigate a remaining self-review threat, in particular whether services that involve the design and implementation of FITS should only be provided by an expert team with different personnel (including engagement partner) and different reporting lines to those of the audit engagement team.

Recruitment of senior management

43 Paragraph 4.78 of Statement 1.201 allows the auditor to carry out recruitment services for an audit client, including advertising, interview and the production of a shortlist, provided the final decision on recruitment of key staff is left to the client. For the purposes of the best practice guidance, the provision of a short list to listed companies and other public interest clients (see paragraph 7.7 of Statement 1.201) is considered to result in too high a threat to objectivity and such work should not be performed.

Provision of accounting assistance - public interest entities

44 Paragraph 4.64 of Statement 1.201 requires auditors of public interest entities not to provide accounting assistance to their clients, as a safeguard against the self review threat. Two exceptions to this are permitted.

a) work of a routine clerical nature;

b) work in an emergency situation.

For the purposes of compliance with the best practice guidance, the exception detailed in (a) above is withdrawn for public interest entity audit clients. Such work may be carried out for subsidiaries of such audit clients provided: that the work is of a technical, mechanical or informative nature; that the financial statements of the relevant subsidiary are immaterial to the overall entity's consolidated financial statements; and that the total fees for such services are collectively insignificant to the consolidated audit fee.

Acting for the audit client in the resolution of litigation

45 The threat to independence arising from the provision of advocacy services to audit clients is addressed in paragraphs 4.67 to 4.73 of Statement 1.201. For the purposes of complying with the best practice guidance, the significance of such a threat is considered to be such that auditors should not act for an audit client in the resolution of litigation relating to matters that might reasonably be expected to have a material impact on the client's financial statements and which involve a significant degree of subjectivity.

46 Transitional arrangements in respect of non-audit services: Where compliance with the best practice guidance set out in paragraphs 34 to 45 above would result in non-audit services not being supplied to audit clients that would be permitted by Statement 1.201, services contracted for prior to 1 November 2002 may continue to be provided to fulfil the contract. However, safeguards should be implemented including, where possible, any additional safeguards specified by the best practice guidance.

Excluded matters

47 The provisions of the EC Recommendation relating to ownership and control of registered audit firms, and disclosure of fees for non-audit services to audit committees and in published financial statements, are not included within the scope of the best practice recommendation by Council.

Definitions of terms used in the best practice guidance Affiliate

An undertaking that together with the audit client is required to be included by consolidation in consolidated accounts.

Without prejudice to the above the term affiliate will include any undertaking, regardless of its legal form, which is connected to another by means of common ownership, control or management.

Audit engagement partner

A principal who has the responsibility for the conduct of the audit and for the issue of an opinion on the financial statements.

Chain of command

Comprises all those persons who have a direct supervisory, management, compensation or other oversight responsibility over either any audit principal of the audit team or over the conduct of the audit at office, country, regional or global levels. This includes all principals and shareholders who may prepare, review or directly influence the performance appraisal of any audit principal of the audit team or otherwise determine their compensation as a result of their involvement with the audit engagement.

Key audit principal

An audit principal of the engagement team (including the audit engagement partner) who is at group level responsible for reporting on significant matters, such as on significant subsidiaries or divisions of the audit client, or on significant risk factors that relate to the audit of that client.In the case of a group, key audit principals are generally those principals responsible for making judgements at group level which are significant to the audit opinion on the group accounts. Where there is no group, the definition above is applied to the company in respect of responsibility at head office level for divisions.

Key management position

Any position at the audit client, which involves the responsibility for fundamental management decisions at the audit client. This management responsibility should also provide influence on the accounting policies and the preparation of the financial statements of the audit client. A key management position also comprises contractual and factual arrangements which by substance allow an individual to participate in exercising this management function in a different way, e.g. via a consulting contract.

Network

Includes the audit firm which performs the audit, together with its affiliates and any other entity controlled by the audit firm or under common control, ownership or management or otherwise affiliated or associated with the audit firm through the use of a common name or through the sharing of significant common professional resources.

Office

The term office means a distinct sub-group of an audit firm or network, distinguished for example along geographical or practice lines, in which a key audit principal primarily practices.A main criterion for identifying this sub-group should be the close working relationship between its members (e.g. working on the same kind of subjects or clients). In particular, it should be taken into account that such working relationships are more and more evolving by means of a "virtual" office, due to technical developments and the increasing multinational activities of audit clients.

Principal

References to a principal include the following:

a. a partner;

b. a sole-practitioner;

c a director of a corporate practice, who deals directly or indirectly with accountancy clients or potential accountancy clients of the firm;

d. a member of a Limited Liability Partnership;

e. an employee of a corporate firm who is:

•   a responsible individual within the meaning of the Audit Regulations;

•   a licensed insolvency practitioner;

•   defined as such in circumstances determined by Council.

The terms closely connected; listed companies; and other public interest companies; are as defined in Statement 1.201.

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