Global Update

Audit Policy Reforms

A draft agreement with the Council of Ministers on legislation to open up the EU audit services market beyond the dominant “Big Four” firms and remedy auditing weaknesses revealed by the financial crisis was endorsed by Parliament on Thursday 3 April. The draft also aims to improve audit quality and transparency and to prevent conflicts of interest. The European Parliament plenary vote is a welcome end to nearly four years of uncertainty for markets and the profession.

Context

Since his appointment as European Commissioner for Internal Market, Michel Barnier has put the European Union (EU) on a path of triple reform aimed at making the financial sector more resilient. Amongst these proposals was the audit reform to improve the relevance of the audit, de-concentrate the market and reinforce auditor independence. On 13 October 2010, Commissioner Barnier published a Green Paper entitled “Audit Policy: Lessons from the Crisis”. He opened a consultation inviting stakeholders to respond to 38 detailed questions on the implementation of statutory audit within the EU.

After this consultation process, in November 2011, the Commission adopted two proposals for a Regulation on the quality of audits of public-interest entities and for a Directive to enhance the single market for statutory audits. This was the beginning of a legislative debate resulting in a provisional agreement on the Regulation and the Directive between the European Parliament, EU Member States, and the European Commission on 17 December 2013. On 21 January 2014, the JURI Committee voted to adopt both the Regulation and Directive. The plenary European Parliament adopted the texts on 3 April 2014. The Council of Ministers (‘Council’), as co-legislator, must ratify the same text subsequently. A publication in the Official Journal of the EU is expected by summer 2014.

The Directive, which amends the text of the Statutory Audit Directive (2006/43/EC), contains a series of new and amended requirements governing every statutory audit in the European Union, as well as some requirements applicable to Public Interest Entities (PIEs) only regarding audit committees. The Regulation contains a series of additional requirements that relate only to the statutory audits of PIEs in addition to the general ones stated in the Directive.

Better quality auditing

The legislation requires auditors in the EU to publish audit reports according to International Auditing Standards (ISAs). For auditors of PIEs, such as banks, insurance companies and listed companies, the text requires audit firms to provide shareholders and investors with a detailed understanding of what the auditor did and an overall assurance of the accuracy of the company’s accounts.

Opening up the EU audit market to competition and improving transparency

As one in a series of measures to open up the market and improve transparency, the approved text prohibits “Big 4-only” contractual clauses requiring that the audit be done by one of these firms.

PIEs will be required to issue a call for tenders when selecting a new auditor. To ensure that relations between the auditor and the audited company do not become too cosy, MEPs agreed on a “mandatory rotation” rule whereby an auditor may inspect a company’s books for up to 10 years, which may be increased by 10 additional years if new tenders are issued, and by up to 14 additional years in the case of joint audits, i.e. when a firm is being audited by more than one audit firm.

The Commission had proposed mandatory rotation after 6 years, but a majority judged that this would be a costly and unwelcome intervention in the audit market.

Independence of non-auditing services

To preclude conflicts of interest and threats to independence, EU audit firms will be required to abide by rules mirroring those in effect internationally. EU audit firms will moreover be prohibited from providing several non-audit services to their clients, including tax advisory services that directly affect the company’s financial statements or services linked to the client’s investment strategy.

Audit reporting

The reporting requirements include the reporting of the most significant risks of material misstatements for PIEs only, the reporting on material uncertainties/going concern issues for all entities. This is broadly in line with the current IAASB proposals on auditor reporting. In addition all statutory audits should therefore be carried out on the basis of the International Auditing Standards adopted by the Commission. In actual fact the Directive introduces a new mechanism for adopting ISAs at European level.

The agreement drew mixed reactions from auditing and accounting organisation leaders.

The EU’s adoption of ISAs was welcomed both by FEE and IFAC. FEE especially welcomes the adoption of ISAs as these are the only set of globally recognised auditing standards; this measure is therefore instrumental to sustaining audit quality. In addition, the stronger role of audit committees will improve corporate governance and the independence of the audit process. The enhancements to the auditor’s report will contribute to a better understanding of the contribution of the auditing profession to the public interest.

Fayez Choudhury, chief executive officer of IFAC said that the global accountancy profession federation welcomes aspects of the European reforms that adopt a globally consistent approach by adopting ISAs. “We strongly support Europe’s step toward adopting International Standards on Auditing. These high-quality international auditing standards are globally accepted, and are currently being used or adopted in over 90 jurisdictions around the world, including many countries in Europe”, said Mr Choudhury, who however criticised other aspects of the legislation, which might have been introduced to ensure its successful passage, and which could lead to regulatory divergence and fragmentation, said the IFAC CEO in a statement released shortly after the EP vote.

FEE expressed concern that many aspects of the legislation will be complicated to implement in practice. “The significant number of Member State options hinders the internal market and the creation of a truly international playing field,” said FEE Chief Executive Olivier Boutellis-Taft. “The reform raises a number of questions that we are committed to help solving. It is time that the whole profession join forces with investors, business and regulators to this end.”

These concerns were echoed by IFAC, who expressed concern that the legislation would create the potential for regulatory divergence. According to Mr Choudhury “we are concerned that other parts of the legislation provide individual member states with options that will create a patchwork of regulation across the union. Not only will Europe be out of step with other major jurisdictions, such as the US and Canada, but member states will potentially be out of step with each other. Just a few years ago, the oft-cited mantra was ‘global problems require global solutions.’ The stakes are high and the rest of the world will certainly be focused on what happens in Europe. Failure to decide a consistent approach to audit regulation within Europe does not auger well for the chances of agreement among the global community.”

The Institute of Chartered Accountants in England and Wales sees major changes ahead for audit firms from the legislation.

“We are glad we have a conclusion to the three-and-a-half-year-long debate about how audit needs to change across the European Union,” said ICAEW chief executive Michael Izza in a statement. “The legislation adopted today will result in big changes both for auditors and the companies they audit. The new rules will apply to public interest entities, which also includes a number of unlisted companies. Some may not be aware of this and it could be a particular challenge for the smaller companies, which in the past will have relied on their auditors to do a lot of work.”

The ICAEW noted that the changes that have been most debated include the requirement for companies to tender their audit contract every 10 years and rotate their auditor every 20 years, an expanded list of prohibited non-audit services that can be carried out by the external auditor, and a cap on how big a proportion of the audit fee can be made from offering non-audit services.

Next steps

On 14 April 2014 the Council of the European Union has adopted the legislative package on audit policy. To come into effect, the Directive will need to be transposed by the respective Member States into their national laws in order to become effective law.

The next step is the publication in the Official Journal of the European Union which can be expected by mid-May 2014. Member states have two years to adopt and publish the provisions to comply with this Directive after the entry into force of the Directive, namely 20 days after Official Journal of the European Union (OJ) publication. After this deadline, the European Commission may sue the Member States that would fail to transpose.

Unlike a Directive, a Regulation binds everybody throughout the EU
and is therefore directly applicable in all EU Member States without the need for any national implementing legislation. Technically speaking, the Regulation comes into effect on the date of entry into force. Nevertheless, mainly due to the fact that the Regulation refers to the Directive, which will need two years to be transposed into national law, there is a two-year delay in the application of most provisions included in the Regulation from the date it enters into force.

Provisions have a two-year delay in the application, except the one regarding the appointment of the auditor (Article 16) that has a three year delay. The timetable for provisions with a two-year delay in the application of the Directive would be:

Final adoption: 15 April 2014; Publication: 10 June 2014; Entry into force: 30 June 2014; Binding effect: 30 June 2016.

Provisions on mandatory audit firm rotation become directly effective (see below).

Transitional arrangements for the provision on mandatory audit firm rotation.

Transitional arrangements will vary depending on the length of the audit appointment at the date the new legislation comes into force. In case the new legislation would be published on 10 June 2014 and come into force on 30 June 2014.

  • If the auditor has been in place for 20 years or more, the first rotation must take place within six years. The first rotation date would be 30 June 2020.

  • If the auditor has been in place for between 11 and 20 years, the first rotation must take place within nine years. The first rotation date would be 30 June 2023.

  • Otherwise, the new regime will apply two years from the legislation implementation date (30 June 2016). The first rotation date would be 30 June 2026 to reappoint the auditor or to appoint a new auditor.

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