The European Parliament endorsed a draft agreement Thursday on legislation to open up the audit services market in the European Union beyond Big Four firms.

The draft agreement aims to improve audit quality and transparency and to prevent conflicts of interest. The legislation requires auditors in the EU to publish audit reports according to International Standards on Auditing. For auditors of “public-interest entities,” which include banks, insurance companies and listed companies, audit firms would be required 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.

As one in a series of measures to open up the EU market to competition and improve transparency, the approved text prohibits “Big Four only” contractual clauses that require audits be done by one of these firms.

Public entities would 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 cozy, members of the European Parliament agreed on a “mandatory rotation” rule that would allow auditors to inspect a company’s books for up to 10 years, which could be increased by 10 additional years if new tenders for audit services are issued, and by up to 14 additional years in the case of joint audits, that is, when a firm is being audited by more than one audit firm.

The European Commission had proposed mandatory audit firm rotation after six years, but a majority of the members of Parliament judged that this would be a costly and unwelcome intervention in the audit market.

To preclude conflicts of interest and threats to independence, EU audit firms would be required to abide by rules mirroring those in effect internationally. EU audit firms would also 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.

The deal will also have to be approved by the European Union’s Council of Ministers. Most of its provisions are to take effect within two years of the package’s entry into force, but the restriction on fee income from non-auditing services is to take effect within three years.

Mixed Reactions
The agreement drew mixed reactions from auditing and accounting organization leaders.  “The measures adopted by the European Parliament today encompass sweeping changes to the audit market,” Cindy Fornelli, executive director of the Center for Audit Quality, said in a statement. “While some provisions will strengthen financial reporting and improve corporate governance, the CAQ has expressed its concerns that other requirements, particularly severe limits on non-audit services and mandatory audit firm rotation, will undermine the role of independent audit committees acting on behalf of shareholders and reduce choice in the marketplace.

“Looking forward, we are concerned that the implementation of these reforms will generate inconsistencies across jurisdictions, which could affect companies and their auditors in the United States, where the idea of mandatory firm rotation was recently considered and set aside for sound public policy reasons,” Fornelli added. “We hope that these new rules can be implemented with the greatest consistency possible across Europe with minimal extra-territorial impacts.”

The International Federation of Accountants expressed concern that the legislation would create the potential for regulatory divergence. The group said it welcomes aspects of the European reforms that adopt a globally consistent approach by adopting International Standards on Auditing, but other aspects of the legislation, which might have been introduced to ensure its successful passage, could lead to regulatory divergence and fragmentation. 

“We strongly support Europe’s step toward adopting International Standards on Auditing,” said IFAC CEO Fayez Choudhury in a statement. “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. However, 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 U.S. 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.

“While perhaps not enthusiastic about all areas of change, I think everybody has now accepted that these are the new rules audit firms and companies will have to operate within,” said Izza. “We are already seeing changes emerge in the market, including the U.K., with longstanding audit engagements being put out to tender and audit committees being more prescriptive about the kind of non-audit services they ask the auditors to provide.”

Izza noted that the legal process is far from done, however. “Big challenges remain, as it is now up to each country within the EU to implement the new regulation and transpose the directive into country law,” he said. “There are still areas that require clarification. What is important is to make the new regulatory framework work in practice for companies, shareholders and markets. This requires collaboration between governments, regulators and the profession.”