The European Commission published its proposals for reform of the audit market on 30 November 2011. These proposals, if enacted in their current form, would entail major changes to the business models of the Big Four auditors, to the work of the audit committees of large listed and regulated companies, and to the regulation of the audit market in the EU. To implement its proposals, the Commission has put forward a draft Directive to amend Directive 2006/43/EC (the Statutory Audit Directive) and a new Regulation on specific requirements for the statutory audit of public-interest entities. The Commission’s press release is here and its useful FAQs are here.
The impetus behind the proposals is the perceived failure of auditors to identify problems in their audits of those financial institutions that had to be rescued by government bail-out in the early stages of the financial crisis. In the words of the Commission’s proposed Regulation:
“Given that many banks revealed huge losses from 2007 to 2009 on the positions they had held both on and off balance sheet, it is difficult for many citizens and investors to understand how auditors could give clean audit reports to their clients (in particular banks) for those periods.”
The Commission’s proposals are made in the context of a wider debate about the trust that can be placed in audited financial statements and the work of statutory auditors. In the UK, the Economic Affairs Committee of the House of Lords produced a report in March 2011 that was extremely critical of the large firm audit market – see our discussion in this post – and the Office of Fair Trading has referred the large firm audit market to the Competition Commission, as we report in this post.
The Commission’s proposals
The market for the audit of large firms in the EU is dominated by the “Big Four” auditors – PwC, Deloitte, Ernst & Young and KPMG. In the majority of EU Member States, the Big Four audit more than 85% of large listed companies (in the UK, they audit more than 95% of the FTSE 350.) The Commission argues that this audit market faces a number of weaknesses:
- “a lack of choice for audit clients resulting from high concentration levels (in essence an oligopoly);
- systemic risk if one of “the Big Four” collapses. In that case, there would be even more concentration at the top end of the audit market;
- possible conflicts of interest and issues around the independence of auditors;
- doubts around the credibility and reliability of the audited financial statements of banks, other financial institutions and listed companies.”
The Commission’s proposals principally relate to the statutory audit of “public-interest entities” – banks, insurance companies and listed companies as defined in the Statutory Audit Directive – which category would be extended to include investment firms, payment institutions, UCITS and alternative investment funds. The key proposals are, as described in the Commission’s press release:
“Mandatory rotation of audit firms: Audit firms will be required to rotate after a maximum engagement period of 6 years (with some exceptions). A cooling off period of 4 years is applicable before the audit firm can be engaged again by the same client. The period before which rotation is obligatory can be extended to 9 years if joint audits are performed, i.e. if the entity being audited appoints more than one audit firm to carry out its audit, thus potentially improving the quality of the audit performed by applying the “four-eyes principle”. Joint audits are not made obligatory but are thus encouraged.
Mandatory tendering: Public-interest entities will be obliged to have an open and transparent tender procedure when selecting a new auditor. The audit committee (of the audited entity) should be closely involved in the selection procedure.
Non-audit services: Audit firms will be prohibited from providing non-audit services to their audit clients. In addition, large audit firms will be obliged to separate audit activities from non-audit activities in order to avoid all risks of conflict of interest.
European supervision of the audit sector: In addition, given the global context of audit, it is important that coordination of and cooperation on the oversight of audit networks is ensured both at EU level as well as internationally. Therefore, the Commission proposes that the coordination of the auditor supervision activities is ensured within the framework of the European Markets and Securities Authority .
Enabling auditors to exercise their profession across Europe: The Commission proposes the creation of a Single Market for statutory audits by introducing a European passport for the audit profession. To this end, the Commission proposals will allow audit firms to provide services across the EU and to require all statutory auditors and audit firms to comply with international auditing standards when carrying out statutory audits.
Cutting red tape for smaller auditors: The proposal also allows for a proportionate application of the standards in the case of small and medium-sized companies.”
And in more detail, from the Commission’s FAQs:
“Mandatory rotation of the audit firm after 6 years (9 years if two audit firms used). A cooling off period of 4 years will be applicable.
Prohibition of Big 4-only contractual clauses (clauses requiring that the audit is undertaken by one of the Big 4 firms).
Mandatory tendering for audit mandates.
Stricter rules on the appointment of auditors with an increased role for the audit committee.
The audit committee’s recommendation for the appointment of an auditor should be discussed at the general meeting of shareholders. The audit committee’s independence and technical competence should be reinforced: at least two of its members must be independent and at least one should have knowledge of audit.
Auditors will be prohibited from providing non-audit services to audit clients. The provision of non-audit services to non-audit clients is allowed.
Large audit firms will be required to separate their audit activities into pure audit firms i.e. a complete ban on the provision of non-audit services by the large audit firms.
EU-level cooperation by the European Securities and Markets Authority (ESMA).
National audit supervisory authorities would be strengthened. The mandate, powers and independence requirements for audit supervisors would be established at EU level, but supervision would be carried out nationally.
European certification of audit firms recognising their aptitude to perform high quality audits of listed companies. The certificates would be issued by ESMA.
Regular dialogue will be held between auditors, audit committees and supervisors.
Mutual recognition of statutory auditors approved in Member States to ensure cross-border mobility of auditors.
The content of the audit report will be expanded to provide more information to all stakeholders.
An additional more detailed audit report for the audit entity itself which will provide detailed information on the audit carried out to the audit committee and management.
Establishing additional requirements on the internal organisation and governance of audit firms.
Compliance with the International Standards on Auditing (ISAs) by all statutory auditors and audit firms. Member States should ensure that the audit standards are adapted to the size of the audited entity to ensure a proportionate and simplified audit for SMEs.”
The Commission’s proposals now pass to the Council and to the European Parliament, where the concerted lobbying efforts of the past few months will continue.
UPDATE 25 September 2012: A group of long-term institutional investors, including the USS, Railpen, LGIM and the Local Authority Pension Fund Forum has published a position paper strongly supportive of the need for reform of the audit market. “At a very fundamental level, we are concerned about auditor independence and professional scepticism.”
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