Various Documents considered by the Committee - European Scrutiny Committee Contents


2 Audit policy

(32116)
15274/10

COM(10) 561

Commission Green Paper: Audit Policy — Lessons from the Crisis

Legal base
Document originated13 October 2010
Deposited in Parliament22 October 2010
DepartmentBusiness, Innovation and Skills
Basis of considerationEM of 4 November 2010
Previous Committee ReportNone, but see footnotes
To be discussed in CouncilNo date set
Committee's assessmentPolitically important
Committee's decisionNot cleared; further information awaited

Background

2.1 According to the Commission, the measures adopted in the aftermath of the financial crisis have focussed on the need to stabilise the financial system, with limited attention having been given so far to how the audit function could be improved so as to contribute to greater financial stability. It says that some of the real and perceived failings in the way in which the activities of banks and others have been audited — particularly where those revealing huge losses have been given clean reports — raise questions about the adequacy of the present legislative framework. It has therefore sought in this Green Paper to open a debate, which it sees as part of a wider consideration of issues relating to the financial sector, including those raised in the Green Paper[4] it produced in June 2010 which looked at corporate governance and addressed a number of concerns regarding the audit of financial institutions.

The current document

2.2 The Commission identifies seven headings for discussion — the role of the auditor, the governance and independence of audit firms, the supervision of auditors, the configuration of the audit market, the creation of a single market for the provision of audit services, the simplification of rules for small and medium sized enterprises (SMEs) and practitioners (SMPs), and international cooperation for the supervision of global audit networks.

THE ROLE OF THE AUDITOR

2.3 The Commission observes that the annual accounts of limited liability companies are required by law to be audited, but that this does not mean auditors are obliged to ensure that accounts are entirely free from misstatements, in that they are only required to provide "reasonable assurance" that financial statements as a whole are free from material misstatement. The Commission suggests that auditors thus seek to minimise, rather than eliminate, risk, and that their activities are more geared to ensuring that financial statements are prepared in accordance with the applicable financial reporting framework. It also notes that the knowledge gained by external auditors may be useful to the supervisory authorities, but that any further cooperation between them, although highly desirable, should not blur their respective responsibilities. The Commission goes on to look at a number of different aspects of the audit function.

Communication to stakeholders

2.4 The Commission says it is important to define clearly what sort of information should be provided, and that this should include not only the audit report itself, but also information on audit methodology and the extent to which there has been substantive verification of the audited company's balance sheet. It then addresses the following issues:

—  Higher level of assurance to stakeholders

The Commission says that auditors should provide a very high level of assurance on the components of balance sheets and their valuation, and that it wishes to explore the case for "going back to basics" by focussing strongly on substantive verification of the balance sheet, and relying less on compliance and systems work (which it sees as mainly a task for internal audit). It adds that auditors should disclose which components have been directly verified, and which have been verified on the basis of professional judgement, hypotheses and management explanations, and that, to provide a "true and fair view", they should ensure that substance prevails over form.

—  Auditor behaviour

The Commission suggests that, whilst the primary responsibility for providing sound financial information rests with the company being audited, auditors could actively challenge this by exercising "professional scepticism", possibly resulting in an appropriate "emphasis of matter" in the report. However, it also cautions against a proliferation of disclosures which have less meaning for stakeholders.

—  Qualified audit reports

The Commission comments on the negative perception attached by both clients and auditors to a "qualified" audit report, which it says has led to an "all or nothing" philosophy. It also observes that, unlike credit ratings, auditors do not categorise clients, which it suggests derives from the fact that they are expressing a view on fairness, and not on the relative performance of one entity as compared with another. It says that consideration should be given to whether informative matters, such as potential risks, sectoral evolution, and commodity and exchange rate risks, should be provided as part of the auditor's report.

—  Better external communication

The Commission says that further consideration should be given to the auditor's responsibilities to communicate in order to raise the perception of the value added by an audit, and it notes that the UK has recently sought to make reports more concise and informative. It also raises the question of the extent to which information of interest made available to auditors (such as future risks or events, intellectual property risks, and implications for intangible assets) should be communicated to the public: and it suggests that, since auditors' opinions are often described as "too little too late", the timeliness and frequency of their communication should be considered.

—  Better internal communication

The Commission believes that there should be regular dialogue between a company's Audit Committee, the statutory auditor and the internal auditor, thus ensuring no loopholes in the coverage of compliance, risk monitoring, and the substantive verification of assets, liabilities, revenues and expenses. This would, however, be subject to the proviso that the independence of the statutory auditor should not be compromised.

—  Corporate Social and Environmental Responsibility (CSR)

CSR refers to the way in which companies integrate social and environmental concerns into their business operations, and the Commission suggests that clearer reporting rules may improve the focus on sustainability issues.

—  Extension of the auditor's mandate

The Commission says that the focus of audits has to a large extent been on historical information, and that it is important to consider how far auditors should be forward looking, and should themselves provide an economic and financial outlook for the audited company, so long as this results in real added value for stakeholders.

International Standards on Auditing (ISAs)

2.5 The Commission says that these are set by the International Assurance and Auditing Standards Board (IAASB), and that the Board — with which it is working to improve the governance and accountability of standard setting bodies — performed a thorough revision of ISAs between 2006 and 2009, with the "clarified ISAs" being expected to apply for the first time for the 2010 fiscal year. It suggests that, as a result, it may be possible to enhance fair value accounting, the reporting of estimates and sensitivities, or the approach to transactions with related parties. The Commission also notes the overall support of EU stakeholders for the adoption of ISAs at EU level, coupled with a request for further work to adapt ISAs to the needs of small and medium sized enterprises, and it says that it is considering when and how this might be done. It points out that clarified ISAs have been adopted by the majority of Member States and by many third countries (but not by some key partners, such as the United States).

GOVERNANCE AND INDEPENDENCE OF AUDIT FIRMS

2.6 The Commission points out that audit forms must actively manage their conflicts of interest, but that as — unlike many professional businesses — they have a statutory role, their independence is paramount. It notes that the Directive on Statutory Audit (2006/43/EC) requires statutory auditors to be subject to principles of professional ethics and lays down a number of principles for independence, which have been transposed by Member States either by national specific codes or through binding principles on top of the IFAC Code of Ethics. It says that, notwithstanding this, it would like to reinforce auditors' independence, and to address the inherent conflicts of interest arising from the appointment and remuneration of auditors by the audited firm, low levels of audit firm rotation, and the provision of non-audit services by audit firms.

2.7 It then sets out a number of specific areas for further examination:

—  Appointment and remuneration of auditors

The Commission observes that, although the responsibility of auditors is to shareholders and other stakeholders, they are paid by the audited company, and it says that, where the audit role is one of statutory inspection, it is considering whether the appointment should be the responsibility of a third party (perhaps a regulator) — a concept it suggests is particularly relevant as regards the financial statement of large companies and/or systemic financial institutions. However, it says that the possible benefits should be weighed against the risk of increased bureaucracy.

—  Mandatory rotation

The Commission says that the appointment of the same audit firm for decades appears to be incompatible with the required standard of independence, even when key partners are regularly rotated. Consequently, it believes that the mandatory rotation of audit firms should be considered, whilst recognising that this could lead to a loss of knowledge.

—  Non-audit services

The Commission points out that, although the Directive states that audit services should not be provided where a third party might reasonably conclude that a statutory auditor's independence is compromised, there is no EU-wide ban on auditors offering non-audit services to audit clients. It says that, since auditors should ideally not have any business interest in the company being audited, it would like to examine such a prohibition and the creation of "pure audit firms".

—  Fee structure

The Commission believes that consideration should be given to setting a limit on the proportion of its total fees which an audit firm can receive from a single audit client.

—  Publication of financial statements

The Commission says that thought should be given to how to achieve greater transparency as regards an audit firm's own financial statements, and whether these should be audited. It also suggests that, in view of the potential conflict in being audited by a competitor, it is worth exploring whether this might be done by the statutory bodies which audit accounts of public bodies.

—  Organisational requirements

The Commission says that audit firms should strengthen their corporate governance and organisational requirements so as to further mitigate conflicts of interest and reinforce their independence, and it draws attention to the code of governance recently introduced by the UK.

—  Ownership rules and the Partnership Model

The Commission points out that the Directive requires auditors to hold a majority of the voting rights in an audit firm and to control the management board, and it suggests that the rationale for this should be re-examined. It observes that audit firms have so far operated under the partnership model, but is concerned that, given the size and complexity of some large companies, even one of the systemic firms might not have adequate resources to meet any potential liability claims. Consequently, it considers it worth exploring alternative structures which would enable such firms to raise capital from other sources (which it believes would also help non systemic firms to gain access to more capital).

—  Group audits

The Commission notes that audits of large groups operating in multiple jurisdictions are usually carried out by large global networks, and it says that it shares the concerns of others who consider that the role of the group auditor needs to be reinforced.

SUPERVISION

2.8 The Commission says that public oversight systems play a central role in the supervision of audit firms, and should be organised so as to ensure their full independence from the audit profession. It believes that the supervision of audit firms in Europe should be on a more integrated basis, with closer cooperation between national systems. It says that this could possibly be done through the creation of a "Lamfalussy Level 3 Committee" of the kind which exists for securities, insurance and banking (and which could provide the Commission itself with quality advice on audit matters), or through the establishment of a new European Supervisory Authority: and it would also like to see the supervision of cross-border management entities which cover an audit network's operations in various Member States.

2.9 The Commission considers that there is a need to reinforce a two-way dialogue between regulators and auditors. It notes that auditors of financial institutions and providers of investment services are required under EU law to report to the competent authorities anything liable to constitute a material breach of laws, prevent a company continuing as a going concern, or lead to a qualified audit report, but it says it has no information whether this provision was respected during the crisis. It would therefore like to consider whether communication with the relevant securities regulator should be mandatory in the case of all large or listed companies, with special consideration being given to communication where fraud is involved.

CONCENTRATION AND MARKET STRUCTURE

2.10 The Commission notes that, as a result of consolidation over the past two decades, the market for audits of listed companies is, in the main, covered by the so-called Big Four[5] audit firms, their fees exceeding 90% of total market share in the vast majority of Member States. It adds that entry into this top-tier section of the audit market has been very difficult for many of those mid tier firms capable of auditing large complex institutions. It is concerned that this might lead to an accumulation of systemic risk, with the collapse of a systemic firm disrupting the whole market. It also points out that being an auditor of large listed companies creates a reputational endorsement, which then helps large firms to secure further high profile engagement, thus contributing to a lack of market dynamism — a situation it says is reinforced by some financial institutions requiring "Big Four" auditing as a condition for granting a loan.

2.11 The Commission goes on to list the following measures which it would like to consider:

—  Joint audits/audit consortia

The Commission notes that joint audits as such are enforced only in France, and it says that, in order to allow mid tier non-systemic firms to become active players, this practice should be developed further, possibly by introducing the mandatory formation of an audit firm consortium, with the inclusion of at least one non-systemic audit firm for the audits of large companies.

—  Mandatory rotation of auditors and re-tendering

The Commission believes that mandatory rotation of an audit firm/consortium after a fixed period would not only enhance the independence of auditors, but also help to introduce more dynamism into the market. It suggests that partners should also be rotated, accompanied by mandatory tendering with full transparency as regards appointment criteria and due emphasis placed on quality and independence.

—  Addressing the "Big Four" bias

The Commission says that it would like to examine how far the inclination to appoint a "Big Four" firm is attributable to perception and how much to merit. It will also seek to address the issue of contractual provisions known as "Big Four only clauses", perhaps by means of a European quality certificate for audit firms which would formally recognise aptitude to perform audits of large listed companies.

——  Contingency plan

The Commission says that it will work with Member States, audit firms and other stakeholders to discuss a contingency plan, which would allow for rapid action in the event of the demise of a systemic audit firm, avoid disruption, and prevent further structural accumulation. It believes that the formation of consortia could play a significant role in such a plan, and that, in line with the approach being considered in the banking sector, the concept of orderly failure, including "living wills", especially in the case of systemic audit firms, should be actively explored.

—  Reassessment of drivers of previous consolidation.

The Commission says that it would like to examine to what extent the consolidation of the larger firms has delivered the expected innovation in audit methodology, which it regards as particularly relevant in relation to financial institutions which have developed a plethora of increasingly complex products and processes. It says that it would welcome views on whether the broader rationale for the consolidation of large audit firms over the last two decades is still valid (or indeed whether those consolidations which have taken place should be reversed).

CREATION OF A EUROPEAN MARKET

2.12 The Commission says that, following transposition of the Directive, some big networks have achieved a higher degree of cross-border integration, but that many barriers remain, with low cross-border mobility of audit professionals. It also points out the barriers to cross-border audit operations created by different regulatory layers, and the adverse impact on the development of smaller networks of audit firms arising from the lack of coordination at European and international levels as regards public oversight and quality assurance systems. In particular, it suggests that certain provisions of the Directive could be a potential source of market fragmentation, notably those requiring the approval and registration in each Member State where services are to be provided, and the provision for an aptitude test for an auditor in each Member State where services are provided. It suggests that a single European market for audit services could be based on enhanced harmonisation and a "European passport for auditors", implying the creation of a European-wide registration with common qualification requirements and common governance, ownership and independence rules.

SIMPLIFICATION: SMALL AND MEDIUM SIZED ENTERPRISES AND PRACTITIONERS

Small and medium sized enterprises (SMEs)

2.13 The Commission says that, whilst SMEs obtain value from an audit, this has been identified as a potential administrative burden, and that serious efforts should be made to create a specific environment for the audit of SMEs. It suggests that this might imply discouraging their statutory audit; introducing a "limited audit" or a "statutory review" (where auditors would perform limited procedures so as to detect misstatements due to error or fraud); or, in the case of a prohibition on the provision non-audit services, allowing a limited exemption for SMEs.

Small and medium sized practitioners (SMPs)

2.14 The Commission says that SMPs feel they are surrounded by an ever growing regulated environment, which may not suit their practice or the needs of their SME clients, and that the "limited audit" or "statutory review" could be accompanied by proportionate rules on quality control and oversight by audit regulators, thereby allowing SMPs to reduce their administrative costs.

INTERNATIONAL COOPERATION

2.15 The Commission notes that the Directive provides the basis for close cooperation with audit oversight bodies in third countries, and it says that the first step is to build mutual trust through the exchange of audit working papers. It adds that this would require a Decision from the Commission, with the agreement of Member States and the European Parliament, about the adequacy of third countries' systems, and that such arrangements are possible with a number of countries. It says that this would be followed by mutual reliance between Member States and third countries which have equivalent provisions on matters such as the inspection of audit firms.

The Government's view

2.16 In his Explanatory Memorandum of 4 November 2010, the Minister for Employment Relations, Consumer and Postal Affairs at the Department for Business, Innovation and Skills (Mr Edward Davey) says that, in its response to the Commission's consultation, the Government will say that it is wary of large and risky changes which may impose large costs and have uncertain effects, such as the proposal to break up the Big Four firms. He adds that it will suggest more targeted proposals which are likely, over a period of time, to nudge the audit market towards being less concentrated, improve the content of information about risks in company accounts, or reduce unnecessary burdens on business. These might include mandatory re-tendering for appointment as auditor every five years; greater emphasis on the role and content of the report of the Audit Committee, rather than the report of the auditor; and examination of audit thresholds to make audits for some, if not all, medium sized companies voluntary.

Conclusion

2.17 As will be evident, this Green Paper not only provides an exhaustive analysis of the audit position within the EU, but also contains a number of potentially significant recommendations, and, for that reason, we are drawing it to the attention of the House. Having said that, we do not feel able to reach any more definite conclusions on the basis of the relatively brief remarks provided by the Minister in his Explanatory Memorandum, but we note that the Government will be letting the Commission have its comments, and we assume these will expand on the points which the Minister has highlighted. We would therefore be grateful if the Government could let us see its response to the Commission, at which point we will consider the document further. In the meantime, we are holding it under scrutiny.





4   (31702) 10823/10: see HC 428-i (2010-11), chapter 19 (8 September 2010). Back

5   Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers and KPMG. Back


 
previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2010
Prepared 2 December 2010