(a) Attestation means audit
The standard casts the attestation as an “audit” of internal control over financial reporting, to be integrated with the financial statement audit. It significantly limits the degree to which the auditor can rely on the work of others (management, internal audit) in performing this work – the auditor’s own work must provide the “principal evidence” for the internal control audit opinion. However, the standard does not adopt a specific quantitative threshold and permits the auditor to make qualitative judgments in assessing whether its audit has met this standard.
(b) Auditors will assess audit committees
The standard requires that the auditor assess the effectiveness of the audit committee’s oversight of external financial reporting and internal control over financial reporting. The standard provides that it is an issuer’s board of directors that is responsible for evaluating the performance and effectiveness of the audit committee, and clarifies that the auditor is not responsible for performing a separate and distinct evaluation of the audit committee. The standard notes that it is management, not the audit committee, that is responsible for maintaining effective internal controls.
1.5 APRA releases consultation paper on proposed “fit and proper” standards
On 2 March 2004, the Australian Prudential Regulation Authority (APRA) released, for public consultation, proposed “fit and proper” prudential standards for authorised deposit taking institutions, general insurance and life insurance institutions.
Under the proposed requirements:
APRA-regulated institutions will need to develop their own fit and proper policies that include assessment of the fitness and propriety of individuals to act in positions of responsibility;
these policies must, at a minimum, address the fit and proper requirements that APRA expects responsible persons to meet, which are set out in the proposed prudential standards; and
APRA will only become involved in an assessment when it has specific concerns about an individual.
APRA’s Chairman, Dr John Laker, said the proposals are the first step in the introduction of harmonised governance requirements for these industries.
“The proposals are designed to reflect community expectations about persons who fill positions of responsibility in these industries and will set minimum benchmarks for people in, or wishing to enter, these industries at director, senior management or advisory level,” he said.
APRA plans further governance initiatives in the form of harmonised prudential standards. Proposals relating to general insurance were put forward in APRA’s discussion paper on ‘Prudential Supervision of General Insurance: Stage II Reforms’, which was released in November 2003. APRA expects to provide further information on governance standards around mid 2004 after it considers responses to the general insurance reforms.
Comments on the consultation paper and the prudential standards are invited by 28 May 2004. A copy of the consultation paper and draft prudential standards are available on the APRA website at http://www.apra.gov.au/Policy/Draft-Prudential-Standards-Fit-and-Proper.cfm.
A “fit and proper” regime for the superannuation industry is being dealt with separately through the Superannuation Safety Amendment Bill, currently before the Parliament.
1.6 IAASB calls on auditors to take greater action to consider fraud in an audit and to establish rigorous quality control processes
On 1 March 2004, the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) released a revised International Standard on Auditing (ISA) requiring auditors to be more proactive in considering the risk of fraud in an audit of financial statements and has issued new quality control standards addressed at both audit firms and engagement teams.
(a) Fraud and the auditor’s responsibility
The new ISA, “The Auditor’s Responsibility to Consider Fraud in the Audit of Financial Statements,” builds on the new audit risk standards issued last year and requires the auditor to focus on areas where there is a risk of material misstatement due to fraud, including management fraud. The revised standard emphasizes the need for the auditor to maintain an attitude of professional scepticism throughout the audit, notwithstanding the auditor’s past experience about the honesty and integrity of management and those charged with governance.
The standard, effective for audits of financial statements for financial periods beginning on or after 15 December 2004, requires the engagement team to discuss how the financial statements may be susceptible to material misstatement due to fraud and what audit procedures would be more effective for their detection. The standard also requires the auditor to design and perform audit procedures to respond to the identified risks of material misstatement due to fraud, including procedures to address the risk of management override of controls.
(b) Quality control guidance for audit and assurance engagements
In its ongoing efforts to encourage high quality performance by the world’s accountants, the IAASB also recently approved two new standards on quality control. The first, International Standard on Quality Control 1, establishes a firm’s responsibilities to set up and maintain a system of quality control for all audits and assurance engagements. In addition to setting out guidance on client acceptance and retention criteria that firms should consider, the standard requires that an engagement quality control review must be performed for audits of listed entities and such other engagements as a firm determines.
The review, which must be completed before the audit report can be released, includes consideration of:
Significant risks identified during the engagement and the responses to those risks;
The significance and disposition of corrected and uncorrected misstatements identified during the audit;
Whether appropriate consultation has taken place on difficult or contentious matters and the conclusions arising from those consultations.
The second quality control standard, ISA 220, Quality Control for Audits of Historical Financial Information, establishes standards for the specific responsibilities of firm personnel for an individual audit engagement and is premised on the requirements of the firm-wide quality control standards set out in ISQC1.
To provide firms sufficient time to design and implement the systems required under ISQC1, both of these standards are effective 15 June 2005.
1.7 IBM announces significant changes in senior executive compensation policies
On 24 February 2004, IBM announced a series of changes to further align the equity-based compensation of its senior executives with the interests of shareholders. The changes were approved by the Compensation Committee of the IBM board of directors.
One change will ensure that the company's senior executives benefit from outright, annual grants of stock options only after shareholders realize at least 10 percent growth in their investments.
In addition, IBM senior executives will be able to acquire market-priced stock options only if they first invest their own money.
The new policies, which apply to Chairman and Chief Executive Officer Samuel J Palmisano and the top 300 IBM executives worldwide, will begin in 2004.
IBM said it believes it is the first major company, inside or outside the information technology industry, to set such requirements for equity-based executive compensation.
Details of the changes are as follows:
Premium-priced stock options: Effective immediately, IBM will only make outright, annual grants of stock options to senior executives with a strike price (the fixed price at which shares may be purchased in the future) that is 10 percent higher than the market price on the day the options are issued.
As a result, IBM executives will not realize any value from these so-called "out of the money" options until IBM's share price increases more than 10 percent from the date the options are issued and the options are vested.
"Buy first" market-priced options: The only way IBM senior executives will be able to acquire stock options at market prices is if they first purchase IBM shares of a corresponding value at the market price with their own money. This program will begin in 2005.
For example, in order for a senior executive to acquire market-priced stock options with a target value of $18,000, the executive must first invest a portion of his or her annual cash bonus to purchase $9,000 of IBM stock. The executive then must retain ownership of all of the purchased shares for at least three years in order not to forfeit the entire option grant.
While IBM senior executives already have minimum company stock ownership requirements, this unique, "buy first" policy further encourages executive ownership of the company while ensuring they experience the same ups and downs of ownership as shareholders.
Senior executive compensation at IBM is based on company, business unit and individual performance. Equity in the company, such as stock options, is generally granted annually to most executives as part of their compensation and as a retention tool. Options are also granted annually to high-performing employees as a retention tool; that program will not be affected by these changes.
Option recipients must wait four years before earning the right to exercise 100 percent of an option grant. Options expire after 10 years.
1.8 Kodak board of directors enhances corporate governance guidelines
On 17 February 2004, Eastman Kodak Company's Board of Directors voted unanimously to enhance the company's corporate governance guidelines. In addition, the board adopted strengthened board independence standards, implemented an enhanced director selection process and adopted a director code of conduct.
The board also approved new director qualification standards and implemented a process enabling shareholders to communicate directly with the board's Presiding Director, Richard S Braddock.
These latest enhancements will ensure that Kodak's practices and policies meet or exceed requirements of the Sarbanes-Oxley Act, the New York Stock Exchange's recently finalized corporate governance listing standards, and the Securities and Exchange Commission's new disclosure rules regarding nominating committee functions.
The guidelines are available on the Corporate Governance section of Kodak's website.
Additionally, Kodak announced it would begin expensing stock options starting January 1, 2005. Kodak made the decision in response to a Financial Accounting Standards Board announcement last October concerning stock option accounting, and a shareholder proposal requesting that Kodak expense stock options, which received a majority vote at last year's annual meeting.
1.9 Recent report on proxy voting at general meetings
The following conclusions and recommendations are drawn from the latest Corporate Governance International report on proxy voting at general meetings of the Australian Stock Exchange largest 200 companies in 2003.
The full report, which was issued in March 2004, is available for download at:
http://www.cgi.au.com/user1/1336/doc/Proxy%20Voting%20Report%202003.pdf
(a) Conclusions
CGI drew the following conclusions from the subject matter of the report:
1. The level of proxy voting in major ASX-listed companies has continued to increase, if unspectacularly and not to the levels in the major markets of UK (55%) and USA (80%).
Proxy instructions in 2003 in a sample of 161 widely held major ASX-listed companies represented on average 44% of total voting capital.
Comparable results (albeit with some difference in sample companies) were 2002 – 41%, 2000 – 35% and 1999 – 32%.
2. Research by Computershare estimates the level of ownership of ASX200 companies by Australian institutional investors at around 36%. Statistics provided by major Australian custodian JPMorgan indicate a substantial increase in 2003 in the level of proxy voting by its Australian institutional clients. That increase followed JPMorgan’s introduction of arrangements to encourage and facilitate proxy voting by its clients centred on convenient electronic proxy voting. CGI understands that another major Australian custodian is contemplating introducing similar arrangements.
There is, therefore, considerable scope to lift the Australian level of proxy voting well above the 44% figure.
3. The 161 companies in the 2003 sample held 171 meetings and submitted 880 resolutions in their 2003 notices of meeting for proxy (or other) vote. Except for a handful, including a few board challenges by “external” candidates, all of those resolutions were board sponsored.
Of those 880 resolutions, 4 companies withdrew a total of 6 board sponsored resolutions from shareholder vote prior to or at their meetings. 5 of those withdrawn resolutions related to remuneration of directors. 4 withdrawals were actually or presumably as a consequence of institutional proxy voting and/or lobbying.
All 874 of the remaining board sponsored resolutions were submitted to shareholder vote at the meetings and all were passed by the requisite majority of votes (simple majority or 75% majority, depending on the subject matter).
4. The top 5 “Against” proxy votes in the sample (all on board sponsored resolutions related to remuneration of directors submitted to shareholder vote at the meeting) ranged from 29% down to 12% of total voting capital. While those figures are up on the prior year, none was sufficient to defeat the resolution, all 5 of which, as indicated in 3 above, were passed by the requisite majority of votes.
5. CGI’s voting recommendations on those 880 resolutions were “Approve” 76% and “Against” 21%, almost half of the latter being on remuneration resolutions.
CGI is instructed by its institutional clients to apply the highest standards to its analyses of resolutions submitted to shareholder vote so that the client can take that advice into account as part of its own practical decision on how to vote.
Such a practical voting decision will validly take into account a number of other factors and in many cases that may validly result in a vote to support the Board sponsored resolution.
In CGI’s experience, however, there is always a hard core of Board sponsored resolutions each year, mainly relating to remuneration, which, in CGI’s view, do not merit shareholder support on any rational basis. Those certainly exceed the single digit number of withdrawn resolutions referred to in 3 above.
6. In CGI’s view, therefore, it is not merely a matter of getting the overall institutional proxy voting level up but also of improving the quality of the institutional practical voting decision in some cases.
(b) Recommendations
1. The institutional investor bodies, and especially ACSI and ASFA representing major Australian super funds and IFSA representing major Australian fund managers, should immediately appoint appropriately staffed and adequately resourced committees to review the contents of this report and the new Myners report and ICGN Statement on Institutional Shareholder Responsibilities.
2. In particular, ACSI, ASFA and IFSA should:
a. Consider endorsing, jointly if that can be agreed, the new Myners report, and especially the specific steps recommended for each of the participants in the proxy voting process, as equally applicable to the Australian system (on the basis that our system and its participants are essentially identical to those in the UK).
b. As part of that, agree and publish a target for introduction of electronic voting capabilities by the main 2004 Australian proxy season in October and November of this year.
3. Adoption by institutional shareholders of the best practices set out in the ICGN Statement on Institutional Shareholder Responsibilities will go a long way to lift not only the quantum of overall institutional proxy voting levels in ASX-listed companies but also the associated quality of institutional voting decision-making. ACSI, ASFA and IFSA should, therefore, simultaneously review the ICGN Statement with a view to issuing well prior to the main 2004 Australian proxy season in October and November of this year, again jointly if that can be agreed, a version tailored to Australian conditions.
4. As part of that, ACSI, ASFA and IFSA should specifically consider:
a. The entirety of institutional shareholders’ fiduciary responsibilities to their clients and beneficiaries – not just their responsibility to vote shares;
b. In particular, the conflict of interest provisions and associated safeguards canvassed in the ICGN Statement; and
c. The further issue of stock lending and other sophisticated arrangements relating to “vote renting” referred to in the CGI report.
5. Parliament and regulators (ASIC and ASX) should:
Keep a close watching brief on the progress of 1 to 4 above;
Promptly amend s251AA of the Corporations Act to close the loophole identified in the CGI report;
Police due compliance by ASX-listed companies with the reporting requirements of that section;
Take prompt and effective action to close the “regulatory gap” analysed in the CGI report;
Review whether large-scale professional proxy solicitation and “vote renting” in the Australian market of the type referred to in the CGI report should be subject to some form of regulatory oversight, if not control.
6. Trustees of superannuation or investment funds and other fiduciaries who rely on professional investment managers should, for their own and their beneficiaries’ protection, take a close interest in, and should push for implementation of, all of these recommendations. They should also press their custodians to introduce, if they have not already done so, arrangements to encourage and facilitate proxy voting by institutional investors centred on convenient electronic proxy voting.
1.10 IOSCO report on fees and expenses in managed investments
In February 2004 the Technical Committee of the International Organization of Securities Commissions (IOSCO) published a report titled "Elements of International Regulatory Standards on Fees and Expenses of Investment Funds".
The report is aimed at identifying common international best practices standards in the area of fees and expenses in investment funds through the identification of what regulators should seek to achieve when dealing with some of the issues raised by fees and expenses.
These best practices will evolve over time as regulators may take into account those stated in the report by adapting their approach.
These best practice standards deal with issues that were identified at this stage as key issues and where regulatory best practices were agreed upon, namely those raised by:
disclosure of fees and expenses to the investor;
conditions of remuneration of the fund operator;
performance fees;
transaction costs;
hard and soft commissions on transactions;
fees associated with funds that invest in other funds (including funds of funds);
fee differentiation in multiclass funds; and
fees and changes in fund's operating conditions.
The report is available on the IOSCO website.
2. Recent ASIC Developments
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2.1 ASIC grants temporary relief to additional law societies during period of consultation
On 22 March 2004 the Australian Securities and Investments Commission (ASIC) published two new Class Orders [CO 04/0265] & [CO 04/0266] which amend the following class orders:
Class Order [CO 03/1094] Law societies – professional indemnity scheme and fidelity funds; and
Class Order [CO 03/1095] Law societies – statutory deposit accounts and public purpose funds.
The original class orders were published on 11 March 2004, the end of the transition period for the Financial Services Reform Act.
The recent amendments operate so that the temporary relief granted under the earlier two class orders applies to additional law societies (or their associated entities). These are the Queensland Law Society, the Law Society of the Australian Capital Territory and the Law Society of Tasmania.
The amendments by [CO 04/0265] also permit LawCover Pty Limited, an associated entity of the Law Society of New South Wales, to obtain the relief granted under [CO 03/1094].
'ASIC has previously granted temporary relief to the law societies of New South Wales, South Australia, Western Australia and the Northern Territory (or their associated entities), until 1 July 2005, in respect of the operation of their professional indemnity schemes, fidelity funds, statutory deposit accounts and public purpose funds', ASIC Director Financial Services Regulation, Legal and Technical Operations, Ms Pamela McAlister said.
'This relief was granted pending the outcome of the Review of Discretionary Mutual Funds and Direct Offshore Foreign Insurers (see Media Release 82 of 2003 of the Federal Treasurer), and to permit ongoing consultation by the Federal Government and ASIC. The law societies of other states and territories have since applied for similar relief and it has been granted on the same basis', Ms McAlister said.
Further details about the conditions of relief are available from ASIC Information Release 03-43: ASIC provides temporary relief during period of consultation.
Copies of the Class Orders can be obtained from ASIC's Infoline by calling 1300 300 630 or from the ASIC website at www.asic.gov.au/co
2.2 ASIC relief to allow mixed money to be paid into insurance brokers' s981b trust accounts
On 16 March 2004, the Australian Securities and Investments Commission (ASIC) issued a class order which provides limited relief to insurance brokers regarding their ability to pay money into a trust account under section 981B of the Corporations Act 2001 (the Act).
The class order [CO 04/189] allows other money, paid in a single sum together with client monies, to be paid into a trust account established and maintained under section 981B of the Act by a financial services licensee who is an insurance broker.
Section 981B generally permits only client monies (which are connected with a financial service provided to, or a financial product held by, the client) to be paid into a section 981B account. It does not allow non-client monies, such as remuneration payable to the broker, or monies not connected with a financial service or the client's financial product, to be paid into these accounts.
The class order relief modifies paragraph 981B(1)(b) to allow payment into an insurance broker's section 981B account of mixed payments (ie a single payment of client monies and non-client monies). The relief, however, requires the licensee to pay out of the account any non-client money within five business days.
The relief is only available to insurance brokers.
Insurance broker, as defined in the class order, means the holder of an Australian financial services license who is authorised under the licence to provide a financial service relating to contracts of insurance and who, in providing that service, predominantly acts on behalf of intending insureds.
ASIC has provided this limited relief to reduce the commercial inconvenience to insurance brokers and their clients of requiring separate payments of client money and broker remuneration, while essentially maintaining the protections over client money afforded by the trust account regime.
Copies of the Class order are available from the ASIC website.
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