FC 107/11

Finance Committee

Table of Contents

I. BACKGROUND

II. EARLIER CONSIDERATION OF THE MATTER BY THE GOVERNING BODIES

III. RECENT DEVELOPMENTS ON THE MATTER OUTSIDE THE UNITED NATIONS SYSTEM

IV. EXTERNAL AUDITOR ROTATION IN THE UNITED NATIONS SYSTEM

V. ADVANTAGES AND DISADVANTAGES OF ROTATION OF EXTERNAL AUDITORS

VI. POSSIBLE CONCLUSIONS AND RECOMMENDATIONS

VII. POSSIBLE ACTION BY THE COMMITTEE

I. BACKGROUND

1. In May 2003, the Joint Meeting of the Programme and Finance Committees reviewed the recommendations in the Report of the UN Joint Inspection Unit “Review of Management and Administration in the Food and Agriculture Organization of the United Nations” (JIU/REP/2002/08). At its Hundred and Second Session, held from 5 to 9 May 2003, the Finance Committee also considered in more detail those recommendations of that report concerning matters within its mandate, with particular reference to that whereby the “Council may wish to consider recommending to the Conference a modification of the Financial Regulations of the Organization so as to institute limits on the terms of office of the External Auditor”.

2. Financial Regulation 12.1, relevant to the issue under consideration, reads as follows:

“An External Auditor, who shall be the Auditor General (or person exercising an equivalent function) of a Member Nation, shall be appointed in the manner and for the period decided by the Council”.

3. At the same Hundred and Second Session, the Finance Committee “requested that a comprehensive paper be prepared for its next session on the advantages and disadvantages of limiting the term of office of the External Auditor. The paper should explain what amendments would be needed to the Financial Regulations, if such a change were agreed” (Cf. Report of the Hundred and second Session of the Finance Committee, 5-9 May 2003, Document CL 124/16, paragraph 39).

4. This document is prepared in response to the above request. It describes previous consideration of the matter by the Finance Committee and the Council, reviews recent developments both outside the United Nations system and inside the system and presents advantages and disadvantages of limiting the term of office of the External Auditor. It also outlines possible options which could be implemented in FAO in the event that it should be decided to introduce term limits for the External Auditor.

II. EARLIER CONSIDERATION OF THE MATTER BY THE GOVERNING BODIES

5. Since FAO moved to Rome in 1951 and until 1991, the Finance Committee recommended to the Council the reappointment of the Comptroller and Auditor General of the United Kingdom. In 1979 however, at its Forty-third Session, the Finance Committee, after having recalled that fact, noted: “The Committee, whilst appreciating the advantages of retaining the services of the present External Auditor – such as continuity, intimate knowledge of the operations of FAO and other Organizations in the UN family which he was also auditing – and noting the practical problems which would ensue as a result of a change of Auditors, nevertheless felt that consideration might be given to possible alternative appointments” (Cf. Report of the Forty-third Session of the Finance Committee, 23 April - 4 May 1979, Doc. CL 75/4, paragraph 3.129). Accordingly, the Council continued to re-appoint, for periods of two years, the Comptroller and Auditor General of the United Kingdom until 1993.

6. In 1991, at its Seventy-second Session, the Finance Committee considered the matter in some detail in connection with the review of applications by the Cour des Comptes of France and the Comptroller and Auditor General of the United Kingdom (Cf. Report of the Seventy-second Session of the Finance Committee, 16-26 September 1991, Doc. CL 100/4, paragraphs 3.114-3.119). At its Hundredth Session, held from 5 to 8 November 1991, the Council, during its discussion of the reappointment of the External Auditor of the Organization, “agreed that it was in the interest of the Organization to have the opportunity of recourse to the experience and knowledge of Auditors-General of other Member Nations” (Cf. Report of the Hundredth Session of the Council, paragraph 74).

7. In 1993, the Council reviewed the report of the Seventy-seventh Session of the Finance Committee. The Finance Committee had considered two proposals, i.e. from the French Cour des Comptes and from the Comptroller and Auditor General of the United Kingdom (Cf. Report of the Seventy-seventh Session of the Finance Committee, 21-30 September 1993, Doc. CL 104/4, paragraphs 3.68-3.71). Subsequently, the “Council approved the appointment of the Senior President of the French Cour des Comptes as External Auditor. It also decided that the appointment should be for four years commencing with the year 1994....The Council requested that in future, a large number of countries, including developing countries in a position to offer the required services, be invited to submit proposals”. At that session, the Council expressed appreciation to the Comptroller and Auditor General of the United Kingdom for “the over forty years of valuable service to the Organization” (Cf. Report of the Hundred and Fourth Session of the Council, 2-5 November 1993, paragraphs 39-43).

8. At its Eighty-eighth Session, held from 18 to 26 September 1997, the Finance Committee considered the proposals made for the appointment of an External Auditor and concluded that “it would be appropriate to continue with the Cour des Comptes in office for a further term of four years in recognition of the high quality of its service to date, as well as the need to draw the maximum benefit from the experience that they have gained and the knowledge of the Organization they had developed”. The Committee recommended to the Council the re-appointment of the Cour des Comptes for a four year period commencing with year 1998 (Cf. Report of the Eighty-eighth Session of the Finance Committee, Doc. CL 113/4, paragraphs 46-48). At its Hundred and thirteenth Session, held from 4 to 6 November 1997, the Council approved this recommendation (Cf. Report of the Hundred and thirteenth Session of the Council, paragraph 51).

9. At the above-mentioned Eighty-eighth Session, drawing on the experience gained when considering the proposals, the Finance Committee requested the Secretariat to submit a detailed document for its Spring 1998 Session, covering the arrangements foreseen under Financial Regulation XII for external audit, with options on a range of matters including, inter alia, “the number of terms of the External Auditor” and “ways and means for greater participation of developing countries in the audit bids” (Cf. Report of the Eighty-eighth Session of the Finance Committee, Doc. CL 113/4, paragraphs 46-48).

10. At its Eighty-ninth Session, held from 4 to 8 May 1998, the Finance Committee reviewed, in response to the above request, a document describing the proposed arrangements for the selection and appointment of the External Auditor (FC 89/7). The document proposed, inter alia, that “the External Auditor be appointed for a four year term covering two financial periods, with an option to appoint the same external auditor for a further biennium. It [was] further proposed that three biennia be the maximum period of uninterrupted tenure for the appointed external auditor” (FC 89/7, paragraphs 18-21). The Committee expressed the view that the proposals could be improved in certain areas, “such as the period of appointment, eligibility of External Auditors and weighting of evaluation criteria”. The Committee decided that reference should be made to the experience in these areas of other organisations, particularly IFAD and the World Food Programme (Cf. Report of the Eighty-ninth Session of the Finance Committee, Doc. CL 115/9, paragraph 49).

11. At its Ninetieth Session, held from 21-25 September 1998, the Finance Committee considered again document FC 89/7 in light of additional information provided in document FC 90/12. Document FC 90/12, in paragraph 3.2 a) entitled “duration of appointment” read, inter alia, as follows: “The duration proposed by the Secretariat for [the appointment of the External Auditor] FAO is a maximum of six years”. At that Session, the Committee “reviewed the proposal covering the arrangements foreseen under Financial Regulation XII for external audit together with the additional information on the experience of other organizations which had been submitted at its request”....“Accordingly the Committee endorsed the proposal in FC 87/7 for transmission to the Council for its approval” (CL 115/10, paragraph 37).

12. At its Hundred and Fifteenth Session, held form 23 to 28 November 1998, the Council, when reviewing the above report of the Finance Committee under the section entitled “Arrangements for the Selection and Appointment of the External Auditor”, “endorsed the proposal covering the arrangements foreseen under Financial Regulation 12 for External Audit” (Cf. Report of the Hundred and Fifteenth Session of the Council, paragraph 82).

13. At its Hundred and Twentieth Session, held from 18 to 23 June 2001, the Council, after having noted the Finance Committee’s review of the various proposals and its recommendation, decided to appoint the Comptroller and Auditor General of India as External Auditor of the Organization for a period of four years commencing with the year 2002 (Cf. Report of the Hundred and Twentieth Session of the Council, paragraph 102).

14. As recalled above, in 1998, in connection with the approval of the “Arrangements for the Selection and Appointment of the External Auditor”, the Council endorsed in broad terms a number of proposals made by the Finance Committee, including the establishement of a term of four years (i.e. two financial periods) renewable for an additional term of two years (one financial period) to the appointment of the External Auditor.

III. RECENT DEVELOPMENTS ON THE MATTER OUTSIDE THE UNITED NATIONS SYSTEM

15. The issue of auditor rotation has been discussed by the accounting profession and relevant regulatory bodies for several decades. However, following recent corporate events, the subject has received significantly increased attention. Changes to legislation and/or the introduction of new auditing standards have been considered in several countries.

16. In 2002, the United States introduced a new law, the Sarbanes-Oxley Act, with the purpose of protecting investors by improving the accuracy and reliability of corporate disclosures. This Act, together with several other rules aimed at ensuring auditor independence, introduced a rule that the lead audit partner of any audit must be rotated after five consecutive years. The Act further requested that a study be performed on the potential effects of requiring the mandatory rotation of registered public accounting firms, but did not include any provisions in this regard. This study, released in November 2003, concludes that “mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality considering the additional financial costs and the loss of institutional knowledge of the public company's previous auditor of record, as well as the current reforms being implemented. The potential benefits of mandatory audit firm rotation are harder to predict and quantify.”

17. In May 2002, the European Community issued a recommendation to its Member States entitled “Statutory Auditor’s Independence in the EU: A set of Fundamental Principles”. The recommendation included a rule on rotation of Key Audit Partners after 7 years. The Annex to the recommendation proposes that, in case rotation of the Key Audit Partners is not possible or may not constitute an appropriate safeguard, the statutory auditor should consider whether it is appropriate to continue the audit engagement. In substance, this can be interpreted as the introduction of rotation of audit firms in certain cases. Whilst recommendations of the European Community, unlike other instruments, do not have to be implemented in the individual Member countries, it is expected that Members of the European Community will introduce laws or auditing standards in line with the principles of the recommendation in question.

18. The reactions from the corporate world and the representatives of the accounting profession on the above regulatory developments have not been entirely positive. In particular, they emphasized that in many cases the disadvantages of frequently rotating audit firms and audit partners would outweigh the advantages.

IV. EXTERNAL AUDITOR ROTATION IN THE UNITED NATIONS SYSTEM

19. To date, in the United Nations system, only the United Nations and the World Food Programme have introduced limits on the term of office of their External Auditors. The United Nations General Assembly, by resolution 55/248 of 12 April 2001, has introduced a limit of six consecutive years for each of the three members of the United Nations Board of Auditors, while the World Food Programme has a limit of two terms of four years each. The United Nations Panel of External Auditors has noted, however, that the governing bodies of other organizations might follow with similar decisions.

20. External audit arrangements of a sample of organizations in the United Nations system, insofar as limits to the term of office of the External Auditor are concerned, are summarized in the table below:

V. ADVANTAGES AND DISADVANTAGES OF ROTATION OF EXTERNAL AUDITORS

21. Fundamental auditing standards require that the External Auditor be independent, both of mind and in appearance. Various measures exist to safeguard the External Auditor’s independence and one of these is periodic rotation of the External Auditor. The main advantages and disadvantages of auditor rotation are considered below.

22. The most commonly argued advantages of regular rotation are:

1. Independence, of mind and in appearance

It is argued that long-term relationships between auditors and their clients increase the risk of audit failure as, in such relationships, the auditors may be influenced by friendships and/or identification with management and may lose objectivity and professional scepticism. Also, external readers of financial statements may interpret the regular auditor rotation as a guarantee of independence.

The fact of ensuring that the external auditor’s opinion is perceived as reliable has become increasingly important following the significant number of recent corporate events where the external auditor has failed to identify or failed to report exceptions.

2. Audit efficiency and effectiveness

Certain proponents of auditor rotation have argued that a fresh view of the client may give rise to innovative audit methods and improved audit efficiency. The newly appointed auditor may also identify exception or risk areas that a long-standing auditor may not identify due to habit or not report due to reluctance to change a previously expressed view.

3. Involvement of more audit institutions

Regular change of auditor would ensure the involvement, over time, of a broader range of auditors. This would lead to the opportunity for the client organization to benefit from the experience of various external auditors and could encourage the development of the audit profession.

23. The most commonly argued disadvantages of regular rotation are:

1. Increased costs

The change of external auditor involves significant costs, both for the client and for the auditor. The bidding and selection process is time-consuming and costly. The investment of management and staff time and other resources in the process of helping the new auditor acquaint himself with the organization’s systems and procedures is significant and may be disruptive to other activities. A similar investment of resources is required from the auditor.

2. Increased risk of audit failures

There is evidence that the major part of all audit failures occur during the first and second year of any audit engagement. This is due to the significant time required to develop the necessary knowledge of a client to ensure that the audit approach is fully effective, in particular in large and complex organizations.

3. Reluctance to invest

The external auditor could be reluctant to invest time and resources in learning about the client’s organization and activities when the auditor’s mandate is very short and, as the rotation date approaches, could lose interest in the client.

VI. POSSIBLE CONCLUSIONS AND RECOMMENDATIONS

24. FAO is a large and complex organization with a high public profile and it is important, therefore, that the External Auditor be granted a sufficiently long mandate to allow the development of a thorough knowledge of the Organization. However, in order to benefit from the advantages of regular rotation described above and, in particular, to benefit from the experience and knowledge of Auditors-General of different Member Nations, as requested by the Council at its Hundredth Session, in 1991, it may be opportune to continue to limit the External Auditor’s term of office. The Committee may wish to consider whether the limit decided in 1998 allows the Organization to maintain a suitable balance between the benefits of auditor rotation and of longer term external audit mandates or whether it should be modified.

25. With regard to the steps of an institutional and procedural nature that would be needed with a view to confirming or modifying the limit to the term of office of the External Auditor, although the Committee at its Hundred-and-second Session had admitted the possibility of an amendment to the Financial Regulation, no such amendment would in fact be required, given the broad wording of Financial Regulation 12.1. In this connection, the Committee might wish to consider that it would be advisable to retain the flexibility of the current provisions of the Financial Regulations which have allowed the Council to appoint the External Auditor for periods of either two years or four years. This course of action would provide greater flexibility and would not legally bind the Council in future, when taking decisions regarding the appointment of the External Auditor. Exceptions to the policy decision previously taken could be made by Council, if considered necessary in light of all pertinent circumstances, including the fact that the External Auditor of the Organization is not an individual but an institution. It may be of interest to note that, in introducing a limit to the term of office of the External Auditor, the Executive Board of the World Food Programme did not amend the Financial Regulations. Finally, whatever decision is eventually taken by the Council, such decision should be specifically singled out in its report.

VII. POSSIBLE ACTION BY THE COMMITTEE

26. The Finance Committee is invited to review the present document and provide such guidance as deemed appropriate.