Duties of the committee
The Parliamentary Joint Committee on Corporations and Financial Services (the committee) is established by Part 14 of the Australian Securities and Investments Commission Act 2001 (ASIC Act). Section 243 of the ASIC Act sets out the committee's duties as follows:
to inquire into, and report to both Houses on:
activities of ASIC or the Takeovers Panel, or matters connected with such activities, to which, in the Parliamentary Committee's opinion, the Parliament's attention should be directed; or
the operation of the corporations legislation (other than the excluded provisions); or
the operation of any other law of the Commonwealth, or any law of a State or Territory, that appears to the Parliamentary Committee to affect significantly the operation of the corporations legislation (other than the excluded provisions); or
the operation of any foreign business law, or of any other law of a foreign country, that appears to the Parliamentary Committee to affect significantly the operation of the corporations legislation (other than the excluded provisions); and
to examine each annual report that is prepared by a body established by this Act and of which a copy has been laid before a House, and to report to both Houses on matters that appear in, or arise out of, that annual report and to which, in the Parliamentary Committee’s opinion, the Parliament’s attention should be directed; and
to inquire into any question in connection with its duties that is referred to it by a House, and to report to that House on that question.
Terms of reference
On 1 August 2019, the Senate referred an inquiry into regulation of auditing in Australia for report by 1 March 2020. The terms of reference are as follows:
the relationship between auditing and consulting services and potential conflicts of interests;
other potential conflicts of interests;
the level and effectiveness of competition in audit and related consulting services;
audit quality, including valuations of intangible assets;
matters arising from Australian and international reviews of auditing;
changes in the role of audit and the scope of audit products;
the role and effectiveness of audit in detecting and reporting fraud and misconduct;
the effectiveness and appropriateness of legislation, regulation and licensing;
the extent of regulatory relief provided by the Australian Securities and Investments Commission through instruments and waivers;
the adequacy and performance of regulatory, standards, disciplinary and other bodies;
the effectiveness of enforcement by regulators; and
Conduct of the inquiry
The committee advertised the inquiry on its webpage and invited submissions from a range of relevant stakeholders. The committee set a closing date for submissions of 30 September 2019. On 14 August 2019, the committee extended the submission closing date to 28 October 2019. On 12 February 2020, the Senate extended the time for the presentation of the report to 1 September 2020.
The committee received 111 submissions, which are listed in Appendix 1. The committee also received additional information, including answers to questions taken on notice.
The committee held the following public hearings (as listed in Appendix 2):
19 November 2019 in Sydney;
29 November 2019 in Canberra;
9 December 2019 in Melbourne; and
7 February 2020 in Canberra.
Some references to the Committee Hansard are to the Proof Hansard and page numbers may vary between Proof and Official transcripts.
The committee thanks all individuals and organisations who participated in the inquiry, especially those who made written submissions and participated in public hearings. Further, the committee notes its appreciation to audit industry stakeholders for their willingness to engage in, and contribute to, discussion about the regulation of auditing in Australia and possible areas for improvement.
Scope of inquiry
The inquiry focuses on external audits of companies' financial reports as set out in Chapter 2M of the Corporations Act 2001 (Corporations Act). Therefore, unless otherwise stated, references to 'audit' in this report refer to an audit carried out by a registered company auditor of a company's financial report as required and prepared under Chapter 2M of the Corporations Act.
Purpose and importance of audit
A company's external stakeholders, particularly shareholders of listed companies, are generally quite separate from the company's management. Inevitability, management has access to more detail about the company and its financial operations and position than any ordinary investor can hope to have. This results in the existence of an unavoidable asymmetry of information between the management of a company and its investors.
In order to explain its financial operations and, in turn, reduce the information asymmetry between management and investors, a company must prepare financial reports. A company's external stakeholders use the information contained in financial reports to assess the company, as well as the performance of management and those charged with its governance, in order to inform their decision-making.
Financial reports must be prepared in accordance with relevant legislation and standards; for instance, what information is to be included, how the value of company assets (tangible and intangible) is to be calculated and presented, and what explanations and declarations to provide.
An external audit provides an independent opinion on the integrity of the information contained in a company's financial report. Specifically, an auditor's opinion provides reasonable assurance as to whether a company's financial report complies, in all material respects, with relevant legislation and standards and gives a true and fair view of the company's financial operations.
As set out in the Australian Auditing Standards, the overall objectives of an auditor in conducting an audit of a financial report are:
To obtain reasonable assurance about whether the financial report as a whole is free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial report is prepared, in all material respects, in accordance with an applicable financial reporting framework; and
To report on the financial report, and communicate as required by the Australian Auditing Standards, in accordance with the auditor’s findings.
By providing reasonable assurance of the accuracy of financial reports, audit is integral to enhancing investor confidence and thereby, to supporting the efficient and effective allocation of resources within Australia's capital markets. Audit is therefore a key element of Australia's wider financial reporting framework, and an essential prerequisite to strong economic growth.
Treasury summarised the importance of audit in its submission:
In Australia capital is allocated by the market. Markets require adequate information to function efficiently. Investors require accurate, relevant, and comparable information to make decisions about which investments suit them best, and how much they should invest. This applies whether investors are entities or individuals, with large or small amounts of capital at their disposal.
These decisions will collectively determine how capital is allocated in the economy. If capital is directed towards productive firms, the economy will grow more quickly. If capital is misdirected to less productive firms, the economy will not grow as quickly as it otherwise would.
Audit is therefore one element of a broader financial reporting system, but it is significant because it constitutes the principal independent, external check on the integrity and reliability of companies’ financial reporting. It adds credibility to the financial statements prepared by companies, increasing shareholders’ and other users’ confidence in them.
Reasonable assurance and materiality
As pointed to above, an auditor's opinion provides reasonable assurance about whether a company's financial report as a whole is prepared in accordance with relevant legislation and standards, and is free from material misstatement. Reasonable assurance is obtained when an auditor has acquired sufficient and appropriate evidence such that the risk of expressing an inappropriate audit opinion regarding a company's financial report (that is, that the financial report is materially misstated) is reduced to an acceptably low level.
While the reasonable assurance obtained in an audit is a high level of assurance, it is not an absolute level of assurance. Absolute assurance cannot be achieved due to inherent limitations of an audit; namely, the limited sampling approach used in conducting an audit (see below) and the contingent judgements and estimates applied to asset valuations in financial reports. For that reason, an auditor's opinion does not guarantee a company's future viability, nor does it assure the effectiveness and efficiency of management in conducting the company's affairs.
The concept of materiality as it pertains to audit refers to information that, if incorrect or omitted from a financial report, would be significant enough to influence the economic decisions made by users of the financial report. Misstatements of information only affect an audit opinion where they are considered to be material to the financial report as a whole, either individually or in aggregate.
Chartered Accountants Australia and New Zealand outlined how the materiality level for a listed company audit is applied in practice:
Auditors do not check every transaction as it is cost prohibitive and time intensive. Rather they perform sample testing of controls and transactions and they review assumptions around valuations. A common materiality level for a listed company is 5 per cent of profit before tax. One way to think about materiality is that it means the auditor designs their testing to identify errors in the financial report that are material. For example, say the profit is $100 million; the auditor will design their audit to identify misstatements in the financial statement greater than $5 million (5 per cent of $100 million).
Australia's audit market
The audit market in Australia comprises several sub-markets. Principally, the two major sub-markets are Public Interest Entities (PIEs) and private entities. The financial reports of approximately 2,200 Australian listed entities and 6,000 large private entities are audited by Australian auditors each year. Other audit sub-markets include public sector and not-for-profit entities.
The four largest audit firms in Australia (known collectively as the 'Big Four') are PricewaterhouseCoopers (PwC), Deloitte, EY, and KPMG, with combined revenue of $8.57 billion in 2019. The next two largest audit firms are BDO and Grant Thornton, with respective revenues of $299 million and $266 million in 2019.
The upper end of the PIE audit market is characterised by high market concentration of the Big Four audit firms, with 90–92 per cent of top 200 largest Australian listed entities by market capitalisation audited by the Big Four between 2012 and 2018. The Big Four audited 65–71 per cent of the next
300 largest listed entities and 31–34 per cent of the medium listed entities by market capitalisation over the same period, indicating that the Australian audit market for listed companies is both highly segmented and supplier concentrated.
While the concentration of the Big Four audit firms by market capitalisation in Australia is similar to that of other major jurisdictions, the overall market share of the Big Four audit firms is not nearly so concentrated, declining from 41 per cent of Australian listed companies in 2012 to 38 per cent in 2018. In comparison, the Big Four firms audit 70 per cent and 84 per cent of the listed client market in the United States (US) and United Kingdom (UK) respectively.
Increasing complexity of audit
The business environment in which auditors operate has changed in recent decades. Companies are expanding and operating on an increasingly diverse and global scale; and with this, company transactions, group structures, and regulatory requirements are becoming more complex.
Company expectations regarding the role of the auditor itself have also changed. To meet the demand created by more complex business environments, the original mandate to audit companies' financial reports has expanded to the provision of multidisciplinary professional services. Audit firms now also provide a wide range of non-audit advisory and consulting services in areas including accounting, risk, tax and policy advice, culture, technology, marketing and compliance. Such matters are integral to a company's overall performance and reporting, but are not directly included in its financial statements.
Concerns about audit quality
As previously highlighted, by supporting the quality of financial reports, audit plays an important role in the effective operation of capital markets. Audit quality is therefore critical to ensuring that stakeholders are confident and suitably informed when making economic decisions based on financial reports.
In recent years, public concerns relating to audit quality have been raised repeatedly at both a domestic and international level. In particular, the quality of Big Four audits on large companies has been a focus of ongoing commentary and public inquiry.
Internationally, much of this public concern has stemmed from high-profile collapses of corporate entities; for example, the collapses of US corporations Enron and WorldCom in the early 2000s and, more recently, the 2018 collapse of Carillion Group in the UK. Ensuing reviews into audit quality have focused on conflicts of interest and any resulting consequences for auditor independence and the application of sufficient professional scepticism by the auditor.
Typical market reforms proposed and, in some cases, implemented with the aim of improving audit quality include:
limiting audit tenure through mandatory partner or firm rotation;
limiting the provision of non-audit services by the incumbent auditor;
regulator appointment of auditors and/or setting of audit fees;
joint auditing of larger listed companies; and
an operational split between audit and non-audit services provided by audit firms.
Recent reviews relevant to audit quality in the UK and commissioned by government include the:
Independent Review of the Financial Reporting Council by Sir John Kingman (Kingman Review);
Competitions and Market Authority (CMA) study of the statutory audit services market; and
Independent review into the quality and effectiveness of audit by
Sir Donald Brydon (Brydon Review).
International approaches and proposals for reform to improve audit quality are discussed where relevant throughout this report.
The Australian context
In the Australian context, audit quality has been of interest to the committee for some years, featuring in a number of its statutory oversight reports in recent Parliaments. The committee's long-standing interest in audit quality has largely emanated from concerns raised by the Australian Securities and Investments Commission (ASIC).
In its role as conduct regulator responsible for regulatory oversight of the Corporations Act, ASIC assesses auditors' compliance with audit requirements under the Act primarily through its ongoing audit inspection program. ASIC uses risk-based methodology to select firms, audit files, and key audit areas for review. As noted in ASIC's Audit inspection report for 2018–19, the objective of the audit inspection program 'is to promote the improvement and maintenance of audit quality'.
As illustrated in Table 1.1, successive findings from ASIC's audit inspection program show an apparent ongoing deterioration in audit quality.
Table 1.1: Adverse audit file review findings on key audit areas for all audit firms inspected
18 months to 30 June 2012
18 months to 31 December 2013
18 months to 30 June 2015
18 months to 31 December 2016
18 months to 30 June 2018
12 months to 30 June 2019
Source: ASIC Report 648—Audit inspection program report for 2018–19, p. 5.
Indeed, as far back as December 2012, Mr Greg Medcraft, former ASIC Chairman, noted his considerable disappointment and frustration in audit inspection results:
Tomorrow we will release our audit inspection report for 18 months to
30 June 2012, which shows there has been no improvement in audit quality since our last report. In fact, our review shows an increase in instances where auditors failed to perform all the procedures necessary to obtain a reasonable assurance that the audited financial statements were not materially misstated.
The report will be released tomorrow, so I will have more to say about it then. These results, as I pointed out last year, when we released them, the observation was 15 per cent of what we inspected was found to be inadequate. That number has gone up, not down, and last year I indicated that a level of 15 per cent was already far too high in terms of having problems where it really was inadequate evidence to support an audit opinion. I think clearly we expect as a country that that number should be substantially less than 10 per cent and, in terms of audit quality, significantly less. These results, I find, being a former auditor and chartered accountant, very disappointing and frustrating. I consider what we are seeing now as second strike for the audit sector and it is clearly one I think the profession should consider itself on notice: it needs to lift its game.
At that time, Mr Medcraft commented that the level of scepticism being exercised by auditors 'was often found wanting'. Mr Medcraft also noted that, internationally, measures such as audit firm rotation had been discussed as a possible solution to improve audit quality.
In evidence to the committee in October 2017, Mr Medcraft again raised the issue of audit quality, stating that 'audit quality continues to decline, as reflected in our reports every 18 months. The audit firms themselves are concerned about it'.
More recently, the committee noted ongoing concerns in its statutory oversight report of the 45th Parliament. The committee acknowledged concern about audit quality as a global issue, and that 'there is debate about both the severity of the problem, and potential solutions'. The committee recommended that ASIC devise and conduct, alongside or within its current audit inspection program, a study which would generate results which are comparable over time to reflect changes in audit quality.
Relevant to the committee's recommendation, in December 2019, ASIC published Report 649—Audit quality measures, indicators and other information: 2018–19, which was intended to supplement ASIC's latest audit inspection findings and to promote:
discussion on the measures and indicators that might be used by auditors and audit committees in monitoring initiatives to improve audit quality; and
good behaviours by auditors and audit committees that support audit quality.
ASIC's audit inspection program, as well as other matters relevant to audit quality in Australia, are discussed in detail in Chapter 3.
The quality of external audits of financial reports affects everybody. All Australians, whether or not they are directly aware, rely on auditors as important gatekeepers within the wider financial reporting system. As such, the committee concurs with the views expressed in the recent report of the CMA in the UK:
Audits cannot be expected to prevent company failure, nor are they likely to be the cause of failure; but they are a vital part of the warning system that should protect savers’ interests.
There is no doubt that audit quality is a global issue, with calls for regulatory reform in recent years following high-profile corporate failures internationally, most notably in the UK. As articulated by ASIC:
If a company fails but its financial report did not properly show its declining financial position and results, or going concern issues, it is reasonable for questions to be asked about the role played by the company directors and the auditor. Questions may also be asked if investment decisions are made using financial reports that do not reflect a company’s true financial position and performance.
Despite the absence of such high-profile failures in Australia, the committee considers that it is timely to consider audit regulation in Australia, given the persistence of concerns regarding audit quality. However, while international proposals for reform are worth considering, it is important to acknowledge that the regulatory framework for auditing in Australia is not homogenous with other jurisdictions. Of course, there will always be arguments for and against various policy options, but reforms suggested internationally may not necessarily be in the best interests of audit quality in Australia. Any amendments to current regulatory arrangements need to be carefully considered in the context of the Australian market.
The committee is also mindful that there is a distinction between the existence of issues that result in actual variation in audit quality outcomes, and issues that are based predominantly on perception. While perceptions relating to audit quality are important (as audit quality is assessed by the market), in the interests of avoiding unintended consequences and best facilitating improved outcomes, the committee is of the view that any reform to audit regulation in Australia should be based on good evidence of its effectiveness. Further, in considering options for regulatory reform, the effectiveness of existing arrangements in meeting stated objectives should also be evaluated.
Structure of this report
This report comprises five chapters, including this introductory chapter:
Chapter 2 provides an overview of Australia's legislative and regulatory framework for audit.
Chapter 3 reviews matters relevant to the state of audit quality in Australia.
Chapter 4 discusses threats to auditor independence, as a key component of audit quality, as well as potential solutions to these threats.
Chapter 5 examines the gap that exists between the regulatory requirements pertaining to audit and the public's expectations of the functions of an audit, as well as proposals to expand the scope of audit to better meet user needs.
Matters raised in this report are intended to provide an indicative, though not exhaustive, overview of the issues examined during the committee's inquiry.
Government and agency response
While this is an interim report, it contains several substantive policy recommendations. The committee therefore expects the government and the various regulatory agencies to respond in a timely manner to the recommendations in this report.