Thursday, December 08, 2011

European Commission Proposes Broad Reform of the Outside Audit, Including Audit Firm Rotation and Enhanced Audit Report

Audit firms will be required to rotate after a maximum engagement period of 6 years under a Regulation proposed by the European Commission as part of a broad and deep reform of the EU financial statement audit regime designed to strengthen the independence of outside auditors as well as inject greater diversity into the highly-concentrated audit market. According to Commissioner for the Internal Market Michel Barnier, the proposals are intended to restore confidence in the independent audit of a company’s financial statements.

The Commission is acting through a Regulation since the outside audits of the financial statements of EU companies should be performed on the basis of a harmonized framework and the supervision of audit networks should be carried out at an EU level in order to be effective. This can best be achieved through a Regulation, which would be directly applicable, therefore providing a higher level of harmonization and legal certainty.

The Commission enunciated a guiding principle of the Regulation that audit quality derives from independence, professional skepticism and technical competence. The proposed reform of the outside audit is driven by the enhancement of these elements, and, consequently, the overall improvement of audit quality. Professional skepticism is reinforced. The auditor should always remain alert to the possibility of a material misstatement due to error or fraud, notwithstanding the auditor's past experience with the company.

The six year auditor rotation cycle is a key component of the proposal. The six-year period before which rotation is obligatory can be extended up to eight years under exceptional circumstances. The performance of joint audits would be such an exceptional circumstance. Joint audits occur when a company being audited appoints more than one audit firm to carry out the audit, thus potentially improving the quality of the audit performed. Joint audits are not made obligatory but are encouraged.

Mandatory auditor rotation is based on the rationale that a long professional relationship undermines auditor independence and negatively impacts on auditor professional skepticism. The Commission rejected the idea of simply rotating the key audit partner as insufficient because the main focus would still be client retention. A new partner would be under pressure to retain a long standing client of the firm, reasoned the Commission, and it would be unlikely that he or she would criticize the work of the previous audit partner.

Audit firms would also be prohibited from providing non-audit services to their audit clients. In addition, large audit firms would have to separate audit activities from non-audit activities in order to avoid all risks of conflict of interest. The Commission reasoned that a ban on the provision of any non-audit services to audit clients will ensure that high quality audits are the primary focus of the audit provider. It will prevent potential conflicts of interest, as well as reinforcing independence and professional skepticism. Large audit firms will be required to separate their audit activities into pure audit firms, which would result in a complete ban on the provision of non-audit services by the large audit firms.

The content of the audit report disclosed to the public would be expanded so that it explains the methodology used, especially how much of the balance sheet has been directly verified and how much has been based on system and compliance testing, the levels of materiality applied to perform the audit, the key areas of risk of material misstatements of the financial statements, and whether the statutory audit was designed to detect fraud. In the event of a qualified or adverse opinion or a disclaimer of opinion, the audit report would provide reasons for such a decision. The audit report should also explain the variation in the weighting of substantive and compliance testing when compared to the previous year.

Moreover, under the proposed Regulation, the auditor would also prepare a longer and more detailed report for the audit committee, providing more detailed information on the audit carried out, on the situation of the undertaking as such, for example, going concern, and the findings of the audit, combined with the necessary explanations. This additional report would also present and justify the audit work carried out to the audit committee.

This longer report would be submitted to the audit committee and to company management, but not to the public, since its content would include business secrets and potentially price sensitive information. However, upon request, the auditor should make this report available to the competent regulatory authority.

In addition, the Commission would require that the appointment of the auditor must be on a recommendation of the audit committee. Unless it concerns the renewal of an audit engagement, the recommendation should contain at least two choices, excluding the incumbent auditor, and the audit committee should express a duly justified preference for one of them. The Regulation would prohibit Big Four-only contractual clauses requiring that the audit be undertaken by one of the Big 4 firms.

The Commission is also proposing broader ownership rules eliminating the requirement to keep the majority of the capital of an audit firm in the hands of auditors. In the Commission’s view, this will give audit firms more access to capital and, in turn, could increase the number of audit providers and encourage new entrants into the market. The requirement that a majority of the members of the administrative or management body of an audit firm are audit firms or statutory auditors will be maintained. This, in addition to other safeguards, will ensure that the shareholders do not intervene in any way that would jeopardize the independence and objectivity of the auditors. Investors should not be able to have a controlling influence on the audit firm.

The Regulation sets forth that the auditor should take the necessary steps with a view to forming an opinion as to whether the financial statements give a true and fair view and have been prepared in accordance with the relevant financial reporting framework. It does not include the assurance on the future viability of the audited company nor the efficiency or effectiveness with which management has conducted the company’s affairs. However, this exclusion should neither undermine the tasks that an auditor needs to undertake in order to conduct the audit properly nor any reporting requirements.

Finally, the Regulation would require that the EU-wide cooperation between oversight authorities takes place within European Securities and Markets Authority, thus taking over the current EU-wide cooperation mechanism under the aegis of the European Group of Auditors' Oversight Bodies. The Commission noted that ESMA is already working in the field of auditing and accounting and the new EU legal framework foresees the cooperation of ESMA and other authorities within their joint committee in the area of auditing. ESMA is required to create a permanent internal committee which should at least be composed of the national oversight authorities. Further, it is envisioned that ESMA will issue guidance on several issues, including the content and presentation of the audit report and the additional report to the audit committee, on the oversight activity of the audit committee, and on conducting quality assurance reviews.

A voluntary pan-European audit quality certification is introduced to increase the visibility, recognition and reputation of all audit firms having capacities to conduct high quality audits. ESMA will publish the requirements for obtaining the certificate along with any administrative and fee implications. National oversight authorities should be involved in the examination of the application for the certificate.