2 Audit policy
(32116)
15274/10
COM(10) 561
| Commission Green Paper: Audit Policy — Lessons from the Crisis
|
| Legal base | —
|
| Document originated | 13 October 2010
|
| Deposited in Parliament | 22 October 2010
|
| Department | Business, Innovation and Skills
|
| Basis of consideration | EM of 4 November 2010
|
| Previous Committee Report | None, but see footnotes
|
| To be discussed in Council | No date set
|
| Committee's assessment | Politically important
|
| Committee's decision | Not 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
| 
