A new EU-regime for statutory audits came into force on June 16, 2014. Although the new framework applies to all statutory audits, the most significant reforms relate to public interest entities (PIEs) which include listed companies, credit institutions, insurance undertakings and potentially other nationally designated entities (with significant public relevance on account of type, size and number of employees). The primary objective of the reform is to increase the quality of the statutory audit by enhancing audit independence and providing investors with better and more detailed information on key areas of risk and fraud.
The most eye-catching reforms require decennial mandatory rotations of PIE-auditors, detailed reporting obligations to enhanced and independent audit committees, the abolition of “big four only” contractual clauses, the prohibition on the provision of specified non-audit services, caps on non-audit fees and disclosure of audit fees exceeding 15% of audit firm fee income.
Reform was considered especially necessary on account of the shortcomings that were brought into sharp focus by the financial crisis; a sense that the relationship between management and auditors was too cosy; a lack of real choice; and a systemic risk at the top end of the audit market.
The reasons given for mandatory auditor rotation were that long professional relationships and commercial pressure to retain such relationships subverted independence, encouraged repeated inaccuracies and militated against fresh thinking. In order to facilitate the smooth transition, an outgoing auditor must now provide the incoming one with a handover file. The 10-year period may be reduced by national governments and in the case of a joint audit the period may be extended to 14 years. As might be expected there are quite involved transitional provisions with member states having 2 years to put in place enabling legislation, three years for the prohibition of “big four only” contractual clauses and the transitional provisions for mandatory rotation subject to longstops of 2020 or 2023.
New rules exist for the composition, role and reporting obligations to the audit committee. In particular, a detailed audit report must be produced for the audit committee (which can remain confidential depending on national legislation). Most members of the audit committee must now be independent, have proven sector relevant experience and play a direct role in the appointment and monitoring of the auditor.
The new rules will also enable 5% of shareholders (of all companies/entities) to initiate an auditor dismissal action and for shareholders to have access to all auditor appointment information.
New rules exist for the provision of non-audit services to PIEs. The regulations provide for a “black list” of services that cannot be provided by retained auditors which include specific tax, consultancy, and advisory services to the audited entity; services that involve playing any part in the management or decision-making of the audited entity; and services linked to the financing, capital structure and allocation, and investment strategy of the audited entity. Some of these may be subject to national derogation if considered immaterial. No restrictions exist for either services that do not appear on the blacklist or for services provided to non-audited PIEs.
Significantly, a cap on fees is imposed for the provision of non-audit services by reference to 70% of annual audit fees over a 3-year period. The fact that audit fees exceed 15% of a firm’s annual fee income must be disclosed to the audit committee who should then carry out a quality control review and restrict the audit engagement to no more than 2 years.
The reforms seek to encourage the development of a level playing field for audit firms at EU-level by establishing a “European audit passport” and it’s hoped that mid-tier audit firms will benefit the most from the amended directive.
From a compliance and governance point of view, opening up and improving the top-end audit market should be commended but there is a risk that the true cost of losing long established and specialist sector expertise may prove disproportionate. Further unintended consequences may involve, perish the thought, fee earners using new client pitches as a pretext for billable hours and the cost of unsuccessful client pitches feeding into hourly audit fees.
The new EU regulatory framework on statutory audit can be found here.
Alistair Craig is a commercial barrister practicing in London.