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European Commission Proposes Major Reforms of Outside Audits of Company Financial Statements

By Jim Hamilton

The European Commission has issued a green paper seeking comment on legislation to reform the financial statement audit process to enhance the role of auditors, eliminate conflicts of interest by mandating rotation of audit firms and ending the issuer pay model, and encouraging joint audits that include a non-Big Four audit firm in order to involve more mid-tier firms in large company audits. The Commission also proposes that audit firms be paid by thirds parties, such as a regulator, rather than by the client company. In addition, the provision of non-audit services could be eliminated to create pure audit firms akin to inspection units. A green paper is the first step in enacting new regulations, and can be loosely analogized to a US federal regulator?s advanced notice of proposed rulemaking.

In the green paper, the Commission also asks if the focus of audits should be extended beyond the current historical information to assessing forward looking information provided by the company, and, given their privileged access to key information, the extent to which auditors should themselves provide an economic and financial outlook of the company. The Commission noted that an independent auditor?s assessment of the company?s financial outlook going forward would be particularly pertinent within the context of going concern. Forward looking analysis, at least for large listed companies, has so far been covered by equity analysts and credit rating agencies. The Commission cautioned that the role of the auditor should be extended in this direction only if there is real value added to the stakeholders.

The Directive on Statutory Audit (2006/43/EC) currently subjects outside auditors to principles of professional ethics and lays down a number of principles for independence, ranging from behavioral aspects to considerations of ownership, fees, rotation or companies' governance, such as audit committees. While conceding the importance of the Directive, the Commission would reinforce the independence of auditors and address the conflicts of interest which are inherent in the current landscape characterized by features such as the appointment and remuneration of the auditors by the audited firm, low levels of audit firm rotation, and the provision of non-audit services by audit firms.

In the Commission?s view, it is a conflict of interest that auditors are appointed and paid by the company that needs to be audited, given that the auditor?s responsibility is to the shareholders of the audited company. Thus, the Commission is considering a scenario where the audit role is one of statutory inspection wherein the appointment, remuneration and duration of the engagement would be the responsibility of a third party, perhaps a regulator, rather than the company itself. This third party concept may be especially relevant for the audit of the financial statements of large companies and systemic financial institutions.

The Commission also proposes the mandatory rotation of audit firms, not just the rotation of key audit partners as currently required by the Audit Directive. While acknowledging that rotation could cause a loss of knowledge, the Commission believes that a company?s appointment of the same audit firm year after year for decades is incompatible with desirable standards of independence.

Since auditors provide an independent opinion on the financial health of companies, noted the Commission, they should not have any business interest in the company being audited. Thus, the Commission would reinforce the prohibition of non-audit services by
audit firms. This could potentially result in the creation of pure audit firms akin to
inspection units.

There is currently no EU-wide ban preventing auditors from offering non-audit services to audit clients. The Audit Directive, Article 22, provides that audit services should not be provided in cases where an objective, reasonable and informed third party would conclude that the auditor's. This rule applies also to the provision of non-audit services.

Unfortunately, Article 22 has been implemented in a very divergent manner across the EU. For example in France there is a total ban on the provision of non- audit services by the auditor to its clients as well as strong restrictions on the possibility for the members of the network of the auditor to provide services to the members of the group of the audited company. In many other Member States, however, the rules are less restrictive and the provision of non-audit services by auditors to their audit clients remains a regular feature. The Commission also noted that under US federal securities law the auditors of listed companies are prohibited from providing a number of non-audit services to their clients. This has ramifications in the EU for the provision of non-audit services to the companies listed in the US.

Audits of large groups which operate in multiple jurisdictions are usually carried out by large global networks in view of the high level of resources such audits require. The Commission shares the concerns of a number of audit oversight bodies around the world which consider that the role of the group auditor needs to be reinforced. Arrangements need to be put in place to allow the group auditor to assume its role and responsibilities. Group auditors should have access to the reports and other documentation of all auditors reviewing sub-entities of the group. The Commission also proposes that group auditors should be involved in, and have a clear overview of, the complete audit process to be able to support and defend the group audit opinion.

The Commission would also like communication between the auditors and the relevant securities regulator to become mandatory for all large or listed companies; with special consideration given to communication with appropriate authorities in the case of fraud within companies.

A number of Commission proposals address the concentration of the audit market in the Big Four. In terms of the revenues or fees received, the total market share of Big Four
audit firms for listed companies exceeds 90% in a vast majority of EU member states. Entry into this top-tier section of the audit market has proven very difficult for many mid- tier audit firms despite their capacity to work in the international audit market. In the Commission?s view, such concentration entails systemic risk since the collapse of a systemic firm or a firm that has reached systemic proportions could disrupt the whole market.

To encourage the emergence of other players and the growth of small and medium sized audit practices, the Commission would require joint audits and the mandatory formation of an audit firm consortium with the inclusion of at least one non-systemic audit firm for the audits of large companies. The concept of joint audit could also be one way of mitigating disruption in the audit market if one of the large audit networks fails.

It would appear that there are ``Big Four only?? contractual clauses that are sometimes imposed on companies by financial institutions as a condition to grant a loan. The Commission proposes to address the issue of these contractual clauses by exploring the creation of a European quality certification for audit firms which would formally recognize their aptitude to perform audits of large listed companies.

Full post as published by Jim Hamilton's World of Securities Regulation on October 13, 2010 (boomark / email).