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The Consultation Draft issued by the Audit Commission
Comments from The Association of Chartered Certified Accountants

 

Introduction and Background

The Association of Chartered Certified Accountants (ACCA) is pleased to comment on the draft Code of Audit Practice (the draft), published by the Audit Commission (the Commission), as part of the Commission’s formal consultation process with key stakeholders.

We are pleased to see that the proposed Code incorporates most of the views expressed by ACCA in response to the Commission’s invitation to comment on its earlier (November 1999) discussion paper. We believe, however, that there are still some fundamental issues outstanding from the discussion paper that need to be addressed by the Commission prior to its approving a final version of the Code by early March 2000.

The purpose of this submission is to provide the Commission with ACCA’s views on the draft, and to inform the Commission’s work on the development of its revised Code. In preparing this submission, ACCA has taken into consideration emerging issues in public sector accountability as follows:

• the Hampel Report on corporate governance issues
• Internal Control: Guidance for Directors on the Combined Code (Turnbull)
• the work of the Committee of Standards in Public Life (Nolan and Neill) and the Public Interest Disclosure Act 1998.

We have also taken into consideration the wider perspective of the role of public audit in safeguarding public money in the light of public and political expectations and issues currently being considered by the Public Audit Forum.

 

Executive Summary

• ACCA believes that the proposed Code does not fully achieve the Commission’s objective of presenting the Code as a high-level document covering three principal elements of the audit (i.e. the accounts, governance arrangements and aspects of performance management).

• In our view the proposed Code does not demonstrate the Commission’s commitment to a risk-based approach to audit work, to allow auditors to tailor their work to the circumstances of the individual auditee.

• The proposed Code does not accommodate the following current developments in audit practice:
  • the new wider meaning of ‘materiality’ as applying to those transactions/events that may influence addressees of audited accounts
  • the modernisation of the auditor’s role in line with emerging practice in the private sector, particularly in relation to scope for reviewing corporate governance arrangements.

• We believe that the review of the entity’s corporate governance framework is not only fundamental to the concept of a risk-based approach to audit but also underpins public accountability. We do not believe the auditor should be asked to comment whether the management arrangements are appropriate unless the commission provides further guidance in this area.

• The background information states that the Commission believes that to extend auditors’ responsibilities generally beyond internal financial controls at this point in time “would serve to position it’s audit regime too far in advance of current governance arrangements in local government”. ACCA believes that the Commission cannot use inertia in one part of the public sector as a reason for not developing public sector audit practice. ACCA points out that progressive local authorities have restructured their governance arrangements in accordance with the 1996 Audit and Accounts Regulations and in anticipation of current Central Government reforms to modernise Local Government.

• The background information also states that “the Commission has welcomed and supported the corporate governance initiatives in the NHS and is keen to support similar initiatives in Local Government, where governance and reporting arrangements have fallen behind best practice in other parts of the public sector”. ACCA believes that, in revising the Code, the Commission has an ideal opportunity to shape events. We are disappointed, however, that the proposed Code appears passive and unimaginative in promoting change in the area of governance.

• ACCA believes that the proposed Code places too much emphasis on financial matters to the detriment of the risk-based approach to audit. The Code fails to fully recognise the consequences to an organisation (and hence the image of the public sector) and its management in terms of loss of credibility which follow from a misstatement (qualitative or quantitative), an illegal action or misappropriation regardless of the financial consequences.

• We recommend that the Commission widens the scope of the audit to include the whole system of internal controls, consistent with Turnbull’s internal control recommendations. We believe that an entity’s governance framework should cover the authority’s arrangements for policy setting, decision-making, planning and control and for achieving value for money in the delivery of services to the public.

• We also recommend that the Commission adapt and adopt, for the public sector, the auditor’s review requirements of the Combined Code as interpreted by The Auditing Practices Board (APB), The Combined Code: Requirements of Auditors Under the Listing Rules of the London Stock Exchange, Bulletin 1999/5.

We address the main issues raised in this consultation draft in more detail in the following paragraphs.

 

1. General Comments

1.1 ACCA welcomes the Commission’s intention to provide a high-level Code, as set out in its new model of public audit, with specific focus on three main objectives, i.e. to review and where appropriate report on the audited body’s:

• corporate governance arrangements
• financial statements
• aspects of performance management.

We also welcome the Commission’s commitment to a risk-based approach to audit work, which gives auditors additional flexibility to tailor the audit to the particular circumstances of the individual entity. We do not believe, however, that the proposed Code has fully achieved either of the Commission’s aforementioned objectives. The draft falls somewhat short of presenting either a high level Code or a detailed statement of guidance. It is also our view that the Code does not adequately address the risk-based approach to audit work.

1.2 The draft explains that the Commission is required to prepare and keep under review:

• a Code of Audit Practice prescribing the way in which auditors appointed by the commission are to carry out their functions under the Audit Commission’s Act 1998 (paragraph 13)
• a Code of Practice prescribing the way in which auditors appointed by the Commission are to carry out the their functions in relation to the audit of best value performance plans under the Local Government Act 1999 (paragraph 17).

Paragraph 18 of the draft explains that the Code embodies the Commission’s view of best professional practice with respect to the standards, procedures and techniques to be adopted by auditors in discharging their functions. It is our view, however, that the proposed Code lacks sufficient detail and use of examples to be of practical assistance to auditors.

1.3 ACCA believes that the Commission’s requirement for auditors to consider whether an audited body has ‘adequate’ and ‘proper’ management arrangements in place may create unrealistic public expectations and runs contrary to developments taking place in private sector audit practice. Turnbull places the responsibility for reviewing (annually) the adequacy of the internal control arrangements firmly in the hands of the governing body. The auditor’s responsibility is confined to reviewing whether the governing body has specific policies and procedures in place, but without having to comment on their adequacy and appropriateness.

1.4 The explanatory foreword (paragraph 24) introduces the auditor as having “an important role to play in reviewing and, where appropriate, reporting on financial aspects of audited bodies’ corporate governance arrangements”. These are defined as “the arrangements set in place by the audited body to ensure the proper conduct of its financial affairs”. It is our view that the Commission should widen the scope of the audit to accommodate the whole internal control environment (from policy setting to decision making) in accordance with Turnbull’s recommendations as interpreted by the Auditing Practices Board (APB), The Combined Code: Requirements of Auditors Under the Listing Rules of the London Stock Exchange, Bulletin 1999/5.

1.5 Paragraphs 24 and 26 of the explanatory foreword introduce areas of the auditor’s work in relation to aspects of corporate governance and performance management respectively. ACCA believes that “arrangements to be put in place by the audited body to secure economy, efficiency and effectiveness (3 Es) in its use of resources”, i.e. value for money (VFM), are a corporate governance issue and hence are inappropriately classified under Performance Management in the draft. We believe that accountability for ‘outcome’ against plan/target, as highlighted through annual published performance information, is paramount to performance management (whether or not VFM is the outcome would be subject to a much wider study over a longer time-frame).

1.6 It is stated in the background to the draft that “the Commission has welcomed and supported the corporate governance initiatives in the NHS and is keen to support similar initiatives in local government, where governance and reporting arrangements have fallen behind best practice in other parts of the public sector”. It is ACCA’s view that NHS governance developments are in line with Turnbull’s ‘Control Guidance for Directors on the Combined Code’ for the private sector. ACCA believes that the Commission has an ideal opportunity to influence governance developments in Local Government, in line with Turnbull’s recommendations, through the modern risk-based approach to auditing.

1.7 The main reason given by the Commission for lack of progress in the governance area relates to the Commission’s belief “that to extend the auditors’ responsibilities generally beyond internal financial controls now would serve to position it’s audit regime too far in advance of current governance arrangements in local government”. We do not believe that ‘inertia in Local Government’ is a valid justification for the Commission delaying developments in public sector audit practice.

1.8 ACCA believes that local authorities have been given every opportunity to develop suitable governance arrangements under the 1996 Audit and Accounts Regulations, which place the responsibility for maintaining an adequate and effective system of internal audit on the authority as a whole. We understand that local authorities, by tradition, already have well-established governance frameworks in place. We have observed that since 1996, many local authorities have strengthened their internal control environment through providing a more independent internal audit function. The more progressive authorities have radically restructured their governance frameworks, in anticipation of the Government’s modernising Local Government agenda, to ensure greater accountability to the local electorate.

1.9 Specific comments are outlined in section 2 below.

 

2. Specific Comments

We have structured our specific comments below, under the five sections of the draft as follows:

• general principles
• the audit framework
• corporate governance
• audit of the accounts
• performance management.

General Principles

2.1 Paragraph 6 (a) of the proposed Code states that the audit objectives in relation to corporate governance are to review and where appropriate report on:

• the legality of transactions that might have a significant financial consequence
• systems of internal financial control
• standards of financial conduct.

It is ACCA’s opinion that, by limiting the scope of the audit to the consideration of financial aspects of corporate governance arrangements, the Commission does not fully address the issue of public sector accountability. ACCA believes that the scope of the audit should be consistent with Turnbull’s guidance and thus be widened to encompass the whole system of internal controls, financial or otherwise, established in order to provide assurance of:

• effective and efficient operations
• internal financial control
• compliance with laws and regulations.

2.2 Paragraph 6 (c) outlines the audit objectives in relation to aspects of performance management in local government “to review and, where appropriate, report on the audited body’s arrangements to manage its performance, as they relate to the ‘3 Es’ in the use of resources”. ACCA believes that such arrangements should be considered under the corporate governance framework outlined in section 3 of the draft. We believe that the auditor’s role in relation to aspects of performance management is concerned with the audited body’s requirements to prepare and publish specified performance information, achieve value for money for the use of public resources, meet efficiency targets (NHS) and to comply with statutory regulations such as the preparation and publication of best value performance plans (local authorities).

The Audit Framework

2.3 Paragraph 17 states that auditors should carry out the audit “in as timely a way as possible”. ACCA believes that such open-ended terminology is not appropriate for a Code of Practice. While we appreciate that the Code is not the right document in which to prescribe detailed procedures, it is our view that the Code should stipulate that the auditor be required to establish the time-scale and resource requirements for each stage of the audit as part of the planning process.

2.4 ACCA does not believe that it is part of an auditor’s remit, as derived from legislation, to “support and encourage worthwhile change” as stated at paragraph 17(d) of the draft. We believe this point introduces subjectivity into the audit process and is unhelpful in the context of the rest of the paragraph, which enforces independent scrutiny and hence objective analysis. Similarly at point 17(e) we do not believe that the auditor should be required to ‘encourage’ corrective action.

2.5 It is ACCA’s view that audit reports could be used more constructively in order to promote improvements in management practice, although the auditor may need guidance in this area. We believe that auditors should be able to report their findings in the context of developing practice on the part of the entity. For example, when weaknesses are identified in an entity’s system, the auditor may be able to turn an otherwise negative report into a more positive statement by referring to an agreed action plan.

Corporate Governance

2.6 Paragraphs 42 and 45 of section 3 of the draft require the auditor to consider whether the audited body has ‘adequate’ and ‘proper’ arrangements to: (a) satisfy itself that its systems of internal financial control are both adequate and effective in practice and (b) maintain ‘proper’ standards of financial conduct. ACCA believes that unless the Commission provides specific guidance in this area in the context of public sector audit, then the aforementioned words in inverted commas should not be included in the Code.

2.7 In its discussion paper the Commission defines corporate governance, as the system by which organisations are directed and controlled. Section 3 of the consultation draft, however, only considers the financial aspects of corporate governance. The background information to the draft explains that “in the longer term it may be appropriate to extend the proposed new audit responsibility to all systems of internal control, whether financial or non-financial, in line with the Turnbull Committee’s conclusions”. The Commission recognises that in practice it is impossible to distinguish between financial and non-financial internal controls and that failure of organisational or operational controls can expose the organisation to significant business risks with major financial implications. ACCA believes that, in revising the Code, the Commission should heed Turnbull’s guidance and address the whole internal control issue.

2.8 ACCA believes that the financial standing of a public sector organisation may be at risk from having an inadequate corporate governance framework in place. We believe that weaknesses in organisational or operational controls can result in serious damage to credibility regardless of the financial consequences. We believe that the proposed Code places too much emphasis on financial matters and does not pay due attention to the authority’s attitude to risk, as illustrated in the following examples.

• An illegal transaction (whether ultra vires or a misappropriation), irrespective of its financial consequences, may be considered material (i.e. influence the users/addressees of audited accounts) and have adverse consequences for the organisation (and hence the image of the public sector), its management and the governing body.
• The terminology ‘internal control’ is all embracing and fundamental to the concept of corporate governance whereas ‘internal financial controls’ by definition excludes systems set up to ensure efficiency, value for money and legal and regulatory compliance, all of which are particularly pertinent to the public sector.
• Standards of conduct are also fundamental to the principles of corporate governance and include policies on ethical issues as well as financial issues.

2.9 ACCA believes that, in line with Turnbull’s guidance, the word ‘financial’ should be deleted from points (a), (c) and (d) of paragraph 33 of the proposed Code. Similarly the words “that might have a significant financial consequence” should be deleted from paragraph 35 and 36 (a) to (c). The proposed Code also restricts the auditor’s scope (paragraphs 42 and 43) to the consideration of internal financial control which is not consistent with practice emerging in the private sector which considers the integrity of whole internal control function.

2.10 Paragraph 49 of the draft (“Reporting on Financial Aspects of Corporate Governance”) is very brief and lacks sufficient detail to be of much help to audit practitioners. The proposed Code appears passive and unimaginative throughout in relation to reporting on an entity’s governance framework. In our view the auditor’s review should not be restricted to financial matters but should encompass the whole governance framework of policy setting, decision making and planning and controlling of events to ensure value for money in the delivery of services to the public.

2.11 ACCA recommends that, when reviewing aspects of corporate governance in the public sector, the Commission should adapt and adopt, as a minimum requirement, the seven principles of the ‘Combined Code Provisions’ that auditors are required to review under the listing rules of the London stock exchange (see Appendix A). We also suggest that auditors should review an authority’s arrangements for:

• ensuring the ‘3 Es’ in the use of resources
• collecting, recording and publishing specified performance information

and the extent to which a local authority has:

• made arrangements for securing continuous improvements in the delivery of local services (i.e. best value)
• responded to the spirit of the 1996 Audit and Accounts Regulations
• developed new arrangements to ensure strong strategic leadership for the delivery of public services and established an independent scrutiny function to demonstrate public accountability in line with the 1999 Modernising Local Government Act.

Audit of the Accounts

2.12 Paragraph 52 (a), (c) and (d) of the draft states that the audit opinion is “subject to the principle of materiality”. Paragraph 22 of the Statement of Responsibilities states that auditors must take into consideration the extent to which non compliance might cause a material misstatement in the accounts of the audited body when viewed as a whole. ACCA believes that, to avoid any ambiguity, the concept of materiality should be defined at the beginning of the Code as being ‘any information, both qualitative and quantitative, that may influence the decisions of an addressee of the auditor’s report’.

Performance Management

2.13 Paragraphs 60 and 64 of section 5 of the Code require the auditor to make professional judgement as to whether the audited body has ‘adequate’ and ‘proper’ arrangements respectively to secure the ‘3 Es’ in its use of resources. ACCA believes that, unless the Commission provides specific guidelines as to what constitutes ‘adequate’ and ‘proper’ arrangements, then these words should not be included in the Code. In any case, ACCA believes that any review of management arrangements is more relevant to section 3 of the proposed Code which deals with aspects of corporate governance (see comments 1.5 and 2.2 above).

 

3. Other Related Comments

ACCA made the following comments in response to the November 1999 discussion paper and we believe that they are still relevant:

• when Compulsory Competitive Tendering was introduced (itself a test of VFM), the Commission did not attempt to reduce its workload in relation to VFM and ACCA has fears that this will happen again with ‘best value’
• as the Commission has a duty to resource its audits adequately, it may need to address the skills, competencies and experience of auditors in relation to auditing governance arrangements and the ‘best value’ aspects of performance management.

ACCA urges the Commission to proceed with its plans for the development of a managed audit approach for the public sector. It is our view that there needs to be a partnership between internal audit and regulatory bodies to provide a consistent and co-ordinated approach to public audit and so provide value for money in the process.

 

APPENDIX A

‘Combined Code Provisions’ that auditors are required to review:
Code Provision reference	Wording
A.1.2	The board should have a formal schedule of matters specifically reserved to it for decision.
A.1.3	There should be a procedure agreed by the board of directors in the furtherance of their duties to take independent advice if necessary, at the company’s expense.
A.6.1	Non-executive directors should be appointed for specified terms subject to re-election and to Companies Act provisions relating to the removal of a director, and re-appointment should not be automatic.
A.6.2	All directors should be subject to election by shareholders at the first opportunity after their appointment, and to re-election thereafter at intervals of no more than three years. The names of directors submitted for election or re-election should be accompanied by sufficient biographical details to enable shareholders to take an informed decision on their election.
D.1.1	The directors should explain their responsibility for preparing the accounts and there should be a statement by the auditors about their reporting responsibilities.
D.2.1	The directors should, at least annually, conduct a review of the effectiveness of the group’s system of internal controls and should report to shareholders that they have done so. The review should cover all controls, including financial, operational and compliance controls and risk management.
D.3.1	The board should establish an audit committee of at least three directors, all non-executive, with written terms of reference, which deal clearly with its authority and duties. The members of the committee, a majority of whom should be independent non-executive directors, should be named in the report and accounts.

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