Reforming EU audit services to restore investors’ confidence

It’s happened at last. A draft agreement between the European Parliament and EU Council, yesterday, follows a trilogue process which broke down towards the end of last year after MEPs couldn’t agree a position to move the process forward.  Now we can expect legislation to open up the EU audit services market beyond the dominant “Big Four” firms and remedy auditing weaknesses revealed by the financial crisis. See the press release here.

Improvement of audit quality and transparency is included and the aim, we are told, is to prevent conflicts of interest and “reform weaknesses in the audit market” (particularly in the audit tendering practices used).

Why is this happening?

The role of auditors was called into question due to the financial crisis. “Reform of the audit market is long overdue and the proposals that were voted through today are unprecedented. This draft legislation will have positive ramifications, not just for the audit market, but for the financial sector as a whole. We are rebuilding confidence, one step at a time”, said Sajjad Karim (Legal affairs spokesperson, ECR, UK), the person responsible for the audit reform package and who has led the process since its inception.

What’s in the draft?

·    Better quality auditing: The law would require auditors in the EU to publish audit reports according to international auditing standards. For auditors of public-interest entities (PIEs), such as banks, insurance companies and listed companies, the agreed text would require audit firms to provide shareholders and investors with a detailed understanding of what the auditor did and an overall assurance of the accuracy of the company’s accounts.

·    Opening up the EU audit market to competition and improving transparency:  As one in a series of measures to open up the market and improve transparency, the agreed text would prohibit “Big 4-only” contractual clauses requiring that the audit be done by one of these firms. PIEs (see above) would be obliged to issue a call for tenders when selecting a new auditor.

·    Rotation: To ensure that relations between the auditor and the audited company do not become too cosy, MEPs agreed on a “mandatory rotation” rule whereby an auditor can inspect a company’s books for a maximum of 10 years, which may be increased to 10 additional years if new tenders are carried out, and by up to 14 additional years in the case of joint audits, i.e. when a firm is being audited by more than one audit firm. The Commission had proposed mandatory rotation after 6 years, but a majority in committee judged that this would be a costly and unwelcome intervention in the audit market.

·    Independence of non-auditing services: To preclude conflicts of interest and threats to independence, EU audit firms would be required to abide by rules mirroring those in effect internationally. Moreover EU audit firms would generally be prohibited from providing non-audit services to their clients, including tax advisory services which directly affect the company’s financial statements.

Next steps

The deal will be put to a vote by Parliament as a whole, when it will be put before 751 MEPs for their consideration at a plenary session in Strasbourg, between 14 and 17 April.

Most interesting for me is that the proposals include a prohibition on Big Four-only contractual clauses. It’s a bit like the guidance given out to managers in the 1980s and early 1990s: “Nobody ever got sacked for buying IBM equipment”. The next few tiers of firms after the Big Four will have to get their act together and their PR machines in action to convince boards and shareholders across Europe and beyond that not only are they up to the job but they can actually do a better job.