With European audit reform pretty much a done deal — albeit considerably watered down from original, draconian proposals — the audit profession and some regulators on this side of the pond think Europe is going down the wrong path.
Legislation is expected to be enacted in April, when the full European Parliament will vote to put into place reforms that call for auditor rotation and prohibitions on non-audit services and third-party clauses.
Brian Hunt, CEO of the Canadian Public Accountability Board, would have preferred "to have seen something like the comprehensive review of audit firms every five years [by the audit committee] as we proposed in our own Enhancing Audit Quality Initiative. We feel there are better solutions for enhancing audit quality. But, when I look at the extremes proposed before, this is not a bad compromise."
John Gordon, KPMG’s Canadian managing partner, audit, said: "We don’t think this is a good solution. There could be significant unintended consequences from the new requirements."
Eric Turner, principal, auditing and assurance standards, with CPA Canada, pointed out that by the time mandatory audit-firm rotation reforms are in place in Europe, Canada will have had some experience with the guidance available under the EAQ initiative. "It will be possible to assess whether our own initiative has been effective in addressing the threats of long-term firm tenure and enhancing audit quality," said Turner.
In January, the EU legal affairs committee voted to approve a draft agreement — the exact details of which are still under wraps — that would include an auditor-rotation requirement of 10 years. That period could be extended by up to 10 years if companies put the engagement out for bid, and by up to 14 years when the company being audited appoints more than one audit firm to carry out a "joint audit."
Also included is a prohibition on audit firms providing certain non-audit services to the public-interest entities they audit. Member states will have the right to allow firms to provide some tax and valuation services to their audit clients, provided they are immaterial and have no direct effect on the audited financial statements. Fees from permitted non-audit services to an audit client cannot exceed 70 per cent of the audit fees.
The new rules will also prohibit the restrictive third-party clauses that require one of the Big Four to conduct certain audits.
"[The rules] are aimed … at strengthening the independence of auditors of public-interest entities as well as at assuring greater diversity into the current highly concentrated audit market," Lithuanian Finance Minister Rimantas Šadžius said in a statement.
The requirements are scaled back from those in a 2011 European Commission proposal that would have mandated rotation every six years, and every nine years in cases of joint audits.
EU Commissioner Michel Barnier, who started the reform process with those 2011 proposals, welcomed the current agreement, saying in a statement that "this is a first step towards increasing audit quality and re-establishing investor confidence in financial information, an essential ingredient for investment and economic growth in Europe.
"Although less ambitious than initially proposed by the [EU] Commission, landmark measures to strengthen the independence of auditors have been endorsed, particularly in the auditing of financial institutions and listed companies. This will ensure that auditors will be key contributors to economic and financial stability."
The EU rules follow similar moves last year by U.K. regulators imposing mandatory audit tendering among FTSE 350 companies. As well, the U.K. competition commission last October required companies to mandatorily tender every 10 years, with those tendering less frequently than five years required to report when they plan to do so.
"Now that the EU proposals are close to being finalized, we’ve taken the common sense decision to delay slightly so that we can ensure our measures are in harmony with theirs," said commission spokesperson Rory Taylor.
The large global firms are less than enthusiastic about the legislation. According to Richard Sexton, PwC’s vice-chairman, global assurance, "this package of regulatory interventions is in danger of undermining the importance of good governance by imposing rules which restrict the ability of shareholders and investors to choose what is best for the companies they own." Moreover, he said, the legislation "would increase cost and complexity for business just as the fragile European economy is recovering. It is hard to see how forcing companies to change auditors periodically does anything to improve audit quality and that case is certainly not borne out in those countries which already have such rules."
Grant Thornton, on the other hand, welcomed the agreement, which according to Ed Nusbaum, Grant Thornton’s global CEO, "Will substantially address investor concerns over sparse communication from the auditor, long tenure of the auditor and excessive volume of non-audit services provided to a company by its auditor."
Chief executive of the Institute of Chartered Accountants of England and Wales Michael Izza said he was pleased decision-makers have managed to come to an agreement. "The debates on audit reform have been going on for three years; a lot of work has gone into it and it carries with it a lot of new requirements, some of which will automatically be translated into law at country level and some that will take longer to trickle through." The focus now needs to move to the transition and practical implications, he added.
Cindy Fornelli, executive director of the U.S. Center for Audit Quality, is against the reform package. Like Hunt, she sees no benefit for audit quality. "There is no evidence to show that mandatory firm rotation improves audit quality, and in fact some studies show it has an adverse effect," said Fornelli. "There is also little evidence that fees from non-audit services adversely affect the quality of financial reporting. "Additionally, these provisions undermine the important role that audit committees have with respect to auditor selection and scope of services. Service providers should be chosen by those best equipped to understand business needs, not the government."
She also said she has serious concerns about the impact these provisions could have for U.S. companies or EU companies with U.S. subsidiaries. "For example, an EU subsidiary of a U.S. company will be subject to these provisions if, for example, the subsidiary is a bank or insurance company, or listed on a European exchange. Likewise, U.S. subsidiaries of European companies also could be affected depending on the decisions made on rotation and non-audit services at the European parent company level. In addition, we are concerned by the provisions because they allow EU member states to go beyond those proposed, for instance, by sweeping in an even broader array of entities than those currently contemplated."
This is something that worries Gordon as well. "There were all sorts of compromises made to push this though," he said. "Individual states have the option to make changes to the legislation to suit their purposes, for example, to shorten the auditor rotation period and relax the rules on non-audit services. What does that do for companies that work all across Europe? … This will add complexity and more risks of unintended consequences."
Gordon also reiterated what Grant Thornton has been saying all along. "The decision on whether or not to keep the auditors should rest with the audit committee, which is entirely consistent with what the Canadian Public Accountability Board is trying to achieve with its EAQ initiative."
Of course, what goes on in Europe doesn’t stay in Europe, agreed Hunt, noting that the U.K. auditor rotation requirements have initiated a number of tenders in Canada through U.K.-based relationships. "In the U.K., most companies that have gone out to tender have actually switched auditors. So, is there going to be an expectation that, if you go to tender, you will switch your auditors? That would be a concern of ours. Tendering and rotation are not good for audit quality. All kinds of research shows that, after a change of auditors, in year one or two, that’s where most frauds or accounting irregularities occur. So, we don’t think that this is a good solution for enhancing audit quality."
Canada is moving forward with the EAQ recommendations, Hunt said. "I don’t want to predict what is going to happen 12 months from now, but we will clearly monitor the activities in the EU and U.S. It will take more than 12 months to see what the impact of all this is."
Turner added that the EAQ initiative concluded that the European remedies "could distract the attention of audit committees and corporate management by calling for tenders and reviewing them at the expense of focusing on audit quality. Further, they may undermine the important role that audit committees play in recommending to the board the appropriate external auditor for the entity, overseeing the auditor’s work and approving non-audit services."
But, he said, "It is evident that the EU reforms will have global implications. According to the proposed timetable, the agreement process will be completed by April 2014 and the requirements of the legislation will be in force from the second quarter of 2016. Affected Canadian companies and their auditors will then have to assess how the final reforms affect them."