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An Exposure Draft issued by the International Federation of Accountants

Comments from ACCA
September 2005

ACCA welcomes this opportunity to respond to the exposure draft issued by the International Federation of Accountants (IFAC) Proposed Revised Section 290, Independence – Assurance Engagements.

The Ethics Committee’s rationale for the proposed revision to the definition of network firm is to address the concerns expressed by some that the existing definition was too narrow and did not appropriately consider the importance of the way firms present themselves.

We support the Ethics Committee’s objective to provide the necessary clarity regarding the nature of interests and relationships that may pose threats to independence.

Similarly, we welcome the intent of the explanatory text to provide guidance to assist professional accountants to assess the significance of the interests and relationships that may pose a threat to independence.

We are, nevertheless, concerned, in particular, that:

• the proposed revised definition appears to have moved away from being principles-based to a rules-based one. As a result there is lack of clarity, for example as a result of linking the word ‘sharing’ to the word ‘costs’
• there are unintended consequences of the definition of firm being unchanged and as a result there is duplication in the definition of firm and network firms
• the proposed revision to the definition does not appear to take into consideration other definitions with international application
• there are additional tests and inconsistencies in the explanatory text
  and
• other IFAC pronouncements may not be consistent in the way network firm and terms that refer to similar concepts are used.

Our concerns are explained further below.

COMMENTS ON THE PROPOSED REVISION TO THE DEFINITION OF NETWORK FIRM

Larger structure
Part (a) of the proposed revised definition introduces the concept of a ’larger structure’. This is, presumably, not intended to act in a restrictive way but is a necessary concept in order to word the remainder of part (a) of the definition in a clear fashion. Nevertheless, it may be preferable to use a definition that does not rely on the introduction of a new term.

Principles-based definition
On a cautionary note, we are concerned that there is no equivalent test to that in the existing definition of what a reasonable and informed third party, having knowledge of all relevant information would reasonably conclude. As a result the definition appears to have moved from being principles-based to a rules-based one. For the principles-based approach to be robust, it should not be undermined by the proliferation of detailed underlying rules.

We agree there are judgemental factors still in the definition, for example to what extent professional resources have to be shared for that sharing to be considered to be significant. There are, however, absolute rules - any sharing of profits or costs and any use in whole or in part of a name. It is important, therefore, to understand how these absolute rules would apply to see whether the stated intention of the change is achieved.

By way of an example, if we consider firms in different countries which have different names but market themselves as being independent firms that are part of the XYZ International network. One of the firms would be a network firm in relation to the other if any costs were shared. For example, a subscription to the international organisation. Some might argue that this is not a sharing of costs in the same way as is understood in relation to profits in an industry where a partnership structure is common. For the avoidance of doubt, it may be helpful to reword the proposed definition to avoid connecting the word ’sharing’ to the word ’costs’. The definition could refer to incurring costs in connection with being part of a larger structure. Again, for the avoidance of doubt, the word ’profits’ should be replaced by ’profits or losses’.

Unintended consequences
We believe that, as a result of the definition of firm being unchanged, there are unintended consequences. In the extant definition of network firm some entities are not included because of overlap with the definition of firm. Thus an entity is a network firm if under common control; but part of the firm if it controls or is controlled by the firm (the latter use of the word ‘firm’ being understood to refer to that part of the firm that is not the entity under consideration). Part (b) of the proposed definition includes as a network firm an entity that controls or is controlled by the firm. There is, therefore, some duplication in the definitions.

It is, however, not simply the case that the definition of network firm also includes some entities that would be part of the firm according to that definition. This is because the definition of network firm itself uses the word ‘firm’. It is important to analyse whether the word ’firm’ in the definition of network firm includes or excludes the entities that would reasonably be included.

If the word ’firm’ in the definition of network firm is intended to take a narrow meaning of the word ‘firm’ in the definition of firm (as it is used in order to test whether entities that control it or are controlled by it are also included in the definition of firm), this should be contrasted with the wider meaning of the word ’firm’ after such controlling or controlled entities have in effect been consolidated.

Under the narrow interpretation, a controlling entity would be included within the definition of network firm. The controlling entity would also be included within the definition of firm. Consequently, in such circumstances, network firm will include firm.

Under the wider interpretation, the inclusion of controlling or controlled entities in the definition of firm removes the need for the wording in part (b) of the definition as it is not logically possible for there to be controlling or controlled entities that are different, (this follows irrespective of whether one considers the narrow or wider interpretation). Had the definition of firm included some limitation on the proximity of control, such that control had to be direct rather than indirect, this might not have been the case.
It is tempting to suggest, therefore, that part (b) of the proposed definition is incorrect. The wording is redundant where a wider interpretation of firm is appropriate and inadvisable where the narrower interpretation applies, as an entity should not be both part of the firm and network firm simultaneously; this is because, section 290 requires a different independence provisions to be applied to network firms.

International harmonisation
We believe the proposed revision to the definition of network firm should be aligned to the definition in the draft European 8th Directive.

We appreciate that the Ethics Committee aims to serve the needs of the wider global community and not simply to European needs. However, the substance of the definition is the same except as noted below. While we have some reservations about the wording of the definition in the draft European 8th Directive, we believe it would be helpful to align the proposed revised definition of network firm to the draft European 8th Directive but amended only for the fact that IFAC Code of Ethics defines ‘network firm’ whereas the draft European 8th Directive defines ‘network’.

In the draft European 8th Directive networks is defined as

‘the larger structure:
- [which is] aimed at cooperation to which a statutory auditor or an audit firm belongs, and;
- which is clearly aimed at profit or cost sharing or shares common ownership, control or management, common quality control policies and procedures, common business strategy, the use of a common brand-name, or a significant part of professional resources.’

It does not aid international harmonisation if some codes adopt the draft European 8th Directive definition and others that in the IFAC Code of Ethics, even though the substance of the definitions is the same as regards financial statement audit engagements.

COMMENTS ON EXPLANATORY TEXT

Paragraph 290.14
At paragraph 290. 14, the spectrum of association is presented as being two-dimensional. In reality, association is multi-dimensional and can relate to such matters as identity, profit-sharing, degree of control, quality control, methodology and linguistic convergence. Also the term of ‘correspondence firm’ is irrelevant as it is only used by certain large networks. It may well be more important globally to examine the relationship between audit firms and tax firms that are part of the same larger structure. Presenting as one end of the spectrum firms operating under common brand name is paying too much attention to appearance. Control is by far the most important factor.

Paragraph 290.15
Paragraph 290.15, reintroduces the judgemental test that was in the existing definition. Unfortunately, the proposed definition only requires judgment in relation to the degree of significance of sharing of professional resources. This is much narrower than a judgment about the ’degree of association’. There is, therefore, inconsistency between the proposed definition and this paragraph that should be eliminated.

We are also concerned that paragraph 290.15 is loosely worded. We do not see why it refers to ‘factual circumstances’ rather than just ‘facts’ or just ‘circumstances’. Is this intended to exclude consideration of circumstances that are not factual? Whatever these may be?

Paragraph 290.16
Paragraph 290.16 refers to ‘substantially the same firm name’. The proposed revised definition does not refer to this phrase and so the explanatory text appears to require a different test. This is inappropriate. Once that part of the definition relating to name is satisfied, it is not appropriate to then require consideration of the facts that might indicate otherwise. This paragraph exposes the need to remain principles-based as it introduces a further rule (giving exemptions) where the application of the primary rule results in circumstances which are inappropriate. We are also concerned that the wording in paragraph 290.16 could be used by firms to justify not being network firms because they make appropriate disclosure.

Paragraph 290.17
There is some inconsistency in paragraph 290. 17 in that the second half of it seems to be unconnected to the first half. If the firm describes itself as being part of a network firm, either it is part of a network or it is doing so in a fraudulent way. For example, if ABC firm describes itself as part of XYZ International organisation but it has absolutely no connection with that organisation. In such a situation, the remainder of this paragraph is hardly likely to encourage it to make disclosures in its own stationery.

It is our understanding that firms that wish to describe themselves as ‘an independent firm associated with XYZ association of accounting firms’ pay for the privilege. They, therefore, share costs and are considered to be a network firm. There is no ‘get out’. This paragraph should be deleted.

Paragraph 290.18
In paragraph 290.18, the words ’nature of the relationship thereby established’ are inappropriate. The intent is to consider whether a relationship is established such that firms are network firms. In considering the significance of sharing of professional resources one has to consider the nature of the resources shared and the extent of that sharing in order to form a judgment on significance. For example, sharing resources unrelated to an assurance activity is likely to be less significant than one that is so related. Sharing resources that will amount to a material portion of the firm’s resources are more likely to be significant than if the resources are much less.

There is no natural order to the list noted in paragraph 290.18. It is normal in explanatory material to give an indication as to which factors are the more significant.

Paragraph 290.19
Paragraph 290.19 is unlikely to be used in practice. If no tests of significance are used elsewhere in the definition, all firms that would be considered under it will already have been classified as network firms.

Paragraph 290.19 again introduces the term ’factual circumstance’. In particular the use of the word ’available’ implies that there are some factual circumstances that are ’hidden’ in some way. We assume that this is not the intent and perhaps is a consequence of a ’misunderstanding’ in the use of the third-party viewpoint.

Similarly, paragraph 290.19 strays into referring to using the term ’Association for promotional purposes’. This might be relevant to an overall consideration as was made in the existing definition, but paragraph 290.19 is merely considering the significance of sharing of professional resources.

OTHER COMMENTS

IFAC pronouncements
In our view, it is of overriding importance that the Code of Ethics, the international standard on quality control and engagement standards, such as international standards on auditing, are consistent in the way network firm and terms that refer to similar concepts are used.

In essence, firms that market themselves as being part of a network should not escape the obligations to independence which that implies. Conversely, ‘near membership’ of a network cannot be used by a firm as justification for reliance on the network or quality control and hence the ability to place reliance on the work of a network firm in connection with the audit of group financial statements.

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