The European Union has been considering an overhaul of the audit profession that could have a far-reaching impact on the Big Four.

In 2011, European Commissioner for Internal Markets and Services Michel Barnier introduced a draft law that included provisions proposing to split up the largest firms, in effect forcing them to create a separate entity for their audit and advisory functions (see Europe Proposes Splitting Audit Firms). Other provisions call for mandatory audit firm rotation to encourage greater diversity of audit firms, and more stringent rules for audit firm independence.

The European Parliament has taken up the draft law and, amid much controversy, is getting set to move forward on at least some of the provisions. I had an opportunity to talk Tuesday with Sajjad H Karim, a member of the European Parliament representing the northwest of England. He is also the lead rapporteur on audit for the European Parliament’s Legal Affairs Committee who has been tasked with leading the effort on audit reform.

He was in New York to meet with representatives of the accounting profession in a panel discussion hosted by the Association of Chartered Certified Accountants. There he met with representatives from some of the major audit firms, such as Deloitte, PricewaterhouseCoopers, KPMG, and Grant Thornton as well as the private equity firm BlackRock, to discuss audit transparency, audit quality and independence. Unfortunately the panel discussion was closed to the press, but ACCA kindly arranged for an interview with him. Karim declined to say exactly which provisions would be included in the final legislation, but I asked him to explain the current status of the draft law and how it might affect audit firms in Europe and the U.S.

“I have now tabled my draft in the Parliament,” he said. “We have had something in the region of over 900 amendments moved to it, which I think is a Parliamentary record. It is a subject area that’s capturing people’s attention, even their imagination. A vote will take place in Parliament the week commencing the 22nd of April. During that week, at some stage, most likely the 24th or 25th, we will have a vote. Hopefully the European Council will have an agreed position at some stage in May. We then go into trialogue negotiations between the Parliament, Council and Commission, with a view hopefully toward having the whole thing wrapped up either by the end of this calendar year or certainly by the end of this Parliamentary term, which finishes in July 2014.”

Based on the amendments that have now moved through the Parliament, negotiations are now going on between various political groups to see where compromise can be reached on different areas. At the end of that process, the legislation will be put to a vote the week of April 22. Once there is a Parliamentary vote, tripartite negotiations begin between the European Parliament, European Commission and European Council, which includes the heads of state of the European Union. There is also a further amending process at that point. If they can agree on a final document, it comes back to the European Parliament for a final vote.

Karim declined to speculate on what the final document would contain in terms of provisions such as mandatory firm rotation. “I can’t give too much away at this stage because we’re in a very sensitive negotiating period between groups at the moment,” he said. “What I can say to you is, in my draft, I had certainly put forward a 25-year proposal. The Commission draft had started with a six-year proposal on rotation. So it will be interesting to see what happens.”

However, he noted that there had been a very interesting development in the Economic Affairs Committee, which voted last month to scrap the provision for mandatory audit firm rotation. “One of our other committees in the Parliament, the Econ Committee, drafted an opinion on the matter, and that’s been voted through,” he said.

The Economic Affairs Committee adopted a proposal in favor of mandatory retendering, to be carried out on a seven-year basis, which was a key difference from the Commission’s proposal and the draft report that was tabled in Legal Affairs.

Mandatory retendering would only require companies to consider changing audit firms every seven years, but they would not necessarily be required to change firms. Karim said he couldn’t comment on whether retendering is more likely to be required as opposed to mandatory rotation.

The European Parliament might also be influenced by a recent report by the United Kingdom’s Competition Commission, which found that the audit market is not serving shareholders and suggested mandatory rotation as one of the possible remedies (see U.K. Commission Says Auditors are Not Serving Investors).

“The provisional findings of the U.K. Competition Commission came out, and they have certainly formed a part of the Parliamentary debate,” said Karim. “I have made specific reference to them in two of the committee debates that we’ve had where I introduced the provisional findings just to form a part of the Parliamentary debate. But that’s still an ongoing process in itself in the U.K. We are following it very closely. It’s been a very useful exercise that’s been conducted there. Obviously as one of the member states that’s crucially involved in this whole process, it will be quite interesting to see how things develop there in the U.K.”

Asked whether there could be differences between what the U.K. and the E.U. end up deciding for audit firms, Karim acknowledged that might happen. “Potentially there could be, but we’re going into negotiations now, and the Competition Commission findings are provisional as well, so they themselves could change,” he said. “It’s not really an answerable question. It’s a moving piece on all sides.”

In the U.S., the Public Company Accounting Oversight Board has also been holding a series of roundtable meetings around the country to gauge reactions to a concept release proposing mandatory audit firm rotation and auditor independence. Karim has been watching those developments as well and he met with the PCAOB on Monday.

“I took the initiative of coming out here because, in terms of the U.S. debate, there had been linkage with the European Commission, but not with the European Parliament,” he said. “I understand the reason for that is that your Congress isn’t really involved in the sort of exercise that we’re involved in, which meant that that natural linkage didn’t quite become established.”

The European Commission, in Barnier’s original draft, had seen it as an issue of competition. “They pointed in their original draft, in very clear terms, to the fact that you have, as a best-case scenario in some of our member states, the Big Four, but that’s the best-case scenario in terms of market concentration,” said Karim. “In some of our member states, you’re down to three, even two big firms to carry out audits. That’s regarded as being far too risky. It was my view, however, that in trying to deal with market situations or potential monopolies, this is not the best way to go about it. If there are competition issues, they should be dealt with by DG Competition [Directorate-General for Competition at the European Commission]. We have a very different role to play and that is to concentrate on making sure that we have got standards and working practices functioning in an appropriate manner within the audit market. So there was a clear difference of approach between how the Commission first saw this and how I wanted to steer it through the Parliament.”

Asked about lobbying by the audit firms, Karim responded, “All I can say is that throughout the time that I have held this brief, I have held representations from a whole host of interested parties, from right across the board. I’ve listened to what everybody has had to say, and as a legislator dealing with such an important brief, I think it’s only right that one should do that. There were certainly one or two issues before I took the brief on, but I’ve not had any experience of the sorts of things that were being alleged. I’m quite happy with the way people have wanted to speak to me about the matter and have conducted themselves.”

Asked about what kind of conduct had been alleged, Karim answered, “Oh, you’ll find it all on the Internet. I’m not going to speculate on what may or may not have happened.”

I also asked him whether he thinks the PCAOB might ultimately decide to issue similar standards as the European Parliament. “I think you’ve got particular issues in the U.S. in terms of competences and the dynamics as to what powers the PCAOB may or may not have,” he said. “From that point of view, it’s quite a different starting point to where we were, but I think there is certainly a desire to ensure that standards are strengthened in terms of the role of auditors generally.”

At Tuesday’s ACCA panel in New York, he met with some audit firm representatives, and he noted that he held a comparable meeting in Europe. “I did a similar thing in Europe when I first took on the brief,” he said. “I had a roundtable, which was also arranged by ACCA. At that stage, it was fairly early in terms of the debate just starting, and we had very polarized positions, so it was quite useful from that point of view. What I’m conscious of is that whatever we do in the European Union, it does have a bearing on what’s going to happen in the USA. So I’m just keen to get as much input as I possibly can as to people’s views here. Ultimately there is a need to make sure that at a European level, we have an appropriate setup so that we’re not going to end up in a situation where you’ve got unintended consequences and added complications where we can avoid them. If it means coming across here and talking to people, then so be it.”

There will be an enforcement mechanism set up once the E.U. agrees on what to do about audit firm independence, but the exact nature is not clear yet. “Once we’ve got the final agreed text and it’s been implemented, then of course it will be enforced,” said Karim.

But he declined to speculate on what types of disciplinary proceedings or actions there might be if audit firms violate any of the final rules. “One thing I will emphasize is that the overall view is not to put in place a penalizing mechanism,” Karim said. “The starting point and the viewpoint is to ensure that we are creating the context in which our auditors can reach the highest standards that can be expected of them. That’s the view. It’s not to put forward a penal code of some sort.”

Asked about any troubling behaviors the E.U. had seen at audit firms, Karim responded, “What we’re dealing with here is an issue of reality and perception. Following the financial crisis and the ongoing accounting situation, a big part of the debate in Europe has been about accounting, accounting standards, bankers, roles of bankers, auditors, and clear distinctions have not always been drawn where they ought to have been drawn, which has led to an overall perception that there is a need to have a framework to govern—to use a phrase—‘these guys.’ But my view was that it wasn’t simply a case of getting into the politics of doing something. What we needed to do was ensure that we actually identified the issues. And one of the issues that we have been able to identify is that actually there isn’t a huge amount of evidence to underline the so-called ‘accepted fact’ that auditors were not performing the role in the way that they should have been, or that they in some way had been neglectful in their duties, and that has caused a collapse in X, Y and Z.”

While the original European Commission draft law had aimed at ensuring more competition in the audit market, Karim prefers to concentrate on the standards.

The draft report contains a framework for an international outlook in terms of standards for auditing and ethics. Karim's group has been working cloely with the International Auditing and Assurance Standards Board to discuss its ongoing projects on auditor reporting and going concern, as well as with the International Ethics Standards Board for Accountants on its code of ethics On each of those topics, Karim's group is looking to take on a framework approach with the draft regulation and draft directive, and then to supplement it by adopting International Standards on Auditing on a European basis, while relying on the code of ethics.

However, the standards from the IAASB and the IESBA, which operate under the auspices of the International Federation of Accountants, would not be written into law. Instead the standards and the law would effectively complement each other.

At the ACCA panel, Karim hoped to learn more about where the debate in the U.S. over audit firms is heading. “I think on this particular issue, we are someway ahead of the USA,” he said. “I recall being in a place where we had the sorts of debates that are taking place in the USA today, but that’s going back about 14 or 15 months. So it’s to try and get a feel and gauge as to quite where the U.S. is going to go and how that’s going to impact on us.”

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