Statutory Audit Reformed


1 March 2006 Prof. Henri Olivier


Prof. Henri Olivier, Secretary General of the FEE, welcomes the EU Eighth Company Law Directive. He believes it will both strengthen the standing of the auditing profession and protect the public interest.


Since March 2004, the European Parliament, the European Commission (EC) and the EU member states have been engaged in finalising a revision of the Eighth Company Law Directive on the qualification of statutory auditors. The agreement reached in October 2005 should now allow it to pass into European law in the first half of 2006, and so start the two-year notice period for each member state to ensure their own national law falls into line with the European requirements.

The antecedents of the Directive lie in a 'green paper' published as early as 1996 by the EC, following corporate scandals such as the collapse of the Maxwell Empire and the bankruptcy of the BCCI. The Green Paper addressed most of the key issues related to the role, position and liability of the statutory auditor in the EU.

The EC preferred at that time to take a soft approach to regulation. Accordingly it published two recommendations relating, respectively, to quality assurance for the statutory audit (2000) and to statutory auditors' independence (2002).

Regulatory developments in the US, as well as, to a certain extent, the Parmalat scandal in Italy, forced the European authorities to change tack and opt for regulation instead of soft law. The new Directive on Statutory Audit of Annual and Consolidated Accounts could have consequences just as profound and far-reaching as its famous US counterpart, Sarbanes-Oxley.

A COMPREHENSIVE PIECE OF LEGISLATION

The existing Eighth Directive (1984), which will be replaced, deals with the qualification and registration of statutory auditors and audit firms; it also sets out some high-level principles on ethics and discipline. The new Directive will broadly cover all aspects influencing the quality of statutory audit: qualification and registration, but also ethics and independence, auditing standards, quality assurance, investigation and sanctions, appointment and dismissal.

"The new Directive could have consequences just as profound and far-reaching as its famous US counterpart, Sarbanes-Oxley."

An important part of the Directive is also devoted to public oversight and cooperation between oversight bodies, both within the EU and internationally. One area of agreement is an instrument of 'minimum harmonisation', which simply means that in many areas the Directive sets a minimum threshold that national laws ought to meet, but leaves member states with the flexibility to go beyond that point in their own jurisdiction if they so choose.

Only on a limited number of issues does the Directive restrict the autonomy of member states to provide more restrictive rules. In terms of auditing, the common reference will be the International Standards on Auditing (ISA) issued by the International Audit and Assurance Standards Board (IAASB), as endorsed by the EC. Under limited circumstances, additional requirements or carve-outs are permitted. The Fédération des Experts Comptables auditing & tax global auditing standards support high-quality audits.

PUBLIC OVERSIGHT AND INDEPENDENCE

The Directive addresses the need to establish a common European architecture for the independent oversight and regulation of the profession, which is central to enhancing the credibility of the audit profession, and a key aspect of the Sarbanes-Oxley act in the US. In a discussion paper published in 2004, the FEE called for a coordination of oversight systems in member states. The objective was also to set structures in place at EU level to allow for discussions with the US PCAOB.

Another important aspect of the Directive relates to independence of statutory auditors. The existing Directive provides that auditors shall not carry out statutory audits if they are not 'independent in accordance with the law of the member state which requires the audit' (article 24). The EC recommendation of 2002 helped EU member states to adopt convergent rules based on a demanding system of threats and safeguards, which also forms the basis of the new code of ethics of the International Federation of Accountants.

As expected, the Directive builds further on the recommendation. For instance, it does not prohibit audit firms from providing non-audit services to their audit clients, but it requires them to consider if their independence is under threat and, if there are not sufficient and appropriate safeguards, the firm must withdraw from the audit or the non-audit service concerned.

However, after long discussions in the EU Council of Ministers and in the European Parliament, it was also agreed that further details could be added to the text of the Directive using secondary legislation, especially in the case of public interest entities. A good example can be found in the discussions about mandatory rotation of audit firms.

Notwithstanding evidence provided by independent governmental and academic sources that such a system is detrimental to audit quality, the initial version of the Directive considered that rotation of audit firms, a system which is only applied in Italy, could be a valid alternative to reinforce auditors' independence. The European Parliament removed this provision, but this was compensated for with an additional article recognising that the Directive aims for minimum harmonisation. It is hard to see the benefits to European capital markets of such additional rules beyond the European benchmark.

LIABILITY OF STATUTORY AUDITORS

The original draft Directive was silent on the topic of auditor liability. It is not acceptable that statutory auditors be held accountable for the mistakes of other parties. However, the previous Commissioner in charge of internal market issues, Frits Bolkestein, delivered a speech as recently as 2003 arguing against limited liability for auditors. The Commission was asked to bring forward a report analysing the policy issues involved, and if appropriate, to make recommendations to member states.

The newly appointed Commissioner, Charlie McCreevy, acknowledged in a statement to the European Parliament, that the issue is likely to have an internal market effect, and agreed to submit a report to Parliament before the end of 2006. This will be facilitated by the fact that, in addition to countries such as Germany, Austria or Greece, where a cap on liability has been in place for a long time, different measures to limit auditors' liability have been recently considered or already adopted by other member states, including Belgium, Spain, Italy and the UK.

AUDIT COMMITTEES AND INTERNAL CONTROL

The Directive on statutory audit follows the example of the US Sarbanes-Oxley Act in dealing with audit committees and internal control. These provisions were approved despite intense lobbying against mandatory provisions, and in favour of soft law based on national corporate governance codes using the 'comply or explain' approach.

The main idea is that Europe needs to learn from experience, not least in the US and France, and to move carefully and incrementally to ensure that business and investors recognise that the undoubted additional costs do yield real and worthwhile benefits.

Member states have two years to incorporate the Directive into their national laws. If implementation is reasonably consistent and balanced, we will have a robust system to protect the independence and quality of financial reporting audits in Europe, to the benefit of the public interest and all those who rely on the reports of statutory auditors.

Henri Olivier is secretary general of the Fèdèration des Experts Comptables Europèens, which represents Europe's 44 leading accountancy bodies, with a combined membership of more than 500,000 professionally qualified accountants.