Select Committee on Treasury Appendices to the Minutes of Evidence

Annex A


  1.  This annex updates the guidance attached to DAO(GEN) 2/95 issued on 2 May 1995. It addresses three issues:

    —  the appointment of accountancy firms to audit and other assignments in the public sector;

    —  various aspects of the nature of assignment; and

    —  the responsibilities of the external auditors of executive Non-Departmental Public Bodies (NDPBs).


  2.  Responsibility for appointing external auditors to about half of the number of executive NDPBs, and to most public corporations and nationalised industries is vested by statute in the Secretary of State (or other Minister) of the sponsoring department. The guidance given in this annex is aimed primarily at such appointments, but may prove useful when considering private sector firms for other assignments such as those for internal audit and those concerned with corporate finance and taxation advice (referred to in this paper as "non-external audit" assignments or work). Non-external audit assignments are unlikely to be governed by legislation, and the terms of reference are at the discretion of the department and the body concerned.

  3.  The recommendations of this annex relating to the appointment of auditors do not apply to:

    —  the arrangements for the appointment of auditors to Local Authorities and the National Health Service as these are administered by the Audit Commission and the Accounts Commission for Scotland;

    —  those cases where the Comptroller and Auditor General (C&AG) is the statutorily appointed auditor, eg Departmental Resource Accounts, Appropriation Accounts, Supply-financed Executive Agencies, Trading Funds and a number of Non-Departmental Public Bodies.

  4.  In accordance with the Government's procurement policy, the procurement of external audit services should be based on value for money. Value for money is the optimum combination of whole life costs and quality to meet the user's requirement. To that end, services should be acquired by competition unless there are convincing arguments to the contrary. The procedures to be followed should be those adopted in respect of any public sector procurement and departments planning to award audit or accountancy appointments should seek the advice of their procurement units. The paper considers some aspects of the procedures which are peculiar to audit and accountancy appointments.

EC Procurement Rules

  5.  The EC Services Directive, which has been implemented in the Public Services Contract Regulations 1993 (SI 1993/3228), reinforces Treaty provisions on the free movement of goods and services within the EC. In seeking to ensure non-discrimination and fair competition, it imposes procedural rules which public authorities must follow if they wish to award a contract above specified threshold values[15]. Contracts with a value equal or in excess of these thresholds must normally be advertised in the Official Journal of the European Communities. Proper planning is essential in such cases; for example to ensure that the minimum periods laid down in the Regulations for expressions of interest and the return of tenders are complied with.

  6.  This annex does not provide a comprehensive interpretation of the Regulations. Departments which are likely to award contracts to which the rules apply should consult their procurement units on the action needed to comply with the Regulations.


  7.  The arrangements for appointing advisers—including reporting accountants—to work on the privatisation programme are covered in separate guidance (NIP(94)) issued in February 1994, but departments may find this annex provides a useful supplement to this guidance.

Bodies responsible for appointing their external auditors

  8.  There may be cases where bodies which are substantially dependent on public funds are themselves responsible for appointing their external auditors, although the department may sometimes be given powers to approve the appointment. Departments may wish to treat this annex as indicative of best practice and to encourage bodies to follow its recommendations.


Selection of firms to be invited to tender

  9.  Departments applying the Restricted Procedure under the EC Procurement rules should specify in the advertisement the number of firms to be short-listed for invitation to submit tenders. The short-list should comprise prospective tenderers who have shown at the selection (pre-qualification) stage that they satisfy the Department's requirements as to their economic and financial standing, ability and technical capacity. Sufficient firms should be invited to ensure genuine competition, with a minimum of three. All firms which have expressed an interest should be told whether or not they are on the short-list.

    —entities listed in Schedule 1 of SI 1995/201: £104,435 for most types of service including audit services (previously £108,667);

    —other public sector contracting authorities: £160,670 (previously £158,018).

Qualifications: audit appointments

  10.  The statutory framework establishing a public sector body may include one of the following possibilities:

    —  that the C&AG should be appointed as the auditor;

    —  that the Secretary of State can appoint the auditor, and specifies the qualifications required; and

    —  that the Secretary of State can appoint the auditor, but does not specify the qualifications required.

  11.  In the first case, bodies are not at liberty to put the audit appointment out to tender (see also paragraph 3);

  12.  In the second case, the qualifications required are normally those required of the auditor of a limited company. The Companies Act provides that auditors are to be members of a recognised supervisory body and eligible for appointment under the rules of that body. The Act also requires supervisory bodies to keep a register of individuals and firms who are eligible for appointment as company auditors and only such "registered auditors" may be appointed. As the C&AG does not meet these requirements, he is ineligible for consideration for audit appointments where the qualification for appointment is specified in this way. He is, however, eligible for appointment if membership of the Chartered Institute of Public Finance and Accountancy (CIPFA) is one of the qualifications required. As noted in paragraph 37, the C&AG should be given inspection rights where he is not appointed as external auditor.

  13.  Where the legislation does not specify the required qualifications, departments are free to invite the C&AG and/or private sector firms to tender for the appointment. It should be noted that, during the Lords' debate on the Access to Justice Bill (Hansard col 661-662 16 March 1999), the Lord Chancellor stated that "we believe that the auditor of public bodies should be the C&AG rather than an auditor appointed by the relevant Minister unless there is some special reason why the auditor of a particular public body should have knowledge or experience which can only be found in the private sector.".

Qualifications: non-external audit appointments

  14.  For non-external audit assignments, there are no formal requirements relating to membership of a particular professional accountancy body, although departments should ensure that the qualifications of the firm or person tendering for the assignment are appropriate to the task to be performed. Bodies considering whether to invite the National Audit Office to tender for non-external audit assignments should bear in mind that NAO should not be considered for tasks which would require it to be involved in the actual design of accounting or financial management systems.

When to make an audit appointment

  15.  To allow the new auditors adequate time to plan and complete their work, their formal appointment should be announced as soon as possible after the latest annual audit has been completed.

Conflicts of interest

  16.  The department should establish whether a particular firm would have a conflict of interest if it were appointed. The ethical rules of the professional accountancy bodies prohibit a firm from accepting an audit assignment in certain circumstances. Comments on conflicts of interest were made in the Checklist of Points in the PAC's 8th Report on the proper conduct of public business (DAO(GEN) 3/94). The conclusions reached in that report were:

    —  there was occasionally a failure to secure arms' length relationships with private sector consultants, leading to conflicts of interest in decisions to spend public money; and

    —  care should be taken to avoid actual, potential, perceived or perceivable conflicts of interest when employing consultants and staff.

  17.  Departments will need to discuss possible conflicts of interest with potential tenderers. If the firm can demonstrate that there will be an arm's length relationship between the various parties, and that there are adequate procedures to prevent unauthorised access to information, there may, in fact, be no conflict of interest. However, each case must be considered on its merits. As noted in paragraphs 24 to 26, there is a presumption that the same firm should not be appointed as both internal and external auditors.

  18.  The examples given in Annex B to this annex give prima facie evidence of a conflict of interest. The list is illustrative only and is not intended to be comprehensive.

  19.  Departmental staff may face potential conflicts of interest, especially if they are involved in the procurement process; this issue is addressed in CUP Guidance No 16 Purchasing Ethics.

  20.  If departments have any doubt about conflicts of interests, they should consult, as appropriate, the Central Accountancy Team or the Central Unit on Purchasing in the Treasury.

Consultancy work

  21.  There has been considerable debate over whether a firm which has been successful in winning a contract to undertake an external audit assignment should be permitted to tender for consultancy or other non-external audit work from the same organisation. Examples might include consultancy work on accounting systems or acting as accounting advisers on PFI schemes. Arguments which support the separation of the audit and non-external audit work include the need to avoid conflicts of interest, and suspicion that firms may put in low bids for audit work in the hope of obtaining consultancy work. On the other hand, it can sometimes be more cost-effective if a firm which is conversant with an organisation's operations and systems also undertakes additional work of an investigative nature.

  22.  It would be unnecessarily restrictive to prevent, in all cases, firms from undertaking audit and non-external audit work, especially if the work were conducted by separately managed divisions of the firm and was of relatively low value,[16] but the presumption is that it would be exceptional for one firm to undertake both audit and non-external audit work for the same organisation. Non-external audit work should be subject to the same tendering procedures as for audit work, but the external auditor should not be invited to tender.

  23.  If, very exceptionally, the size of the consultancy or non-external audit work does not justify a tendering procedure and the body wishes to appoint the external auditors to undertake the non-external audit work, it should consult its sponsor department.

Relationship between internal and external audit

  24.  The Public Audit Forum's consultation paper What Public Sector Bodies can expect from their Auditors states that the same firm should not be appointed to undertake both the internal and the external audit function as this can lead to a loss of objectivity and independence. The Further Education Funding Council goes further in ruling that the same firm can never act as both internal and external auditors for FE colleges. There must therefore be a presumption against appointing the same firm to undertake both roles and departments should consult the Treasury if they feel that a case can be made; it is worth stressing that such cases will be exceptional. It is not possible to give definitive guidance on such circumstances but the following aspects should be taken into consideration—the size of the body (eg, is it too small to justify the separate staffing of the two functions); the number of financial and other staff; and the value of its internal and external audit assignments.

  25.  If appointing a single firm can be justified, the sponsor department should receive details of the planned internal audit work and a copy of the annual report on the work carried out. It should also undertake a periodic peer review of the work and the working papers of the internal audit activity. In examining the audit arrangements, the sponsoring department should be alert to any indication of a loss of objectivity. Although the C&AG may be the statutorily appointed external auditor of an NDPB he may sub-contract the day-to-day work to a private sector firm, and similar considerations may also apply if the body wishes to appoint that firm to undertake the internal audit function. The NAO's standard conditions forbid firms who act as sub-contractors from taking up internal audit appointments with the same body—were this to happen, the firm would immediately be removed from the external audit work.

  26.  Departments should also ensure that close working relationships are established between the internal and external auditors. The two types of auditor should consult each other and co-operate in order to seek opportunities to avoid duplication of work and achieve an efficient use of audit resources. Good practice advice on internal and external audit co-operation is available in the HM Treasury/National Audit Office exposure draft Co-operation between Internal and External Auditors—A Good Practice Guide.


  27.  Assessment of performance should be a continuous process with any shortcomings being noted by the sponsor department and the body and taken up promptly with the appointed firm. In extreme cases, it may be appropriate to make a fresh appointment. Contracts should include a break clause to facilitate the arrangements for making a fresh appointment should this prove necessary.

  28.  Even if the performance of the incumbent firm is entirely satisfactory, it is strongly recommended that audit appointments are re-tendered at least every five years. Unless there are unsatisfactory aspects of the performance of the incumbent firm, there is no need to exclude that firm from those invited to tender.

  29.  Public bodies which have been set up as limited companies have to comply with the provisions of the Companies Act in respect of the appointment of auditors (ie that the auditor holds the office from the end of a general meeting at which the annual accounts are laid to the end of the next following general meeting at which the annual accounts are laid). There are also some NDPBs for which the founding legislation provides for the Secretary of State to appoint the auditors annually. However, these provisions do not require the audit appointment to be re-tendered each year. It is acceptable for the contract to be placed for a period of 5 years, but subject to annual reappointment. Departments are not precluded from adopting this approach even if there are no statutory provisions regarding annual appointments.


  30.  Ethical guidance issued by the accountancy profession recommends that a partner should not remain in charge of an audit of a listed company or other public interest entity for a period exceeding seven consecutive years. This recommendation should be followed in the case of public sector audit assignments. If the incumbent firm is successful in winning the contract following the re-tendering exercise referred to in paragraph 28, the partner who was previously in charge of the audit may remain until the expiry of the seventh consecutive year of his or her appointment, but a new partner should then take over.


  31.  The department, as the "owner" of the body being audited, has the right to receive documents (in particular management letters) submitted by the auditors to the body.


  32.  Increasingly, private sector firms are including clauses in contracts which impose a limit on their financial obligations in the event of claims being made against them for negligence or other reasons. A letter to Principal Finance Officers dated 6 May 1997 Restriction of Liability in Contracts for Public Sector Auditing and other Financial Assignments, stated that departments and public bodies should not agree to any proposal by a firm to limit its liability in the event of a claim being made against them when the contract is one for external "certification" audit work. It went on to say that departments may negotiate with firms over the terms of any restriction of their liability in the case of other assignments, such as (but not confined to) those for internal audit, consultancy and financial advice, and "due diligence" (including investigations) if the terms of the contract represent the best value for money and protect the interests of the department and the taxpayer. It concluded by saying that it was unlikely that these interests would be satisfied if restrictions were accepted.

  33.  Experience gleaned from the practical application of this guidance suggests that more emphasis should be placed on the customer (ie a department or body) being satisfied that the contract represents an appropriate and acceptable balance of risk and cost. This approach has been applied, in particular, to assignments for internal audit. For example, if a private sector firm carries out individual internal audits under the direction of a department's Head of Internal Audit, the degree of risk to the department is low, and the firm has a limited prospect of being sued other than for a sum related to the job being done. It would therefore be reasonable for the department to accept a limit on the firm's liability with consequent advantages to the fee charged for that assignment.

  34.  In contrast, if the firm is responsible for the full internal audit service, including drawing up an internal audit plan, advising the department on audit need and producing an annual internal audit opinion, it has accepted a high level of risk with potentially high claims. To safeguard the interests of the department, the presumption should be that the firm must accept no capping of its liability, or at least must accept a high level of liability.

  35.  Although it may be argued that firms will apply more quality control and supervision if they perceive that their exposure to financial loss is high, they are likely to charge more for their services if they bear a higher level of risk. Departments and bodies should therefore weigh up the potentially higher cost of the service provided against the greater confidence that the job will be well done. By reducing their exposure to financial risk, private sector firms are limiting the scope of departments to seek compensation in the case of loss and a balance must be struck between the interests of the department and those of the firm and, while there is advantage to be gained by having the opportunity to seek redress if liability has not been capped, as a generality, the balance of consideration should tilt towards greater satisfaction that the work will be done properly so that the need for redress does not arise.

  36.  Annex D reproduces the annex to the PFO letter referred to above but its conclusions should be read in the context of the approach which has been adopted since that letter was written.


  37.  Guidance on the C&AG's rights of access to NDPBs is given in a letter to Principal Finance Officers issued in November 1992 (PFO 92/5). In addition, the Treasury's response to the first report by Lord Nolan Spending Public Money—Government and Audit Issues (Cm 3179) noted that the Government will ensure that the C&AG has inspection rights over all executive NDPBs which he does not audit, including the few where they have not so far been agreed, and over companies which are wholly or mainly owned by executive NDPBs. (This latter reference has been taken to apply also to companies limited by guarantee and those to which the NDPB has given an indemnity.) Departments should ensure that these commitments are observed.


  38.  Guidance on the responsibilities of external auditors of NDPBs is given in Annex C.

July 1999

15   The thresholds are reviewed from time to time. The values introduced on 1 January 1998 and expected to run to 31 December 1999 are: Back

16   As a very general guide, external auditors may undertake non-external audit work if the value of the assignment is less than £10,000 or 10 per cent of the audit fee (if greater). Departments may wish to impose their own restrictions in any detailed audit specification which they prepare as part of the tendering procedure. Back

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