Audit policy: lessons from the crisis

2011/2037(INI) 24/05/2011

The Committee on Legal Affairs adopted unanimously the own-initiative report by Antonio Masip HIDALGO (S&D, ES) on audit policy: lessons from the crisis.

Members consider that an in-depth debate needs to be relaunched on the function of the auditor and the structure of the audit market given the high degree of market concentration of the Big Four audit firms.

They make a series of general recommendations in which they welcome the Commission’s Green Paper and its proposals (in particular as regards improving the legal rules with respect to auditing). In Members’ opinion, the debate on the role of the auditor should go hand in hand with a strengthening of the role of the audit committee – now largely ineffective – and of the financial and risk reporting that companies are required to carry out. They see as yet no sufficient basis for a final assessment, and therefore remind the Commission that more use of regulations and a wide-ranging, in-depth impact assessment are needed:

looking at the various political options,
focusing on practical issues in line with the principles of ‘better lawmaking’,
addressing the importance of accounting in providing accurate information about the sustainable economic development of companies, and
including an analysis of interest groups in order to clarify the segmentation of the impact assessment study for the various groups, such as SMEs, SIFIs and other listed and non-listed companies.

The role of the auditor: Members welcome the intention of the Green Paper to increase transparency and improve the quality of audit reports in order to contribute to the stability of the financial market and improve access to financing. They are in favour of any measures based on the evidence that costs and burdens to financial institutions, in particular, are outweighed by improving their quality significantly, as well as by regular external evaluation and appropriate regulatory oversight. They stress the need for specific legislation in this area and also call for:

the Commission to present its proposals on corporate governance and audit;
financial institutions’ audit reports to include enhanced disclosure requirements for the valuation of less liquid assets;
the extension of the role of the auditor to include audits of risk reports provided by the entity being audited.

As regards the form that audit reports take, Members consider that these should be brief, contain with clear, concise conclusions,and should address all aspects of the auditors’ statutory remit. Financial institutions’ audit reports should include enhanced disclosure requirements for the valuation of less liquid assets, so as to allow a comparison of financial instrument valuations between institutions.

Other specific recommendations deal with the issue of transparency. Members believe that auditors have both a forward- and outward-looking responsibility. They take the view that information available to auditors that is in the public interest and relates to risk, off-balance sheet operations or future potential future exposures should always be disclosed to regulators and in most circumstances made available to the public.

Members call for the role of the audit committees of all financial institutions to be strengthened by requiring them to approve a risk model assessment which includes firm-specific comparisons to benchmarks including reporting potential future financing needs, bank covenants, future cash flows, risk management, management estimates and adherence to major accounting principles and any foreseeable risks with respect to the company’s business model. They call for this assessment to be presented on an annual basis to the executive and supervisory boards of financial institutions, along with the full audit report, for consideration and approval. They take the view that professional scepticism is vital in auditing and has an impact on each and every stage of an audit. They point out that this scepticism comes about as a result of the objectivity and independence of the auditor, combined with professional judgement developed by experience for which box-ticking procedures cannot be a substitute. They believe that fluent, regular dialogue between the external auditor, the internal auditor and the audit committee is vital to allow effective auditing.

Members believe there is a need for the two facets of auditing – internal and external – to be clearly circumscribed in law. They suggest that the Commission urgently adopts the International Standards on Auditing (ISA), clarified through a regulation, which would make it possible to harmonise audits at European level and facilitate the task of supervisory bodies.

Governance and independence of audit firms: Members are of the view that there is an inevitable conflict in the auditor being appointed and paid by the audited entity. They do not, however, currently see any justification for this appointment to be made by a third party and call for the audit committee’s role to be strengthened. They take the view that the auditor, where that role is a statutory one, should be appointed by the audit committee and not by the management board of the company to be audited. They consider that the audit committee should take steps to ensure that the auditor is independent.

Members support the creation of an international code of good governance for auditing firms that audit public-interest entities.

To strengthen auditors’ independence, Members call on the Commission to deal with the following issues: i) regular changes in internal auditors (preferable to external rotation); ii) a clear demarcation between the audit services and non-audit services that an audit firm provides to a customer; iii) a list of conditions under which accountancy services would be deemed incompatible with audit services; iv) external auditors should be banned from providing to the audited company services that could give rise to non-compliance with the applicable requirements regarding independence, or with other ethical requirements.

Members note in particular that audit services which are deemed to give rise to a conflict of interest must not be carried out by the same company, including certain advisory services and evaluations of complex structured products. They recommend that the audit committee, as an entity of the supervisory board, not the executive board, should decide whether to permit the provision of non-audit services to a given financial company and should negotiate the tender and details of the mandate.

Other recommendations include:

the fees an audit firm or a network of audit firms can charge a single client should be published when they exceed a given threshold ;
supervisors should be able to intervene with checks, limits or other planning requirements when they exceed a certain percentage of its total income, so as to prevent a situation in which the audit firm loses its economic independence;
firms that audit public-interest entities ought to publish their accounts.

Members consider that, where there is proof of abuse of the position of director of an undertaking or of a public-interest entity and/or of the audit firm, it must be possible to prosecute all concerned.

They call on the Commission and the Member States to ensure that audits of public bodies are exemplary and to prevent any conflicts of interest from arising as a result of links between the auditor and decision-makers within the public body being audited

Supervision: in this regard, Members call:

on the Commission to submit a proposal to improve communication between auditors of public‑interest entities and the regulatory authorities;
for the harmonisation of audit supervisory practices ;
for the integration of the European Group of Auditors’ Oversight Bodies into the European System of Financial Supervision, possibly through the ESMA;
for enhanced, two-way communication between auditors and financial supervisors of financial institutions, especially in relation to specific areas of concern;
for the same communication to be established for cross-border entities by auditors and the European supervisory authorities;
on the Commission and the Member States to ensure compliance with the findings published by national audit offices in pursuit of their audit remit.

Concentration and market structure:

Members believe, in view of the current configuration of the audit market, that the collapse of one of the Big Four firms would undermine the credibility of the auditing profession as a whole. They take the view that firms that are deemed ‘too big to fail’ could create the risk of moral hazard and that the contingency plans relating to the major auditing firms should be reinforced; believes, furthermore, that these plans should be designed to minimise the risk of an audit firm leaving the market without good reason and to reduce the uncertainty and disruption that would cause. These plans ought to include a mechanism via which the regulator is informed of any problems threatening an audit firm nationally or internationally, in order to allow the regulators to play their role and handle such situations with due care.

Members support the introduction of living wills for the Big Four audit firms and those auditors providing significant audit services to the financial sector, as well as the laying down of cross-border contingency plans for the orderly transfer of client contracts should a significant player withdraw from the market.

Members emphasise that one of the aims of every action undertaken in the field of auditing must be to develop competition among the various firms operating in the sector, while maintaining audit quality, accuracy and thoroughness. They therefore call on the Commission to establish equal competitive conditions for all firms operating on the auditing market and to simplify the rules governing auditing at European level. This easier access to the market and the removal of obstacles for firms wishing to enter the market are vital if a larger number of participants is to be attracted on to the auditing market. The Commission should explore ways that will allow public-interest entities, the public sector and European institutions better to judge the quality of audit services provided by audit firms, irrespective of their size.

Members also propose: i) the implementation of joint audits; ii) an assessment of the potential benefits and the costs of mandatory introduction both for audit firms, in particular small audit firms, and for audited companies – in particular financial institutions – and how it might affect the concentration of the audit market and financial stability; iii) the introduction of a ban on including in contracts restrictive clauses that favour the Big Four firms.

Members call for mergers between small and medium-sized audit firms to be encouraged. They urge the Commission to look into creating a quality certificate and register for audit companies, so that small and medium-sized audit firms can show that their work is of a satisfactory standard. Members consider that the public procurement sector should aim to use non-Big Four firms and that public bodies should set a benchmark percentage for use of such firms. They call on the Commission, in connection with tendering by public-interest entities, to stipulate that fair access to the tendering process must be provided for at least two non-Big Four audit firms alongside the Big Four firms. They call on the Commission (DG COMP) to conduct a detailed investigation of the audit market.

Creation of a European market: lastly, Members return to the issue of the European audit market and call on the Commission to:

examine to what extent measures to facilitate the cross-border provision of audit services might serve to eliminate barriers to market access and capacity bottlenecks; examine to what extent a European market for audit services might serve to reduce procedural complexity and costs for all market participants, in particular small and medium-sized audit firms;
take all appropriate steps to incorporate into EU law and enforce international auditing standards which can help to establish genuinely equal competitive conditions for audit firms;
come forward with proposals to enhance harmonisation with a view to creating a European passport for auditors, placing particular emphasis on everything that guarantees the auditor's independence;
develop a pan-European liability regime for the auditing profession.