The European Commission reached a provisional agreement Tuesday with the European Parliament and the member states of the European Union on reforming the audit firm market in Europe, requiring public companies in the E.U. to rotate their auditing firms every 10 to 24 years, avoid non-audit services for the same clients, and prohibit Big Four-only clauses.
Under the provisional agreement, which is still subject to technical finalization and formal approval by legislators, audit firms in the E.U. would be required to rotate after an engagement period of 10 years. After a maximum of 10 years, the period could be extended by up to 10 additional years if tenders are carried out, in which the company puts the audit work out for bid, and by up to 14 additional years in the case of a joint audit, that is, if the company being audited appoints more than one auditing firm to carry out its audit.
The European Commission foresees a transitional period that would take into account the duration of the audit engagement to avoid a “cliff effect” following the entry into force of the new rules.
“This is a first step towards increasing audit quality and re-establishing investor confidence in financial information, an essential ingredient for investment and economic growth in Europe,” said Michel Barnier, European Commissioner for Internal Markets and Services, in a statement. “Although less ambitious than initially proposed by the Commission, landmark measures to strengthen the independence of auditors have been endorsed, particularly in the auditing of financial institutions and listed companies. This will ensure that auditors will be key contributors to economic and financial stability.”
With the agreement, audit firms would basically be required to rotate every 10 years, Barnier pointed out. “Public interest entities will only be able to extend the audit tenure once, upon tender,” he added. “Under this measure, joint audit will also be encouraged. Despite the extension of the rotation period, this principle will have a major impact in reducing excessive familiarity between the auditors and their clients and in enhancing professional skepticism.”
Under the agreement, audit firms in the E.U. would 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 affecting the management of a company. This would also 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. The rules also aim to 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, or ISAs.
The new rules provide tools to limit the risk of conflict of interest, Barnier noted. “To avoid the risk of self-review, several non-audit services are prohibited under a strict black list,’ including stringent limits on tax advice and on services linked to the financial and investment strategy of the audit client,” he said. “In addition, a cap on the provision of non-audit services is introduced. Taken together, the agreed measures will considerably strengthen audit quality across the European Union. In this regard, I particularly welcome the agreement on the harmonization of the International Standards on Auditing.”
The provisional agreement also contains provisions for increased audit quality. To reduce the “expectation gap” between what is expected from auditors and what they are bound to deliver, the new rules will require auditors to produce more detailed and informative audit reports, with a required focus on relevant information to investors. Strict transparency requirements will be introduced for auditors with stronger reporting obligations vis-à-vis their supervisors, along with requests for increased communication between auditors and the audit committee of an audited entity.
To ensure better accountability, the work of auditors in the E.U. would be closely supervised by audit committees, whose competences would also be strengthened by the new rules. In addition, the package introduces the possibility for 5 percent of the shareholders of the company to initiate actions to dismiss the auditors. The agreement also encompasses a set of administrative sanctions that can be applied by the competent authorities for any breaches of the new rules.
To promote competition, the new rules would prohibit restrictive “Big Four only” third-party clauses imposed on companies. Incentives for joint audit and tendering would be introduced, and a proportionate application of the rules would be applied to avoid extra burden for small and mid-tier audit firms. Tools to monitor the concentration of the audit market would also be reinforced.
The Institute of Chartered Accountants in England and Wales welcomed the agreement. “We are pleased that the decision makers have managed to come to an agreement, as there is now hope for all the required follow-up work to be completed before, rather than be stalled by, the E.U. elections next year,” said ICAEW chief executive Michael Izza in a statement. “The debates on audit reform have been going on for three years; a lot of work has gone into it and it carries with it a lot of new requirements, some of which will automatically be translated into law at country level and some that will take longer to trickle through. While we have been concerned about certain parts of the proposals, focus now needs to move to the transition and practical implications. It is important not to underestimate the considerable practical impact the reform package will have—not only on the auditing profession but also on companies across the European Union. It will take time for everybody involved—the profession, businesses, regulators—to work through the details and get to grips with all the changes.”
The provisional agreement also provides for enhanced supervision of the audit sector. Cooperation between national supervisors will be enhanced at the EU level, with a specific role devoted to the European Securities and Markets Authority, or ESMA, with regard to international cooperation on audit oversight.
However, Barnier believes this provision does not go far enough. “On the cooperation between audit supervisory authorities, I regret that ESMA has not been endorsed as the core structure for coordination, but I am pleased that it has been granted an initial mandate on international cooperation,” he said.
Barmier congratulated the European Parliament in announcing the agreement, singling out rapporteurs Sajjad Karim and Kay Swinburne and their shadow rapporteurs, along with the Council, and the successive E.U. presidencies of Denmark, Cyprus, Ireland and Lithuania.
“It is now high time for auditors to meet the challenges of their role—a societal role,” he added. “I trust that once final details are reflected in the text and formally endorsed by the College, co-legislators will also approve the text in coming weeks.”
The European Commission noted that the new rules came in response to the financial crisis, which highlighted serious shortcomings in the stability of the economic and financial system in the European Union, and that auditors play an important societal role by providing stakeholders with an accurate reflection of the veracity of company's financial statements. However, a number of banks were given clean bills of health despite huge losses from 2007 onwards.
In contrast with the real economy, inspection reports from the E.U.’s member states revealed a lack of professional skepticism by auditors, misstatements and a “lack of fresh thinking” in the audits of major companies due to the typically long-lasting relationship between the auditing firm and their clients.