Sunday, December 22, 2013

E.U. Parliament and Member States Reach Deal on Legislation to Reform Audit Reports and Mandate Audit Firm Rotation

In a major step, the European Parliament and the E.U. Member States have reached agreement on legislation to reform the audit report on company financial statements and require the mandatory rotation of audit firms. In order to promote competition, the legislation also would prohibit restrictive Big Four only third party clauses imposed on companies. A lack of choice for audit clients resulting from high concentration levels, in essence an oligopoly, is what the legislation aims to correct. Audit quality derives from independence, professional skepticism and technical competence. The European Commission believes that all of these elements will be enhanced by the proposed reforms and consequently, audit quality as a whole will be improved.

Although less ambitious than initially proposed by the Commission, stated Commissioner for the Internal Market Michel Barnier, landmark measures to strengthen the independence of auditors have been endorsed in the legislative agreement, particularly in the auditing of financial institutions and listed companies. This will ensure that auditors will be key contributors to economic and financial stability.

Mandatory rotation. Audit firms would be required to rotate after an engagement period of 10 years. The ten year period could be extended by up to 10 additional years if tenders are carried out, and by up to 14 additional years in case of joint audit under which the company being audited appoints more than one audit firm to carry out its audit. A calibrated transitional period taking into account the duration of the audit engagement is foreseen to avoid a cliff effect following the entry into force of the new rules.

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. During the comment period, the Big Four audit firms opposed mandatory audit firm rotation and endorsed the current market-driven selection of outside auditors.

Audit report. In order to reduce the expectation gap between what is expected from auditors and what they are bound to deliver, the legislation would require auditors to produce more detailed and informative audit reports, with a required focus on relevant information to investors. Closer cooperation between the auditor, the audit committee and supervisors will also help to clarify and meet the expectations of stakeholders.

Non-audit services. Audit firms will be strictly prohibited from providing non-audit services to their audit clients, including stringent limits on tax advice and services linked to the financial and investment strategy of the audit client. This aims to limit risk of conflicts of interest, when auditors are involved in decisions impacting the management of a company. This is designed to substantially limit the self-review risks for auditors. To reduce the risks of conflicts of interest, the new rules would introduce a cap of 70 percent on the fees generated for non-audit services others than those prohibited based on a three-year average at the group level.

Oversight. Strict transparency requirements would be introduced for auditors with stronger reporting obligations vis-à-vis supervisors. The work of auditors would be closely supervised by audit committees, whose competences are strengthened by the legislation. In addition, in a very novel and innovative change, the legislative package introduces the possibility for 5 percent of the shareholders of the company to initiate actions to dismiss the auditors. A set of administrative sanctions that can be applied by the competent authorities is also foreseen for breaches of the new rules.

Cross-border. The legislation would also provide a level playing field for auditors at the E.U. level through enhanced cross-border mobility and the harmonization of International Standards on Auditing (ISAs). Cooperation between national supervisors will be enhanced at the E.U. level, with a specific role devoted to the European Markets and Securities Authority (ESMA) with regard to international cooperation on audit oversight.