EU audit reform: It’s all in the eye of the beholder

By Fatemeh Jailani, European Affairs Project Director at Mazars Group

The European Audit Reform (EAR) introduces bold changes into the audit market and reinforces communication among companies, auditors and shareholders.¹ Rather than view it as yet another burdensome regulation, appreciate that this reform constitutes a real opportunity to challenge — for the better – the quality of statutory audits and the environment in which they are performed.

2008 – the straw that broke the camel’s back

As backdrop, although noteworthy corporate scandals and small-scale crises occurred over  a number of decades prior to 2008, they pale in comparison to the devastation caused by the global financial crisis. Banks, hedge funds, ratings agencies and even central banks were undoubtedly the primary protagonists in this saga; however, it became apparent to the European Commission (EC) that auditors played a role, too.

In a perfect world, auditors spot problems and communicate them in a report to shareholders, who then can analyse their impact and make a decision as to the ongoing merits of their investment. However, there is growing perception that an auditor’s judgement is influenced by situations where conflicts of interests are high, consequently affecting their sense of responsibility to the public.

But this shortcoming is only part of the problem. The ossification of the market over the past few decades has caused the overall quality of audits to deteriorate, and limiting the entry of a broader set of new players has hindered market competition and impeded potential for innovation. 

EAR objectives are worth defending

The EC launched the EAR with several overarching targets to achieve. These include clarifying the role of statutory auditors; reinforcing their independence and scepticism; facilitating cross-border provisions of statutory audits in the European Union (EU); contributing to a more dynamic audit market; and both improving the supervision of auditors and coordinating audit supervision across the EU.

Today, the EAR translates into the adoption of a regulation that oversees statutory audits of Public Interest Entities (PIEs) and an amended directive that pertains to all statutory audits. Both the directive and regulation must be implemented in EU member states by 17 June 2016. With just months to go, companies and their audit committees must hurry to understand not only the changes that will be introduced and the best way to prepare, but also assume their part in defending the founding goals of the EAR.

What it means to be a PIE within the scope of EAR

The legislation has far-reaching implications for companies who are considered PIEs. Businesses classified as PIEs ² are either entities incorporated in the EU with transferable securities (shares or debt) traded on a regulated market of any member state, or are listed or non-listed credit institutions ³ or insurance undertakings.⁴

Companies must first determine whether or not they are considered a PIE and thus subject to EAR. And a foreign corporation, even though subject to its own country’s rules, must assess whether any of its foreign subsidiaries are considered to be a PIE in the EU, as well.

EAR will bring sweeping changes for PIEs and their auditors. But before plunging headlong into these changes, companies need to appreciate their implications and view them through a prism of different options so that they may develop a relevant strategy that reinforces their corporate governance practices. ⁵

Introducing mandatory rotation and open tenders for PIEs in Europe  Under the new rules, PIEs must rotate their audit firms after a certain number of years and the length of the rotation period may vary. For example, by default, PIEs engaged in a solo audit may keep their service provider for an initial maximum period of 10 years. However, if they wish to extend the period, they must issue an open tender that does not exclude the participation of other firms.⁶ Assuming that the incumbent firm is selected, it could stay in place for an additional 10 years. After 20 years, however, mandatory rotation of the audit firm applies.

Member states also may adopt stricter rotation guidelines, such as a shorter initial maximum period and/or granting or not the possibility to extend the audit engagement following a tender. Since this can present a patchwork of different rules across the EU, it is incumbent upon companies that operate across different member states to learn which rules apply to them and determine whether their audit firm is subject to mandatory rotation or a tender process. ⁷

 If the audit firm is subject to rotation or tendering, the company must define a procurement strategy and have an available pool of audit firms from which to choose. Becoming familiar with both strengths and weaknesses of audit firms will prove vital in making an informed decision as to which ones to invite to tender.

These measures also expand the role of the audit committee to spearhead the process, including engaging with the board of directors and/or shareholders by recommending – at the end of the tender process – at least two audit firms, with a justified preference for one.

In addition, the company, through its audit committee, must prepare for the departure of their service provider, once rotation applies. For example, information may be lost and extra time (and additional fees) may be required to bring the new incoming service provider current.

The merits of joint audit – an alternative to tendering   A compelling feature of EAR is the support shown for joint audit. Depending on the options privileged by member states, joint audit could provide companies with several possibilities. The most noteworthy is that PIEs could engage their auditor for a longer time period – 24 years without interruption – thereby excluding them from the obligation to tender.

Often misunderstood, the benefits of joint audit are both several and obvious and PIEs will need to weigh the advantages against a potentially more unfamiliar process of dealing with two audit firms. The idea of joint audit stems from the ‘four eyes’ principle – two firms working in tandem may discover potential issues before they develop into problems. Requiring both firms to submit one single audit opinion for which they are equally liable promotes a ‘critical eye’, reinforcing auditor independence and objectivity. Additionally, companies can gain deeper technical expertise, broader skills and wider coverage from the knowledge base of two auditors versus one.

Finally, it has been proven in other jurisdictions ⁸  that rotation alone will not address the concentration problems facing the market. Joint audit encourages new entrants into the market place, nurtures competition, helps smaller firms grow and ultimately expands the pool of available audit firms.

From a governance standpoint, joint audit also can ensure a smoother transition. Staggering the two firms’ rotation periods allows the incumbent firm to help bring the incoming firm up to speed.

Prohibited non-audit services, safeguarding independence  To cultivate greater independence, the regulation specifies several services that the audit firm may no longer provide to its PIE audit client 9 and imposes financial caps on revenue  from services that are allowed. ¹⁰ Under these restrictions, companies must select which of the services (audit or non-audit) it wishes its auditor to carry on providing, and then find a new firm to supply the ones that its existing auditor no longer will transact.¹¹

Companies mindful of these all-encompassing independence rules may find that the pool of firms that can provide them with audit services is limited, so they must plan accordingly. The joint audit provision can circumvent this potential issue, as the system would increase the number of service providers within the market.

Finally, companies must ensure that both they and their subsidiaries comply with these independence measures. PIEs operating in the EU will be responsible for assessing and monitoring their auditors to ensure they are not engaging in prohibited non-audit services for subsidiaries, either in the EU or abroad. By the same measure, foreign companies with PIE subsidiaries in the EU are subjected to the same level of compliance.

Empowering the audit committee to uphold the value of the audit report  The legislation proposes a more extensive role for audit committees of PIEs and recognises that properly defining its members’ responsibilities is central to ensure quality throughout the audit process. To this effect, audit committee members may not serve in an executive capacity or be involved in any executive decision-making function within the company. Members also must have relevant accounting and/or auditing experience to be capable of ensuring the integrity of the audit.

From a reporting standpoint, the committee must issue more detailed audit reports to shareholders by incorporating information relating to their audit firms’ engagement and independence, together with specifying the scope and conduct of the audit. Also, in an attempt to render the financial statements more user-friendly, a commentary is also expected on key risks identified and how they have been addressed.

And finally, as a means of reinforcing communication between auditors and audit committees, a specific report must be submitted to the audit committee to support the audit opinion prior to issuing the final report to shareholders.

To prepare for these changes, companies must review, preferably with board members or even shareholders, the composition and functioning of their audit committee and determine if it has sufficient resources to address the new responsibilities stipulated by the legislation. If not, a plan should then be conceived to make the necessary adjustments.

Perception has cursed audits, but can also save them

The 2008 financial crisis saw a resurgence in shareholder demands for enhanced transparency and quality financial reporting. More than the auditors, the role of audit committees and shareholders is central to improving the value of audit reports by challenging auditors to respond to a continually evolving world faced with speedy technological advancement and generational change.  

The challenge facing audits today is perception. Rather than being taken for an added-value service, audits are increasingly being viewed as a commodity. This view encourages harmful trends in reducing audit fees, subsequently damaging overall audit quality and making it difficult for smaller firms to compete. In addition, this weak regard for audits discourages young talent away from the profession, affecting the potential for innovation.

Luckily, perception is not carved in stone. Europe has made a bold stride with EAR and taken a much-needed first step in reframing how audits are perceived and performed. However, be aware that this is a mere stepping stone – not the end solution. Building a secure, relevant and multiplayer audit market relies on the full engagement of companies and, more specifically, their audit committees and shareholders. Their perception and actions will dictate the audit market of tomorrow.

About the Author:

Fatemeh Jailani is European Affairs Project Director at Mazars Group, an international firm present in 73 countries and specialized in audit, advisory, accounting, tax and legal services. Originally an American national, she has worked in Europe over the past seven years with international entities undergoing transformation as a result of changing market trends. In recent years, she has gained expertise in EU financial market regulation and has accompanied various stakeholders in their compliance strategies. She also dedicates her time to Business. For GoodTM – a program endorsed by Mazars as a means to engage companies to act ethically and responsibly in order to build a sustainable future mutually beneficial for business and society. She has a BA from the University of California Los Angeles and an MA in International Economic Policy, from Sciences Po Paris.

Footnotes:

¹ Adopted in June 2014
² Each of the 28 member states can expand the definition of PIE to include other entities.
³ This includes undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits on its own account or electronic money institutions.
⁴ This includes self-employed direct insurance, which either currently are or wish to be established in a member state.
⁵ Member states have 32 options in the regulation and 52 in the directive.
⁶ Firms receiving less than 15% of the total audit fees from PIEs in the preceding calendar year.
⁷ The regulation proposes a transitional regime, and the seniority of the PIE’s current audit mandate will determine when their auditors are subject to rotation, or tender.
⁸ Italy has had mandatory rotation since 1974. An auditor’s term with a client is limited to nine years. Since its implementation, the audit market continues to be dominated by the bigger audit firms.
⁹ These include: tax services; services in which the firm may play a part in the management or decision-making of an audited entity; bookkeeping or payroll services, or preparing accounting records and financial statements; designing and implementing risk management and information technology procedures pertaining to preparing and controlling financial information; legal, valuation, or internal audit function services; engaging in financing, capital structure and allocation, and investment strategy of the audited entity (other than providing assurance services for financial statements); involvement in promoting, dealing, or underwriting shares of the audited entity; and human resources.
¹⁰ Fees for permitted non-audit services may not exceed 70% of the average of the audit fees received for the prior three years.
¹¹ As with the mandatory rotation rules, a member state may add to the list of prohibited non-audit services if it perceives threats to the auditor’s independence.