EU Audit Reform: A Clash of Values

European Parliament

This post originally appeared on Accountancy Live

In early April, the European Parliament adopted legislation that will profoundly affect the European audit market. Several provisions in this wide-ranging package are welcome, strengthening financial reporting and improving corporate governance. Other measures, however, continue to raise serious concerns – and not just for those investing or doing business in Europe.

As these audit reforms move from adoption to implementation, investors, regulators, auditors, businesses and others must remain vigilant and engaged to ensure the evolving European policy environment for auditors does not harm investor confidence or audit quality. Avoiding negative outcomes will likely prove a challenge.

One reason for this is the risk of regulatory fragmentation. This risk arises in particular from the legislation’s provisions imposing mandatory firm rotation. Under the new reforms, statutory auditors of certain public companies and financial institutions – those designated as public interest entities (PIEs) – must rotate after a maximum initial engagement period of 10 years.

At their discretion, member states can permit extensions: 10 years beyond the initial period, if an audit tender has taken place, or 14 years in the case of a joint audit. They can also shorten the initial engagement period to as little as one year, if they see fit. While it is too early to know what will happen, with 28 member states, it is plausible that one or more will change the EU version.

Risk of Multiple Versions

With the number of possible scenarios, the risk is substantial that multiple versions of audit firm rotation will spring up across the EU. This outcome would be a step in the opposite direction from an important ideal: regulations that protect investors and that work effectively in the context of an increasingly global economy. By leaving member states such latitude to diverge, the proposal could create unnecessary costs and a patchwork of conflicting regulatory regimes – all with questionable benefit, as there is no evidence of a connection between mandatory firm rotation and audit quality.

Another risk is that the reforms will undermine sound corporate governance and sensible business practices. Here, we should remember a fundamental principle – businesses, not the government acting on their behalf – are best suited to choose their own service providers based on their individual needs, structures and operations. In this regard, audit committees are generally tasked with selecting and overseeing auditors, but this important role has already been undermined by the mandatory firm rotation requirements of the EU legislation.

Note also that the changes in the EU requirements include limits on non-audit services (as a percentage of audit fees) and prohibit some services altogether. While it can be beneficial to restrict the scope of certain services that auditors may render to the companies they audit – such rules exist in the United States, for example – the EU’s quite stringent approach further weakens the audit committee as the central mechanism for auditor oversight.

Finally, we must reckon with the strong potential for unintended consequences arising from this legislation. To begin with, the reforms raise the prospect that companies will need to use different audit firms in different parts of the world to comply with the EU rotation requirement. In fact, a multinational company could be forced to work with multiple external auditors, which would increase costs and likely produce inefficiency. It would also create new complexities for audit committees and boards. Technically, the new EU rotation regime applies only to statutory audits; thus one solution is to use two firms, one for the statutory work and one for public reporting. It seems unlikely that companies will want to bear that cost.

Unintended consequences could also hit dually-listed companies. Take EU parent companies with U.S. subsidiaries, for example. While mandatory firm rotation would not apply directly to U.S. subsidiaries, it is probable that the EU parent subject to new law’s requirements would want to have the same auditor for the entire group.

Complexity, unnecessary cost, inefficiency: these factors, among others, were concerns that led to the overwhelming rejection of mandatory firm rotation in the United States. Indeed, when regulators floated the idea in a 2011 concept rule proposal, more than 90 percent of commenters voiced their opposition. Two years later, the U.S. House of Representatives voted with an overwhelming, bipartisan majority in favor of a bill prohibiting mandatory firm rotation.

Of course, in contrast to the United States, the EU policy changes were not motivated from a desire to improve the independence, objectivity and professional skepticism of external auditors. Rather, much of the dialogue has centered around concentration of the largest firms in the EU market and mechanisms to improve competition.

At this juncture, key stakeholders can and should commit to working constructively with European regulators. The goal should be rules that can be implemented by member states with the maximum consistency possible and minimal extraterritorial impact. In the longer term, these policies need to be monitored for their unintended consequences – particularly regarding any erosion of audit quality – and then revisited and revised accordingly.

Photo credit: ? European Union 2014 - European Parliament, via Flickr