Why are audits important? The role of audits is to contribute to the credibility and reliability of financial statements. Some would argue that both credibility and reliability of this sector have been brought under scrutiny in recent years. This article looks at the recent proposals of the European Commission to restore confidence in financial statements by making the EU audit market more transparent.

On 30 November 2011, the European Commission (EC) published a proposal for a directive[1] to amend the Statutory Audit Directive (2006/43/EC) and for a new regulation[2] on specific requirements regarding statutory audit of public interest entities. This proposal follows the publication of the EC Green Paper on “Audit Policy: Lessons from the Crisis” in October 2010[3] in response to the weaknesses highlighted in the European audit system following the 2008 financial crisis.

Is the EC right to consider new audit proposals?  As Peverenche Berès, Chair of the European Parliament’s Employment and Social Affairs Committee recently commented, even before the current financial crisis we had Enron in the US and the Parmalat scandal in Europe which highlighted major concerns arising from the inherent risks associated with conflicts of interest between large financial institutions and audit firms. Given recent history, such mounting pressure has not left the EC with much choice but to revisit the audit sector and attempt to address the causes for the lack of trust and credibility in the audit system.

The key elements of the EC’s proposals to bring major changes to the EU audit market include:

– Mandatory rotation of audit firms every six years (or nine years where joint audit firms are used), with a cooling-off period of four years. The six year period can be extended to eight years in exceptional circumstances.

– Mandatory tendering of audit mandates for public interest entities (which includes all EU-listed companies and companies in the financial sector).

– Prohibition on contractual clauses entered into between the audited entity and a third party restricting the entity’s choice of statutory auditor or audit firm to one of the large audit firms.

– More detailed rules on the membership of audit committees which must now also comprise of a non-executive member.

– Prohibition on large audit firms (the Big Four) providing non-audit services to audit clients.

– A single market for statutory audits is to be created by introducing a European passport to make it easier for auditors to exercise their profession across Europe.

– The European Securities and Markets Authority is to assume and encourage European supervision and co-ordination of the audit sector within a new framework.

These proposals are a shift from the previous regime designed to rebuild trust in the audit sector. Michel Barnier, the European internal market and services commissioner, believes that the proposals will promote healthy competition and ensure the enforcement of legislation supervising the audit sector which is key to restoring the trust on a vital service.

Whilst changing policies and restoring confidence in the audit sector is the aim of the European Commission, not everyone is convinced.  Matthew Fell, Director for Competitive Markets was recently quoted by the CBI as saying that the proposals will only serve to add to business costs at a time when the focus should be on promoting growth and job creation.  The EC’s own impact analysis estimates that this could cost up to €150,000 a year in extra compliance costs for each large company. He acknowledges that it is good practice for companies to regularly test the market to determine their auditor but that this should be on the basis of frequent tendering rather than rotation. Changes to the system will never be without criticism but it remains to be seen whether the proposals put forward by the EC will put such a strain on large companies.

The proposals tabled by the EC will now be passed to the European Parliament and the Council of Ministers for negotiation and review.  No date has yet been provided for when these proposals will come into law.

Alex Curry

[1] The text of the proposed directive amending the Statutory Audit Directive is available at http://lgl.kn/35393.

[2] The text of the proposed regulation is available at http://lgl.kn/d0f78.

[3] The EC Green Paper on “Audit Policy: Lessons from the Crisis” is available at http://lgl.kn/f8315.

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