Commission to propose joint audits and mandatory rotation
By Sophie Mosca | Monday 26 September 2011
The European Commission plans to propose drastic legislation to create a framework for the audit market from 2015, especially for auditing of the accounts of public interest entities (PIE), namely listed companies whose activity (banking or insurance, for example) and large size require the use of stricter rules. The 'audit package', set to be presented in late November and seen by
Europolitics, will be made up of a proposal for amendment of Directive 2006/43/EC on statutory audits of annual accounts and consolidated accountsand a regulation for public interest entities. The latter text is giving rise to considerable misgivings among stakeholders, who are organising their counterattack.
Just as governance and supervision of the financial system were called into question as a result of the crisis, there is consensus on the need to revise audit policy to ensure financial stability. This is borne out by the contributions of the green paper of 13 October 2010, the opinion of the European Economic and Social Committee and a European Parliament resolution. However, the latter two institutions recommended a debate or action plan based on a detailed impact assessment before legislating on sensitive issues, such as the rotation of audit firms or joint audits. The Commission is preparing, however, to make public a legislative package and an impact assessment on which stakeholders were not consulted. Its method surprised the sector, as does the content of the package, because what was seemingly being considered is in fact imposed. "The regulation goes much further than what Parliament requested," explained one expert. The objective is to put in place a strict general framework for the sector in order to guarantee reliable, accessible and less costly financial information by opening the audit sector to competition. This means putting an end to the predominance of the 'big four' (Deloitte, Ernst&Young, KPMG and PriceWaterhouseCoopers).
The most binding constraints are found in the specific regulation that defines rules for statutory audits of public interest entities: method, selection of audit firms, limitation of conflicts of interest, control, etc. The key measure is the obligation of a joint audit for the ten largest public interest entities in each country whose stock market capitalisation or assets total €1 billion. These entities will have to have their accounts audited by one of the 'big four' plus another firm whose market share is less than 15%. In addition, to protect against the familiarity that can settle in when the same audit firm repeatedly audits the same entity, a rotation of audit firms will be mandatory. A statutory auditor may therefore audit the accounts of the same PIE for a period of only two to five years and the mandate may be renewed only once for five years at most. The firm will then have to abstain during a four-year period.
To prevent conflicts of interest and artificially low rates on audit services that are compensated for by other services, the regulation rules out such practices and establishes a list of services that are incompatible with audits (drawing up of financial statements, legal consulting, internal audit services, etc). Some services, such as auditing of interim accounts, are authorised but capped at an invoicing amount of 10% of the costs incurred for account certification.
The text imposes constraints in terms of presentation and more detailed content of the auditor's report, which will have to cover at least 19 points, and the internal report addressed to the firm's audit committee. It requires an annual 'transparency report' to be available on the statutory auditor's website for at least five years. The audit committee is also required to have at least one member with competence in audits and at least two with accounting/auditing competences.
The adoption of ISA international standards is recommended and measures are included to strengthen supervision of the sector by national authorities. They would collaborate at European level in the European Securities and Markets Authority (ESMA), which should also develop standards valid throughout the EU. Financial sanctions of at least 10% of the audit firm's total turnover are foreseen for offenders.
The second part of the package, which amends the 2006 audit directive, introduces more consensual rules for all other audits, including the introduction of a European passport for auditors to increase professional mobility in the EU and simplified requirements for audits of small and medium-sized enterprises. Exclusivity clauses in favour of the 'big four' are banned and minimum requirements in terms of voting rights held by statutory auditors are abolished to encourage the access of new entrants on the market.
While some observers welcome this ambitious package, the majority of stakeholders are critical of both its method and substance. The failure to consult them on issues as controversial as joint audits, rotation or the prohibition of certain services is a mistake, they argue. These "missiles fired against the big firms," said one expert, "are going to push them to split their activities into auditing and other services and will deter the development of other firms".
Erik Berggren, an expert at BusinessEurope who represents large EU firms, considers that "many of these proposals will lead to higher costs for companies. Rotation will also lead to lower quality because with the change of auditor there will be a loss of knowledge." He adds that Denmark has backtracked on joint audits, which proved to be "costly and ineffective".
John Davies of the Association of Chartered Certified Accountants (ACCA) is more measured in his criticism. “We recommend that regulators put in place contingency plans, rather than taking early but costly market-wide measures [...] such as mandatory rotation of audit firms and joint audits, which may not suit the EU as a whole".