The Regulatory Environment

CHAPTER LEARNING OBJECTIVES

a) Explain the need for laws, regulations, standards, and other guidance relating to audit,
assurance and related services.[2]
b) Outline and explain the need for the legal and professional framework including:[2]
i. public oversight of audit and assurance practice
ii. the impact of corporate governance principles on audit and assurance practice
c) Discuss the role of the audit committee and its impact on audit and assurance practice in
relation to: [2]
i. the relationship with the external auditor, including the appointment, removal, and
monitoring of effectiveness; and
ii. the oversight and approval of the provision of non-audit services.
1 The need for assurance services- a

 Informed Decision-Making: Assurance services provide decision-makers with reliable information,

enabling them to make well-informed choices, especially in the context of buying and selling shares.
 Investment Confidence: Investors, both individual and institutional, require credible information to
have confidence in their investment decisions. Assurance services help establish trust in financial data.
 Lending Decisions: Banks and financial institutions seek assurance services, such as audited financial
statements, before making lending decisions. This ensures a thorough assessment of the borrower's
financial health and risk.
 Transaction Validation: Companies engaged in transactions, whether as buyers or suppliers, often
request audited financial statements to validate the financial stability and credibility of their business
partners.
 Validation for Forecasting: Independent examination and validation of forecasts through assurance
services enhance the reliability of future financial projections, aiding decision-makers in planning and
strategizing.
2 Regulation of the profession-a

 Regulation of the accountancy profession was covered briefly in Audit and Assurance at the Applied
Skills level. The Advanced Audit and Assurance syllabus looks at regulation from a broader
perspective.
 As a result of financial scandals, and the public concern that followed, many changes were
implemented in the global auditing and accountancy profession. Examples of developments include:
 IAASB Standards: Widely adopted, IAASB's ISAs form the basis for national standards in 100+
countries, endorsed by the World Federation of Exchanges.
 IESBA Code of Ethics: Adopted by numerous institutions, the IESBA's International Code of
Ethics guides professional accountants globally.
 Legislative Changes - SOX: The Sarbanes Oxley Act (SOX) in the US triggered legislative
changes, establishing the Public Company Accounting Oversight Board for standards and audit
firm inspections.
 Public Interest Oversight Board (PIOB): Established in 2005, PIOB oversees International
Federation of Accountants' standard setting and compliance programs for auditing, assurance,
ethics, and education.
2 Regulation of the profession-a cont…

Global regulation
 The challenge with harmonization is that while many countries have adopted ISAs, the
need for adaptation to local customs and laws has led to variations, resulting in persistent
differences in the global quality of audits.
The need for regulation- a

 Market Impact of Business Failures:

 Large business failures undermine confidence in global financial markets.
 Reliability of Financial Information:
 Confidence in financial markets relies on the trustworthiness of financial information.
 Role of Audit in Confidence Building:
 Independent audits play a crucial role in instilling confidence in financial information.
 Impact of Corporate Failures on Trust:
 Recent corporate failures have diminished trust in the assurance market.
 Introduction of Regulatory Mechanisms:
 Increased regulation has been introduced in response to the erosion of trust in the auditing
profession.
Self-regulation

 Origins of Standards:
 Accounting profession introduced standards for financial reporting and shortly afterwards
auditing standards were introduced
 Self-Regulation Rationale:
 Self-regulation made sense due to the profession's expertise and 'public interest' commitment.
 Accountancy's Understanding:
 Accountancy organizations, with their expertise, were deemed best for setting and following
standards.
 Questioning Self-Regulation:
 High-profile failures, like Enron, raised doubts about the adequacy of self-regulation.
 Need for Reevaluation:
 Corporate scandals prompted a reevaluation of self-regulation as a reliable mechanism.
The International Federation of
Accountants (IFAC)
 The International Federation of Accountants (IFAC), established in 1977 and
headquartered in New York, serves as the global organization for the accountancy
profession. With over 175 member and associate organizations, including prominent
entities like ACCA, it represents 3 million accountants across 130 countries. IFAC's
mission centers on serving the public interest, strengthening the global accountancy
profession, and fostering robust international economies through the promotion and
adherence to high-quality professional standards. Key components of IFAC's structure
include the Council, Board, and Nominating Committee, overseeing entities such as the
International Auditing and Assurance Standards Board (IAASB) and the International
Ethics Standards Board for Accountants.
The International Federation of
Accountants (IFAC) cont….
 Despite its influential role, IFAC faces challenges, notably being funded and set up by the
accountancy profession itself, leading to perceptions of self-regulation. The organization
contends with issues such as conflicting national interests impeding the implementation of
international standards and the overshadowing of professional accountancy bodies by the
dominance of major accountancy firms within IFAC's membership. These challenges raise
questions about the appropriateness of IFAC's self-regulatory mechanism and its
effectiveness in navigating global complexities within the audit profession.
The need for Global Accounting Networks

 Global Business Expansion:

 Companies operating worldwide need support and auditing on a global scale.
 Rise of 'Big 4' Firms:
 The 'Big 4' global accounting firms emerged in the 1970s to cater to the needs of expanding global businesses.
 Globalization in Finance:
 Similar trends in globalization are observed in banking and assurance industries.
 Cross-Border Shareholder Influence:
 External shareholders entering securities markets foster cross-border investments, like Nasdaq investing in the
London Stock Exchange.
 Essential Global Networks:
 The necessity for global accounting networks arises from the demand for comprehensive professional services
supporting businesses with global operations.
3 Corporate governance

 Corporate governance is the system by which companies are directed and controlled.
Auditing financial statements adds to their credibility and this enables shareholders to
better understand how the directors and company have performed.
Principles of corporate governance

 The Organization of Economic Cooperation Development (OECD) promotes six Principles

of a corporate governance framework:
 Promote fair markets, efficient resource allocation, and effective enforcement.
 Safeguard shareholders' rights, ensuring equal access to information.
 Foster stock market functionality aligned with good governance, prohibiting insider trading.
 Recognize all stakeholders' rights, encouraging cooperation for wealth, job creation, and
sustainability.
 Ensure timely and accurate disclosure on financial matters and governance.
 Mandate strategic guidance, effective management monitoring, and board accountability,
including self-assessment.
The UK Corporate Governance Code

 The OECD principles are put into effect in a variety of ways in different countries. The UK
Corporate Governance Code published by the Financial Reporting Council (FRC) can be
referred to as an example of best practice. The Principles of the Code emphasize the value of
good corporate governance to the long-term success of the company.
 COMPLY OR EXPLAIN
 In the UK, the corporate governance Code operates on a "comply or explain" basis, applying to listed
companies through the Stock Exchange. While not legally binding, listed firms must either comply with
the code or provide explanations to shareholders if they deviate. This flexible approach allows for some
acceptable non-compliance under specific circumstances, emphasizing transparency and accountability.
 In contrast, the US, led by the Sarbanes-Oxley Act of 2002, adopts a rules-based approach, imposing
statutory regulations on corporate governance. This prescriptive method requires both directors and
auditors to follow specific procedures, with legal consequences, including criminal charges, for non-
compliance. The UK and Europe's principles-based approach offers adaptability, while the US
emphasizes strict adherence to defined rules and procedures.
Main principles of the UK Code

 Board Leadership and Company Purpose

 Division of Responsibilities
 Composition, Succession and Evaluation
 Audit, Risk and Internal Control
 Remuneration
Board Leadership and Company Purpose

 Every company should be headed by an effective board which is collectively responsible for the
long-term success of the company.
 All directors must act with integrity, lead by example and promote the desired culture.
 The board should:
 establish the company’s purpose, values and strategy
 ensure the company has the necessary resources to meet its objectives
 establish effective controls to assess and manage risk
 ensure effective engagement with, and encourage participation from, stakeholders
 ensure that workforce policies and practices are consistent with the company’s values and
support its long-term success.
Division of Responsibilities

 There should be a clear division… between the running of the board and the executive
responsibility for the running of the company’s business. No one individual should
dominate decision making. This means that the roles of CEO and chair should not be
performed by one person as that concentrates too much power in that person.
 The chair is responsible for leadership of the board and should be independent on
appointment (e.g. not an employee within the last 5 years).
 At least half the board should be non-executive directors (NEDs) who are considered
independent (e.g. no close family ties with executive directors, no significant
shareholdings, etc).
 NEDs should provide constructive challenge and strategic guidance and hold management
to account.
Composition, Succession and Evaluation

 Appointments to the board should be subject to a formal, rigorous and transparent

procedure led by a nomination committee. A majority of the committee should be
independent NEDs.
 The board and its committees should have a combination of skills, experience and
knowledge. The length of service of the board as a whole should be considered and
membership regularly refreshed. The post of chairman should not be held beyond nine
years.
 The board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors.
 All directors should be submitted for re-election annually.
Audit, Risk and Internal Control

 The board should establish formal and transparent policies and procedures to ensure the
independence and effectiveness of internal and external audit and the integrity of financial
statements.
 The board should present a fair, balanced and understandable assessment of the company’s
position and prospects. The financial statements should state whether the board considered the
appropriateness of the going concern basis of accounting and identify any material
uncertainties for at least 12 months from the date of approval of the financial statements.
 The board should establish procedures to manage risk, oversee internal controls and determine
the nature and extent of the principal risks the company is willing to take to achieve its long-
term strategic objectives.
To meet the above Principles, the board should establish an audit committee of at least three
independent NEDs (two for smaller companies). At least one committee member must have recent
and relevant financial experience.
Remuneration

 In essence, remuneration should be sufficient to attract, retain and motivate directors of

sufficient quality… but avoid paying more than is necessary.
 Remuneration policies and practices should be designed to support strategy and promote long-
term sustainable success. For example, a significant proportion of executive directors’
remuneration may be structured to link rewards to corporate and individual performance. In other
words, profit-related pay is encouraged. Directors should not receive high pay irrespective of
company performance.
 Remuneration policies and practices should be designed to support strategy and promote long-
term sustainable success. For example, a significant proportion of executive directors’
remuneration may be structured to link rewards to corporate and individual performance. In other
words, profit-related pay is encouraged. Directors should not receive high pay irrespective of
company performance.
Relevance of corporate governance to
external auditors
 If a company complies with corporate governance best practice, the control environment of
the company is likely to be stronger. There will be a greater focus on financial reporting
and internal controls which should reduce control risk and inherent risk which together
reduce the risk of material misstatements in the financial statements.
 In addition, external auditors may be required to report on whether companies are
compliant with the Code. For example, in the UK, external auditors of listed entities are
required to report on whether the company is compliant with the UK Corporate
Governance Code.
 The audit committee of a company must also assess the effectiveness and quality of the
external audit and monitor compliance with ethical standards.
The role of the audit committee
The main roles and responsibilities of the
audit committee include the following:
 Monitoring and reviewing the effectiveness of internal audit. Companies don’t have to
have an internal audit department, but the need for one must be reviewed annually
 Monitoring the integrity of the financial statements and reviewing significant financial
reporting judgements.
 Review the internal financial controls and risk management systems (unless there is a
separate risk committee or the board does this).
 Making recommendations to the board about the appointment, reappointment and removal
of the external auditors and agreeing the terms of engagement. (Note that the external
auditors are appointed by members in general meeting, but the board puts forward the
nomination.)
The main roles and responsibilities of the
audit committee include the following cont…
 Annually assessing the independence, objectivity and effectiveness the external auditors
including confirming that there are no self-interest or familiarity issues and that partners
and staff are rotated properly.
 Acting as a forum to link directors and auditors. Auditors will typically write to the audit
committee about any problems they may be having on the audit or obtaining all the
information they require. If the auditors are worried in some way about the financial
statements they will raise those concerns with the audit committee.
 Developing and implementing policy on the engagement of the external auditor to supply
non audit services: skills, approval and non-approval for certain services, ensuring any
threats to independence and objectivity are reduced to acceptable levels and monitoring the
fees for those services and the total fee for all services provided by the external auditor.
The main roles and responsibilities of the
audit committee in one Para
 The audit committee is responsible for reviewing internal audit needs, monitoring financial
statements integrity, assessing financial controls and risk management, recommending
external auditor appointments, ensuring auditor independence, acting as a forum between
directors and auditors, and developing policies for non-audit services engagement.
The relevance of the external audit process
with the audit committee
 Audit Tendering and Appointment:
 Companies should tender the audit every ten years to compare services, with the audit committee
overseeing the tendering process and appointment.
 Annual Auditor Assessment:
 The audit committee should annually assess the external auditor's qualifications, expertise,
resources, and independence.
 Investigation on Auditor Resignation:
 If the external auditor resigns, the audit committee should investigate the underlying issues.
 Approval of Remuneration and Terms:
 The audit committee is responsible for approving the external auditor's remuneration and terms of
engagement.
The relevance of the external audit process
with the audit committee cont…
 Ethical Standards and Compliance Monitoring:
 Oversight of compliance with Ethical Standards, including fees, former audit firm employees,
partner rotation, and non-audit services.
 Formal Policy for Non-Audit Services:
 Development and application of a formal policy specifying approved types of non-audit services.
 Audit Planning and Quality Assurance:
 Ensuring appropriate plans, consistent materiality levels, and resources are in place for the audit's
start.
 Communication on Audit Quality:
 Discussions with the external auditor on matters affecting audit quality.
The relevance of the external audit process
with the audit committee cont…
 Review of Management's Responsiveness:
 Reviewing and monitoring management's response to auditor findings, recommendations, and the
signed representation letter.
 Effectiveness Assessment of External Audit:
 Assessing the external audit's effectiveness, including discussions on audit risks, plan adherence,
feedback from key personnel, and review of management letter content and action.
Audit Committee's Role in External Auditor
Removal:
The audit committee has primary responsibility for the appointment, including tendering and
selection, and should investigate issues leading to the external auditor's resignation.