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Mr Jorge del Busto


									Mr Jorge del Busto
Secretary Financial Reporting Council
c/- The Commonwealth Treasury
Langton Crescent

Dear Sir
              Reforming audits to meet the reasons for having them

Further to the invitation to comment on Australian Auditing Standards I submit that
they do not achieve the objective required by shareholders in annual accounts to hold
directors accountable. To meet the governance objective of shareholders, quite
different standards are require from those that seek to protect investors, creditors and
other stakeholders from fraud.

A fundamental reassessment is required for the reason for requiring accounts to be
audited in different situations.

Some reasons are outlined in my short article attached as an Appendix below on
“How governance principles got muddled” prepared for publication in the November
2004 issue of Board Report published by The Corporate Directors Association of

The reasons are outlined in this article. The article is based on my academic working
paper on “Corporate Governance implications of across border audit conflicts” which
notes different types of financial reports and so audits are required by other
stakeholders and regulators.

This paper will shortly be posted in the Social Science Research Network archives at The abstract follows:


The purpose of this paper is to consider the corporate governance implications of the
different legal roles of auditors in the US and the UK and the conflicts that arise from
current auditing practices. While the role of a US auditor is to protect investors, the
auditor is conflicted by being appointed by directors. While independent directors are
required to mitigate US conflicts they are not required for a UK auditor who is
appointed by and reports to the shareholders. The UK auditor is appointed to carry
out a governance role that can also protect investors. The UK Combined Code creates
conflicts for directors and auditors as the directors manage the auditor for
shareholders. Some European countries avoid the conflicts found in the US and UK
by the auditor being controlled by a shareholder “watchdog board”. Watchdog boards
can be established without any changes in US and UK company law by corporations
adopting constitutions as suggested by the UK 1862 companies Act. The paper
concludes that international convergence of corporate governance practices based on
current US or UK approach to auditing would be counter productive in reducing
director conflicts or furthering: investor protection, the proprietary rights of
shareholders or self-governance.

In regard to your discussion paper at
I have pasted in the issues raised and included my responses based on the analysis in
my writings. In regards to the three options raised as listed below, I recommend
Option C.

Option A - Develop Australian Auditing Standards (AUSs) based on International
Standards on Auditing (ISAs)

Option B - Adopt ISAs in their Entirety with No Amendment

Option C - Develop Auditing Standards from First Principles

My answers are inserted below in regards to the “proposed strategic direction for the

     (a) Should the objective of having the highest quality auditing standards take
           precedence over an objective of having minimal divergence from ISA,
           particularly given the role of auditing standards in the broader governance
           framework and the need to ensure standards have regard to the public

     ANSWER: Yes

     (b) Should the AUASB follow the approach of its predecessor and continue to
           use ISA as a basis for developing and making Australian auditing

     ANSWER: No because they do not make directors accountable for self-
        serving biases in presenting accounts to members as required by the
        1990 Caparo judgment.

     (c) Does the ‘clarity of standards’ project undertaken by the IAASB impose any
          time constraints on the ability of Australia using current ISA as a basis for
          developing and making auditing standards?

     ANSWER: Yes for accounts presented in prospectuses, etc to protect
        investors from fraud but the standards are not relevant when
        accounts are used to hold directors accountable at annual general

     (d) Should the AUASB have regard to, or even adopt, auditing standards made
           by standard setters other than the IAASB – such as the US PCAOB – when
           developing and making best practice auditing standards for Australia?

     ANSWER: Yes for accounts presented by directors when they are being
        held to account and any self-serving biases need to be reported but not
          for accounts presented to investors or shareholders to protect them
          from fraud.

     (e) Are there any problems posed by adopting rules-based standards within a
           predominant principles-based standards regime and how should these be
           best addressed?

     ANSWER: Yes there are problems but rules based standards are not
        relevant for accounts used to carry out a governance role in
        preventing directors adopting self-serving principles, practices and
        acceptable “puffery” that does not constitute fraud as described by
        the Federal Court of Eastern Virginia on June 15, 2004 in the case
        concerning Cable & Wireless Plc.


                     How governance principles got muddled

                                 Shann Turnbull*

Corporate Governance Principles around the world have become muddled, flawed and

The muddle began in 1934 when the US Congress introduced annual certification of
accounts on a different basis from audits carried out in the rest of the world. The
muddle was compounded in 1992 by the UK Cadbury Committee expecting Audit
Committees to protect shareholders and investors when they were developed in the
US to protect only directors. Recent scandals reveal that they still do.

Muddled thinking has spread globally through the OECD Corporate Governance
Principles adopting the US approach with the auditor reporting to both directors and
shareholders who can have conflicting interests. This is why audits are required.
Stock Exchanges and governance rating agencies typically align their principles to
those of OECD. This creates both institutional and market forces to adopt the flawed
and counter-productive US practice.

The 1844 UK Companies Act required that auditors must hold a share and be elected
by shareholders without any requirement that they be accountants. The 1845
Companies Clauses Act specified that the Commissioners of the Treasury set the
auditors salary paid by the company. A model corporate constitution that established
a shareholder committee to manage the audit process was attached to the 1862 UK
Companies Act. An Audit Committee elected by shareholders, creates a dual board as
found today in France, Italy, Hungary, Spain and Russia.

A dual board should not be confused with Supervisory Boards that appoint the
executive board as commonly found in continental Europe. A dual board can
eliminate conflicts between directors and auditors that a Supervisory board cannot.
As US States determine company law and compete with each other to establish
management friendly jurisdictions for incorporation, many States did not require
companies to publish financial statements. As result, over 30% of companies publicly
traded on the New York Stock Exchange before the crash of 1929 did not issue
accounts and so had nothing to audit!

An incentive to appoint an auditor was to protect directors from being personal
liability for the debts of the company. Financiers commonly requested directors to
sign “negative pledges” when advancing funds. Like shareholder agreements with
contemporary venture capitalists these pledges required that management did not
spend funds on excessive remuneration, loans to officers, investments not approved
by the financier and so on. The directors became personally liable for the loan only if
the pledges were not honored. This provided a compelling incentive for Non-
Executive Directors to meet separately with the auditor to check on how corporate
funds were applied. The auditor only had to follow the money trail to protect the
directors who were his client. Audit committees did not develop to review accounts
presented to investors.

The idea that investors and shareholders can be protected by an auditor controlled by
directors represents muddled thinking. Experience has shown that it does not work
and this is supported by analysis and experiments by US scholars that have shown
how even the most independently minded auditors become unwittingly biased to
protect those that control them, pay them and with whom they work. Auditors
controlled by directors cannot be perceived as being independent. Never the less,
auditing standards prostitute the English language and Auditors by requiring them to
attest their independence.

The US Securities Act of 1933 required a “certified profit and loss statement” from
companies issuing shares across State borders. It was modeled on the UK 1929
prospectus provisions that did not require a balance sheet, only audited earnings for
the last three years.

US auditing practices became muddled when the 1934 Act adopted the 1933
provisions for auditing annual financial statements for companies with existing
securities traded across State borders. The 1934 Act did not specify who appointed,
remunerated or controlled the certifying accountant.

The requirement for audited accounts in US Registration statements and prospectuses
issued in the UK and other countries like Australia, Hong Kong, Malaysia, India,
Ireland, South Africa and Canada is to prevent fraud. However, the legal reason for
Statutory Annual Audits in jurisdictions that follow the UK legal system is not based
on preventing fraud. This compounds the muddle.

The legal reason for UK Annual Audits is to remove any self-serving biases in the
information provided to members of the company in exercising their membership
rights to elect, dismiss, and remunerate directors and vote on other matters. This
reason applies to companies whether or not they issue shares or whether or not they
are publicly traded. Auditing standards institutionalize the muddle by being
concerned with the economic role of accounts rather than their governance role.
While UK audits might also protect investors against economic loss, the idea that this
was their purpose was rejected in the 1990 Caparo judgment. The House of Lords did
not believe that the Statute requiring audits was “inspired also by consideration for the
public at large and investors in the market in particular”. Independent directors are
irrelevant for UK audits concerned with the performance of all directors what ever
their status. Nor can independent directors remove the legally mandated conflicts in
US audits exacerbated when fraud does occur.

Auditors are appointed by directors and report to both directors and shareholders in
the US. UK Auditors report only to shareholders for annual accounts. This removes
the conflicts of interest imposed on auditors and directors by the Sarbanes-Oxley Act.
According to the Caparo judgment, UK auditors should be “acting antagonistically to
the directors”.

Audit Committees that establish close relationships with auditors as specified in
various codes, exacerbate conflicts. It is like a university (shareholders) allowing
students (directors) to nominate, manage and remunerate the examiner appointed by
the university/shareholders to examine the student/directors! This is unacceptable in
academe but is astoundingly accepted as the natural order of things as illustrated by
current muddled corporate governance laws, codes and practices.

No change in company law is required for shareholders to adopt new constitutions to
remove the conflicts between their auditor and their directors by establishing a
shareholder audit committee to protect their interests. It could also manage other
board conflicts that may act against the interests of the company.


*Dr. Shann Turnbull has established shareholder panels to control the auditor of
ventures he has founded in Australia.

Yours faithfully

Shann Turnbull PhD
Principal, International Institute for Self-governance
PO Box 266 Woollahra, Sydney, Australia 1350
Ph+612 9328 7466 Mobile 0418 222 378, Papers at:

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