Documents considered by the Committee on 15 December 2010 - European Scrutiny Committee Contents


1 Audit policy


(32116)
15274/10

COM(10) 561

Commission Green Paper: Audit Policy — Lessons from the Crisis
Legal base
DepartmentBusiness, Innovation and Skills
Basis of considerationMinister's letter of 10 December 2010
Previous Committee ReportHC 428-viii (2010-11), chapter 2 (17 November 2010)
To be discussed in CouncilNo date set
Committee's assessmentPolitically important
Committee's decisionFor debate in European Committee B

Background

1.1 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. It says that some of the failings in the way in which the activities of banks and others have been audited raise questions about the adequacy of the present legislative framework, and it therefore put forward in October 2010 this Green Paper to open up a debate.

1.2 As we noted in our Report of 17 November 2010, the Commission identified seven headings for discussion — the role of the auditor (covering assurance for stakeholders, auditor behaviour, qualified audit reports, better communication, and Corporate Social and Environmental Responsibility); the governance and independence of audit firms (including appointments and remuneration, mandatory rotation, non-audit services, publication of financial statements, organisational requirements, ownership rules and the partnership model, and group audits); the supervision of auditors; the configuration of the audit market (including joint audits and audit consortia, mandatory rotation and re-tendering, addressing the "Big Four" bias, contingency planning, and a re-assessment of previous consolidation); 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.

1.3 We were told by the Government that, in its response to the Commission's consultation, the Government would say that it is wary of large and risky changes which could impose large costs and have uncertain effects, and that it would suggest more targeted proposals which would be likely over time to make the audit market less concentrated, improve the content of information about risks in company accounts, or reduce unnecessary burdens on business. It added that 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.

1.4 In drawing the Green Paper to the attention of the House, we said that we did not feel able to reach any more definite conclusions on the basis of the relatively brief remarks provided by the Government, but that we assumed its comments to the Commission would expand on these points. We therefore asked the Government to let us see its response to the Commission, adding that we would at that point consider the document further.

Minister's letter of 10 December 2010

1.5 We have now received from the Minister for Employment Relations, Consumer and Postal Affairs at the Department for Business, Innovation and Skills (Mr Edward Davey) a letter of 10 December 2010, enclosing a copy of the Government's response to the Commission, and the main points in it are summarised at Annex A.

Conclusion

1.6 We are grateful to the Minister for this information, which tends to confirm our initial view that this Green Paper contains a number of potentially significant recommendations, which it would on balance be right for the House to consider at this relatively early stage. We are therefore recommending the document for debate in European Committee.

Annex: Main Points from UK Response to the Commission's Green Paper on Audit ~

Veracity and quality of audit

The Government believes that audit has an important role, but that it is one element in a multi-faceted regime of corporate governance and regulation, alongside accounting standards, dispersed ownership, risk management committees, audit committees, internal auditors, credit ratings, insurance markets, investment analysts, or additional disclosures above those mandated by accounting standards, the law and regulatory and supervisory bodies. It also says that the benefits of audit vary according to company size, and that there is no unambiguous evidence that mandatory audit provides a benefit across the whole economy: on the other hand, it suggests that, where a company has an audit voluntarily, it benefits because of the signalling effect, and that the bigger the company, the more likely it is to have voluntary audit. It also says that the role of audit varies according to the sector involved, there being a clear need for the prudential supervision of key financial institutions.

As regards audit quality, the Government says that this might be enhanced by improving auditor scepticism, and the content of the report of the audit committee of listed companies. However, in the absence of a robust assessment of the economic impacts, it is cautious about increasing the scope of audit in relation to published accounts.

Communication to stakeholders

The Government says that, whilst audit already provides comfort on the financial health of companies, there has for many years clearly been an expectation gap regarding the degree of assurance any system can actually provide. It notes that attempts have been made to reduce this by increasing the quality of audit inspections and auditing standards and professional education, and by publicising the limits of the audit by amendments to audit report requirements.

The Government believes that information on company-specific issues — for example about the degree of aggression in a company's auditing choices, its risk position, and key judgements taken — might best be disclosed in the report of the audit committee, which should be required to give a view on the extent to which accounting standards have been complied with, and to explain the reasons for auditor (re)appointment. At the same time, it points out that the audit committee is a sub-committee of the Board, and that the latter's responsibility needs to be maintained.

The Government also says that audit works best in normal environments, when normal procedures can be expected to uncover normal errors and managerial misstatements, but that it is unlikely to provide a defence against systemic risk, or against material fraud, especially where there is significant collusion by senior management. It adds that professional scepticism is the key to maximising the usefulness of audit; that one difficulty for auditors is the lack of the more finely tuned and graduated forms of reporting found in other fields, such as health and safety, and that it favours an alternative approach involving increased disclosure by directors, and fuller explanations by audit committees (including the length of time an auditor has been in office, and why they have been re-appointed. However, it notes that there are clearly costs associated with the various routes and that it may be hard to achieve the desired benefits swiftly, adding that additional disclosure by directors in the audit committee's report may be the most successful route to follow.

The Government says that there is already adequate and regular dialogue in the UK between internal and external auditors and the audit committee; that it is not yet convinced that the auditor has any role as regards Corporate and Social Responsibility; and that in general there are already well established channels of communication in the UK between auditors ands stakeholders.

International Standards on Auditing (ISAs)

The Government says that the UK has updated its auditing standards to align with new clarified ISAs, and that, since the use of ISAs is currently widespread in the EU, their use by non-binding legal instruments should be encouraged if there was a perceived need for an EU endorsement process. It adds that, if small and medium-sized enterprises (SMEs) continue to be subject fully to statutory audit procedures, it would favour some adjustment as regards the application of ISAs.

Governance and independence of audit firms

The Government notes that auditors are appointed not by the audited company, but by its shareholders, and it has no evidence of systematic problems of auditor independence, adding that the audit committee is best placed to preserve this. However, it would not be opposed to regulators including restrictions on the firms or individuals permitted to conduct public interest audits, or the audit of banks, if a cost-benefit analysis showed this was appropriate. As regards time limits on auditor appointments, the Government does not believe this would promote independence, but says that issues of rotation and compulsory tendering need to be examined in relation to the current concentration in the audit market.

As regards the possible prohibition of non-audit services by audit forms, the Government notes the major changes in the EU regulatory regime since the Enron collapse in 2002, and that requirements on auditor independence are now more explicit, with greater disclosure and transparency. It adds that a consultation earlier this year showed an overwhelming opposition to a ban on non-audit services, and that the UK would not support this.

The Government says that the present system in the UK — which limits to 10% the fees a listed audit firm can receive from a single client (or 15% for unlisted companies) — ensures continuing independence; that audit firms in the UK are subject to a voluntary code of practice regarding disclosure of audit profitability, with those established as limited liability partnerships or companies obliged to publish accounts; that there is a formal benchmark of good governance practice against which the eight audit firms which together audit about 95% of the companies listed on the main London Stock Exchange market can report for the benefit of shareholders; that it would support an examination of the case for alternative structures allowing firms to recapitalise or to grow their practices so as to enter the audit market for the largest companies; and that it supports the proposals regarding group auditors.

Supervision

The Government supports increased cooperation between national regulators, and the establishment of a closer working relationship between auditors and financial service regulators.

Concentration and market structure

The Government suggests that, whilst the market for the auditing of public interest entities in the UK is highly concentrated, it is doubtful whether a failure of a Big Four firm would cause systematic risk, partly because audit is only one element of corporate governance. It notes that joint audits are already legal in the UK, but adds that their use has declined because companies found that a single auditor model was more effective. It is not therefore convinced of the need for mandation in this area: and it questions whether mandatory rotation of audit firms would increase competition in the audit market, suggesting that it would increase costs. It adds that any question of companies using "Big Four only" clauses would be a matter for the competition authorities; and it points out that any enforced break up of firms to reverse past consolidation would have to be on a global scale and could pose a very high risk of unintended consequences.

Creation of a European market

The Government says that it is unaware of any significant problems requiring action at EU level, and that it is vital any changes are backed up by an assessment demonstrating that the benefits outweigh the costs. It adds that, whilst it is favour of harmonisation of audit services, standards would need to be set to preserve audit quality, and that, whilst it also welcomes the creation of a single European passport for auditors and audit firms, this should not be obligatory for smaller firms operating only within one Member State.

Simplification for SMEs

The Government notes that the UK has successfully introduced audit exemptions for small companies without ill effects, as have other countries outside the EU, and it sees no systemic risks from reducing mandatory audit requirements for unlisted companies. It also believes that auditors of SMEs should be allowed to provide a wider range of non-audit services than in the case of listed companies, although it adds that it does not favour a general prohibition on such services for large companies. However, the Government says that the UK has experimented with forms of limited audit, but that these have not proved effective.

International cooperation

The Government says that it supports greater cooperation between national regulators on audit inspections and the oversight of global network bodies, and that such cooperation would be vital if a large firm found itself in difficulty.


 
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