Annexes to COM(2010)561 - GREEN PAPER Audit Policy: Lessons from the Crisis - Main contents
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| dossier | COM(2010)561 - GREEN PAPER Audit Policy: Lessons from the Crisis. |
|---|---|
| document | COM(2010)561  |
| date | October 13, 2010 |
At present the cross-border management entities that cover an audit network's operations in various Member States are not supervised; only each "national" component of the network is supervised at Member State level. This mismatch between pan European audit networks and national supervision should be addressed. The supervision of international audit networks could be done at the European level similarly to what was recently proposed for Credit Rating Agencies[31].
The Commission considers that there is also a need to reinforce the dialogue between regulators and auditors. This dialogue should be a two-way process so that supervisors also alert auditors regarding particular areas of concern. In the specific case of financial institutions and providers of investment services, auditors are required under EU law to report promptly to the competent authorities any fact or decision which is liable to constitute a material breach of laws, affect the ability of the company to continue as a going concern, or lead to a qualified audit report[32]. The auditors of investment firms are required to report each year to the competent authorities on a number of issues[33]. The Commission has no information on whether this provision has been effectively respected during the crisis and whether such reporting to competent authorities by auditors took place in individual cases[34]. The Commission would like to consider whether communication between the auditors and the relevant securities regulator should become mandatory to all large or listed companies; special consideration could also be given to communication with appropriate authorities in the case of fraud within companies.
Questions
25. Which measures should be envisaged to improve further the integration and cooperation on audit firm supervision at EU level?
26. How could increased consultation and communication between the auditor of large listed companies and the regulator be achieved?
CONCENTRATION AND MARKET STRUCTURE
The market for audits of listed companies is, in the main, covered by the so called Big Four audit firms[35]. In terms of the revenues or fees received, the total market share of Big Four audit firms for listed companies exceeds 90% in a vast majority of EU member states[36]. Entry into this top-tier section of the audit market has proven very difficult for many mid tier audit firms despite their capacity to work in the international audit market.
Such concentration might entail an accumulation of systemic risk and the collapse of a "systemic firm" or a firm that has reached "systemic proportions"5 could disrupt the whole market.
The market appears to be too concentrated in certain segments and deny clients sufficient choice when deciding on their auditors.
Moreover, being an auditor of large listed companies seems to create a reputational endorsement; such a positive association would then help the large firms in securing further high profile audit engagements and thus contribute to lack of dynamism in the market.
Non Big Four firms on the other hand continue to suffer from a lack of recognition of their capacities by the largest companies. It would appear that there are also instances of "Big Four only" contractual clauses that are sometimes imposed on companies by e.g. financial institutions as a condition to grant a loan.
The Commission would therefore like to consider the following measures:
Joint audits / audit consortia
Joint audits as such are only enforced in France, where listed companies are required to appoint two different audit firms, who share the audit work and jointly sign the audit report. This practice, however, should be developed further to "dynamise" the market to allow mid-tier non-systemic firms to become active players in the market segment of the audits of large corporations, which until now has proven elusive. To encourage the emergence of other players and the growth of small and medium sized audit practices, the Commission could consider 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. Such consortia would need to be established with clear lines of responsibility for the overall audit opinion as well a resolution / disclosure mechanism for differences in opinion between consortium members.
The concept of "joint audit" could also be one way of mitigating disruption in the audit market if one of the large audit networks fails.
Mandatory rotation of auditors and re-tendering
Mandatory rotation can not only enhance the independence of auditors as discussed earlier; it could also operate as a catalyst to introduce more dynamism and capacity into the audit market. One could envisage a mandatory rotation of the audit firm / consortium after a fixed period. To prevent partners from changing firms to "take along" certain clients with them, rotation rules should ensure that not only firms, but partners are also rotated. Such mandatory rotation should be accompanied by mandatory tendering with full transparency as regards the criteria according to which the auditor will be appointed. Quality and independence should be key selection criteria in any tendering procedure. Otherwise, if only a very small proportion of audits of leading listed companies come up for open and fair tender in any given year, attempts to dynamise the market would have limited effect.
Addressing the "Big Four is Best" bias
As a result of the consolidation at the upper end of the market, there appears to be a higher level of "comfort" with the appointment of a "Big Four" firm as a company's auditor. The Commission would nevertheless like to understand how much of this is attributable to "perceptions" and how much to "merit". Making such assessment is facilitated by transparent reporting of inspections as is currently the case in the UK[37].
The Commission will also seek to address the issue of contractual clauses that are informally referred to as "Big Four only clauses"[38]. One avenue to explore might be the creation of a European quality certification for audit firms which would formally recognise their aptitude to perform audits of large listed companies.
Contingency plan
The Commission will work with Member States, audit firms and other stakeholders, including international fora, to discuss a contingency plan. Such a plan should allow for a rapid resolution in the event of the demise of a systemic audit firm, avoid disruption in the provision of audit services and prevent further structural accumulation of risk in the market.
Within the context of a contingency plan, it has to be noted that the formation of consortia could play a significant role. In the instance of the demise of one of the consortium members, the "surviving" firm should be able to ensure continuity of the audit until more "permanent" arrangements are in place.
In keeping with the approach being considered in the banking sector, the concepts of orderly failure, including "living wills", especially in the case of systemic audit firms, should also be explored on a proactive basis.
Reassessment of the drivers of previous consolidation
The Commission would like to examine to what extent the consolidation of the larger firms has delivered the innovation in audit methodology that was expected; this is of particular relevance in the context of the audit of financial institutions where the latter developed a plethora of products and processes that became increasingly complex over the period.
The Commission would welcome views on whether the broader rationale for consolidation of large audit firms over the past two decades (i.e. global offer, synergies) is still valid or whether there is a need for a rethink. Moreover, in view of the systemic risk represented by the large, global firms, the Commission would also welcome views on whether the consolidation of the past decades should be reversed.
Questions
27. Could the current configuration of the audit market present a systemic risk?
28. Do you believe that the mandatory formation of an audit firm consortium with the inclusion of at least one smaller, non systemic audit firm could act as a catalyst for dynamising the audit market and allowing small and medium-sized firms to participate more substantially in the segment of larger audits?
29. From the viewpoint of enhancing the structure of audit markets, do you agree to mandatory rotation and tendering after a fixed period? What should be the length of such a period?
30. How should the "Big Four bias" be addressed?
31. Do you agree that contingency plans, including living wills, could be key in addressing systemic risks and the risks of firm failure?
32. Is the broader rationale for consolidation of large audit firms over the past two decades (i.e. global offer, synergies) still valid? In which circumstances, could a reversal be envisaged?
CREATION OF A EUROPEAN MARKET
Some progress was recently achieved with the transposition by the Member States of Article 3 of the Directive, which provides for a possibility of cross border ownership in audit firms. Following the implementation of this article by the Member States, some big networks achieved a higher degree of integration. However, many barriers to integration of the European audit market remain and cross-border mobility of audit professionals is still low.
Regulatory layers at national, European and international levels have led to a degree of complexity that creates barriers to the cross-border operation of audit firms, especially for smaller and medium sized firms. Such complexity has also prevented smaller networks from growing and making inroads into the market for the large company audits. The lack of co-ordination at European and international levels concerning public oversight and quality assurance systems might also deter the development of smaller networks of audit firms.
Certain provisions of the Directive could also be seen as a potential source of the fragmentation in the market:
- Article 3 of the Directive requires the approval and registration in each Member State where the services are to be provided;
- Article 14 of the Directive provides for an aptitude test in each Member State for an auditor to be allowed to provide services.
The above requirements differ from the general rules applicable to other regulated professions[39] and act as a barrier to the mobility of individual auditors.
A single European market for the provision of audit services could be based on enhanced ("maximum") harmonisation and a "European passport for auditors". This would imply creating a European-wide registration with common professional qualification requirements and common governance, ownership and independence rules applicable across the European Union. If European supervision of auditors were reinforced along the lines discussed in Section 4, one possibility to explore further could be to require these auditors to be registered and brought under the oversight of a single regulator in a manner similar to what was recently proposed for Credit Rating Agencies[40]. Such a system could also encourage more competition in the market for large audits as it would simplify the development of European audit networks and reduce the costs of providing audit services on a Europe wide basis.
Questions
33. What in your view is the best manner to enhance cross border mobility of audit professionals?
34. Do you agree with "maximum harmonisation" combined with a single European passport for auditors and audit firms? Do you believe this should also apply for smaller firms?
SIMPLIFICATION: SMALL AND MEDIUM SIZED ENTERPRISES AND PRACTITIONERS
Small and Medium Sized Enterprises (SMEs)
While SMEs get value from an audit in terms of enhanced credibility of financial information, statutory audits have also been identified as a potential source of administrative burden. Serious efforts should be made to create a specific environment for the audit of SMEs. These could imply:
- Discouraging the statutory audit of SMEs.
- Alternatively, where Member States want to maintain some form of assurance, introducing a new type of statutory service adapted to the needs of SMEs such as a "limited audit" or a "statutory review" where auditors would perform limited procedures so as to detect misstatements due to error or fraud. The approach of mandating a limited review for small companies has been followed by Estonia, and is being considered by Denmark. Switzerland also follows such an approach; limited reviews are generally accepted in the USA.
- In the instance of the prohibition of non audit services as discussed in Section 3 above, consideration could be given to providing for a safe harbour which, subject to appropriate safeguards being in place, would allow the auditor of an SME to continue providing certain non audit services to that company – e.g. assistance in their access to credit, in tax returns, payrolls, or even accounting.
Small and Medium Sized Practitioners (SMPs)
SMPs feel that they are surrounded by an ever growing regulated environment which may not necessarily suit their practice or the immediate needs of their SME clients. To ensure appropriate conditions for the development of such firms, the "limited audit" or "statutory review" referred to above could be accompanied by proportionate rules on quality control and oversight by audit regulators. This would allow SMPs to reduce their administrative costs while helping them in servicing their clients better.
Questions
35. Would you favour a lower level of service than an audit, a so called "limited audit" or "statutory review" for the financial statements of SMEs instead of a statutory audit? Should such a service be conditional depending on whether a suitably qualified (internal or external) accountant prepared the accounts?
36. Should there be a "safe harbour" regarding any potential future prohibition of non-audit services when servicing SME clients?
37. Should a "limited audit" or "statutory review" be accompanied by less burdensome internal quality control rules and oversight by supervisors? Could you suggest examples of how this could be done in practice?
INTERNATIONAL CO-OPERATION
In relation to international cooperation on audit firm oversight, the Directive provides the basis for close cooperation with audit oversight bodies in third countries.
The first step in international cooperation is building mutual trust through the exchange of audit working papers between European oversight bodies and their counterparts in third countries. Such an exchange of audit working papers requires a Decision from the Commission, with the agreement of Member States and the European Parliament, which declares that third countries' systems adequately protect professional and personal data. Member States' authorities may enter into bilateral arrangements for the exchange of audit working papers with their counterparts in those third countries whose oversight systems have been declared "adequate". Following Commission adequacy decisions adopted this year, such arrangements are possible as regards the co-operation with the audit oversight bodies of Australia, Canada, Japan, Switzerland and the United States.
The second step would be mutual reliance between Member States and those third countries which have equivalent provisions on matters such as inspections of audit firms. The Commission, with the agreement of the Member States and the European Parliament, is in the process of adopting a Decision to determine which third countries are equivalent to the EU. Mutual reliance will allow for a more effective and efficient oversight of global audit firms. It will also avoid duplication of efforts in the supervision of cross border firms at an international level.
As mentioned before, the supervision of the auditors of large groups which operate in multiple jurisdictions is a matter of concern. In addition to any arrangements which need to be put in place to allow the group auditor to assume its role and responsibilities, the Commission will discuss with its international partners what other measures should be adopted at the global level for the supervision of group audits and global audit networks.
Questions
38. What measures could in your view enhance the quality of the oversight of global audit players through international co-operation?
NEXT STEPS
This Green Paper will be open for public consultation until the 8th of December 2010 . Responses should be addressed to markt-greenpaper-audit@ec.europa.eu . All contributions will be published on the DG Internal Market and Services website unless a contributor requests otherwise, as will a Feedback Statement summarising the responses to this consultation. It is important to read the specific privacy statement attached to this Green Paper for information on how your personal data and contribution will be dealt with.
The Commission will host a high level Conference on 10 th February 2011 . The Conference will aim at discussing the present Green Paper and the main findings of this consultation with all stakeholders and explore possible ways forward. Once this consultation phase is closed the Commission will announce any appropriate follow up measures and proposals in 2011.
[1] Commission Communication of 4 March 2009 to the Spring European Council, "Driving European Recovery" - COM(2009) 114. Commission Communication of 4 March 2010 COM(2010) 2020 Commission Communication: EUROPE 2020 A strategy for smart, sustainable and inclusive growth.
[2] House of Commons Treasury Committee, Banking crisis: Reforming corporate governance and pay in the City p76, 2009 http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/519/519.pdf
[3] “Should statutory audit be dropped and assurance needs left to the market?” Stephen Haddrill, ICAS Aileen Beattie memorial event –28 April 2010.
[4] Maastricht Accounting, Auditing and Information Management Research Centre: The Value of Audit, 1 March 2010.
[5] Results of the public consultation by the Commission (IP/08/1727) on 15/07/2009: " …given the lack of players perceived as having the capacity to audit financial institutions, the collapse of one of the Big 4 would be even more serious for this category of client. Such a loss would also have a serious impact on public confidence for audit services. Given the key role of auditors in the relationship between companies and investors, it could also result in a crisis of confidence in financial markets. The current concentration in the market for large public company audit services therefore poses a threat to financial market stability." http://ec.europa.eu/internal_market/auditing/docs/market/consultation2008/summary_report_en.pdf . See also the study on the ownership rules that apply to audit firms and their consequences on audit market concentration, Oxera, October 2007.
[6] IOSCO http://www.iosco.org/library/pubdocs/pdf/IOSCOPD269.pdf: "The independent audit function is a contributor to investor confidence in the capital markets. A contingency situation involving an audit firm can temporarily disrupt the normal operations of the audit function in a capital market. Disruptions in the availability of audit capacity and audit services can also occur on an international scale if a global audit firm is involved in a contingency that develops into a crisis. By anticipating issues and conditions that may arise and creating securities regulator contingency plans, IOSCO members can seek to minimize potential disruptions and thereby support confidence in the markets."
[7] COM(2010)284 final.
[8] The Fourth Council Directive 78/660/EEC of 25 July 1978 on the annual accounts of certain types of companies, the Seventh Council Directive 83/349/EEC of 13 June 1983 on consolidated accounts, Council Directive 86/635/EEC of 8 December 1986 on the annual accounts and consolidated accounts of banks and other financial institutions and Council Directive 91/674/EEC of 19 December 1991 on the annual accounts and consolidated accounts of insurance undertakings require that the annual accounts or consolidated accounts be audited by one or more persons entitled to carry out such audits. Directive 2204/109/EC of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market requires in Article 4(2)(a) that issuers' financial reports comprise audited financial statements.
[9] Article 51a 1(a) of Directive 78/660/EEC on the annual accounts of certain types of companies.
[10] Reasonable assurance is usually defined as a high, but not absolute level of assurance.
[11] International Standard on Auditing (ISA) 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing , paragraph 11. Fraud in the context of an audit means an intentional act by someone in a company to obtain an unjust or illegal advantage. The concept of fraud probability may be developed further in this context as an important feature.
[12] Auditors reduce audit risk by means of various procedures, including identification of a company's risks, an assessment of relevant internal controls, tests of samples, direct confirmations from third parties, discussions with management, etc. Determining the level at which a misstatement would be material is a key step in this regard.
[13] IAS 1, paragraphs 17 and 21 and IFRS framework. Other relevant principles include neutrality, completeness and prudence.
[14] See question 3.1 in Green Paper on Corporate Governance in financial institutions and remunerations policies- COM (2010)284 - page 15: "Should cooperation between external auditors and supervisory authorities be deepened? If so, how?" In the various responses received so far, there seems to be a general support for improving co operation between external auditors and supervisors.
[15] The Financial Services Authority (FSA) and the Financial Reporting Council (FRC) have issued a discussion paper in June 2010 which questions whether the auditor has always been sufficiently sceptical and has paid sufficient attention to indicators of management bias when examining key areas of financial accounting and disclosure which depend critically on management judgement. – http://www.frc.org.uk/press/pub2303.html
[16] Professional scepticism may also play an important role in the detection and prevention of fraud.
[17] An emphasis of matter paragraph is included in the audit report when an unusual item occurs but which, in the opinion of the auditor, is fundamental and therefore requires disclosure to enable the user(s) of the financial statements to have a better understanding. It is also worth noting that an "emphasis of matter" paragraph does not affect the auditor’s opinion on the financial statements.
[18] The IOSCO (International Organisation of Securities Commissions) has made suggestions to enhance the auditor's report with a view to reduce the expectation gap, to avoid technical jargon, and to revisit the binary nature of audit opinions. Improving the auditors' reports is also on the IAASB's [International Auditing and Assurance Standards Board] agenda for the coming years.
[19] See summary of comments on the consultation, March 2010 athttp://ec.europa.eu/internal_market/consultations/2009/isa_en.htm
[20] The Code of Ethics developed by a board of the International Federation of Accountants is used as a benchmark by practitioners due to adherence of their professional chamber or their firm to the IFAC standards. Codes developed by regulators at national level are generally more stringent than the IFAC Code.
[21] Such a model has still not been tested (with the exception of German cooperatives and savings banks).
[22] In a study performed in 2006, more than half of the respondent companies reported that their auditor has served the company for more than 7 years, and 31% reported that the change of an auditor has not occurred for more than 15 years: the general tendency is the bigger the audited company, the lower the switching rate. (Study by London Economics on the Economic Impact of Auditors’ Liability Regimes; September 2006, table 22, page 43: http://ec.europa.eu/internal_market/auditing/liability/index_en.htm).
[23] It should be noted that under US laws, the auditors of listed companies are prohibited from providing a number of non-audit services to their clients. This has ramifications in the EU for the provision of non audit services to the companies listed in the US.
[24] However in this regard, the UK FRC has recently made specific observations - press release POB PN 60 of the Audit Inspection Unit of the Financial Reporting Council, 14 September 2010.
[25] For example: paragraph 290.222 of the IFAC Code of Ethics states that an auditor of a public interest entity shall disclose its clients situations where the fees from that client represent more than 15% of the total fees received by the firm.
[26] Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit rating agencies.
[27] Audit Firm Governance Code of the FRC and Institute of Chartered Accountants in England and Wales (ICAEW), January 2010.
[28] Article 3 of the Directive 2006/43/EC on Statutory Audit.
[29] Public consultation on control structures in audit firms and their consequences on the audit market, July 2009: http://ec.europa.eu/internal_market/auditing/market/index_en.htm
[30] Any option for a new Committee or a Supervisory Authority would also need to be assessed in terms of the impact on the EU budget.
[31] Proposal for the Regulation of the European Parliament and of the Council on amending Regulation n°1060/2009 (EC) on credit rating agencies, Com (2010)289 final.
[32] Article 55 of Directive 2004/39/EC of 21 April 2004 on Markets in Financial Instruments. Article 53 of Directive 2006/48/EC of 14 June 2006 on the taking up and pursuit of the business of credit institutions.
[33] Article 20 of the Implementing Directive 2006/73/EC of 10 August 2006.
[34] Commission Staff Working Document (accompanying Green Paper on Corporate Governance in financial institutions and remunerations policies) SEC (2010) 669 - page 33, point 6.1.1.
[35] Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers and KPMG.
[36] Study by London Economics on the Economic Impact of Auditors’ Liability Regimes; September 2006, table 5, pages 22-23. http://ec.europa.eu/internal_market/auditing/liability/index_en.htm
[37] Press release POB PN 60 of the Audit Inspection Unit of the Financial Reporting Council, 14 September 2010.
[38] "Restrictive bank covenants keep Big four on top" (Christodoulou, 2010), Accountancy Age, 17 June 2010.
[39] Rules stated in the Directive 2005/36/EC on Professional Qualifications and in the Service Directive 2006/123/EC.
[40] Proposal for the Regulation of the European Parliament and of the Council on amending Regulation n°1060/2009 (EC) on credit rating agencies, Com (2010)289 final.