European Commission Official Tells PCAOB Roundtable that EU Moving Forward with Legislation Mandating Audit Firm Rotation

The European Commission’s proposed legislation mandating audit firm rotation is currently before the European Parliament and the Council of Member States and some action is expected by year end, Nathalie Berger, Director of Audit at the European Commission, told a PCAOB roundtable on auditor independence. After audit inspections in the UK, France and Germany revealed weakness in internal control procedures, insufficient auditor professional skepticism, too much reliance on management representations, and a lack of sufficient evidence to support audit opinions, the Commission drafted reform legislation that included mandatory audit firm rotation every six years for solo audits and nine years for joint audits. . 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 rejected the alternative of voluntary audit firm rotation, said Ms. Berger, who noted that it does not mean much and is no solution to the problem. She said that the status quo, which includes key audit partner rotation every seven years, is not an option.

In her view, mandatory audit firm rotation would element threats to independence, reinforce professional skepticism and enhance competition. It will have positive impact on audit quality and lead to better audit processes and planning. The Commission acknowledges that costs would increase with the introduction of mandatory audit firm rotation, but believes that costs would diminish over time. Importantly, she emphasized that the benefit of improving the quality of the outside audit would far outweigh any increase in costs. The Commission official emphasized that investor protection comes first, adding that the investor is the principal client of the outside auditor.

Mandatory audit firm rotation also presents advantages in terms of meeting potential conflicts of interest and thereby improving audit quality. In a long term audit relationship, reasoned the EC official, the auditor will tend to identify too closely with the management. Proper professional skepticism will be diluted and auditors will be more likely to smooth over areas of difficulty in order to preserve the relationship. Auditors may become stale and view the audit as a simple repetition of earlier engagements. This staleness fosters a tendency to anticipate results rather than keeping alert to subtle changes in circumstances which could be significant.

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.

Director Berger noted that the Commission sees support for mandatory audit firm rotation in the Council and in Parliament and will soon be entering into negotiations with those bodies with an eye towards passing final legislation. The six year term is subject to negotiation, said the official, with some Members of Parliament wanting it to be ten years. The report of the UK Competition Commission, due in November, may inform the negotiations.

The draft would also create an EU Audit Quality Certification to confer on mid-tier audit firms, which would be a label of good quality. There would be no legal value to the certificate that would allow a firm to claim access to a certain market, noted the official, but it would empower mid-tier audit firms to tender to a big firm market and help expand the pool of audit firms serving this market. The European Securities and Markets Authority would draft the certificate and administer it.

This 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.