The auditing and accountancy world has come under greater scrutiny after the Enron-Arthur Andersen scandal in 2001. While the US legislators reacted quickly with Sarbanes-Oxley, in Europe the response has been more gradual. In Europe, national and EU law makers judged that there was a different legal environment in this region. However, the Parmalat case shows that Europe is not immune to accounting scandals. As one of the measures to improve the transparency and quality of statutory audits in Europe, the European Parliament and the Council of Ministers have now passed a new revised 8th EU Company Law Directive, sometimes also known as the ‘Auditing Directive’.
The EU Corporate Governance Action Plan
In response to major financial scandals in the US and Europe surrounding companies such as Enron, Worldcom, Arthur Andersen and Parmalat, the European Commission published an action plan aimed at restoring the confidence of investors in audited accounts, preventing corporate fraud and improving corporate governance in general. The EU Corporate Governance Action Plan, released in 2003, is wide ranging and will come into force in different phases, starting in 2006. One of the proposed near-term measures is the revision and modernisation of the 8th Company Law Directive.
The EU Corporate Governance Action Plan has been compared to the American Sarbanes-Oxley legislation, and while there are similar objectives, the EU approach is quite different. To start with, EU directives are not laws as such. They are legal instructions, which must be implemented by all EU member states within a given timescale. While a directive will prescribe a desired outcome and set a minimum standard that has to be met by national legislation, it leaves member states with a choice of how to achieve the standards set in the directive. At the same time, member states are free to go beyond the instructions of the directive as it outlines a minimum, but not a maximum, standard. This means that EU directives do not lead to a common harmonised legislation and regulations in all member states, but only guarantee a minimum standard.
The 8th EU Company Law Directive
The existing 8th Directive was adopted in 1984 and defines the rules for approving statutory auditors in the European Union. The new revised version will go beyond that, by not only defining who will be qualified to perform statutory audits, but also establishing much more comprehensive rules on the way European companies and companies operating in the European Union are audited. In addition, the new extended EU 8th Directive introduces controls over audit firms to improve the transparency and reliability of the statutory audit process.
The proposed Directive was published in March 2004 by the European Commission and approved by the European Parliament in its first reading in September 2005.
The new Directive makes significant changes to the rules governing statutory audits. The most wideranging clauses will affect audit firms and so called ‘public interest entities’.
Measures affecting audit firms
Most of the measures will have a direct impact on audit firms and will only indirectly concern the companies that are audited.
Establishment of national oversight boards
According to the Directive, EU member states will have to set up audit oversight boards which will have the responsibility for the approval and registration of audit firms. All audit firms and auditors must be registered and approved by the national audit board. They will then be listed in a publicly available national register of statutory auditors.
Public interest entities
These entities are defined in the Directive as entities that are of significant public interest due to the nature of their business, their size or their number of employees. In particular, the Directive names companies that are listed on a stock exchange, banks and other financial institution or insurance companies. Some criticism has been voiced over the vague and general definition, which could lead to legal uncertainty when member states will decide on definitions of their own in national legislation.
The audit oversight boards will also be tasked with furthering the professional education of auditors and control the quality of auditors in accordance with national and international standards.
If necessary, the boards will have the power to investigate audit firms and carry out disciplinary actions against them. Members must ensure that appropriate sanctioning methods for inadequately executed statutory audits are implemented into national law. These sanctions could be either civil, administrative or criminal penalties.
European Group of Auditors’ Oversight Bodies (EGAOB)
The national oversight entities will be organised on a supranational level in a European network and body called the European Group of Auditors’ Oversight Bodies, (‘EGAOB’). The EGAOB is charged with the support and co-ordination of the new public oversight systems in the different member states. It was created by the European Commission in December 2005 and will be composed of representatives from national oversight boards and audit firms.
Transparency of audit firms
Under the new Directive, audit firms will be obliged to produce an annual transparency report in which they disclose their legal and ownership structure and outline their internal quality control systems. These internal quality control systems must be regularly reviewed and assessed. Firms auditing public interest entities must be reviewed every three years.
In this context, audit firms will also have to declare who they conducted statutory audits for and break down the fees that have been charged. In addition, audit firms must supply information on their internal compensation schemes.
International audit standards
The Directive aims to improve the quality of audits by imposing educational requirements and a common standard audit report based on international standards on auditing (ISAs) established by the International Federation of Accountants (IFAC). The adoption of international standards on auditing by EU audit firms will lead to a convergence of European and international auditing standards.
Liability of auditors
One of the more contentious issues is the question of auditor liability. The Directive demands that the European Commission conducts an impact study on existing auditor liability regulations and ways to limit the potential financial burden for auditors. The Commission has set up a forum which will evaluate the results of the study and make recommendations to the member states.
Measures affecting public interest entities and audit firms
In addition to the clauses on monitoring and controlling audit firms, the Directive introduces measures which will change the relationship between auditors and public interest entities.
Independence and objectivity of auditors
The new directive aims to prevent potential conflicts of interest by stating that auditors should not be able to carry out statutory audits if a financial, business, employment or other relationship between the auditor and the audited company exists, which might compromise the auditor’s independence. At the same time, auditors must refuse non-audit or audit-related engagements if these could compromise their independence as auditors. Audit firms are obliged to confirm their independence in writing and report any threats to their independence to the national oversight boards.
Disclosure of all fees
Public interest entities must disclose all fees paid to audit firms including fees for non-audit services. The objective is to increase the transparency of the audit process. EU member states must ensure that the fees paid are appropriate to guarantee a proper audit and that they are not influenced by fees for additional services.
While the new Directive stipulates that all information and documents obtained by the auditor during the audit process must be treated as confidential, this will not be applicable to investigations by the oversight board.
The new 8th Directive requires companies to change their statutory auditor, but not the audit firm itself, every seven years. This falls short of the initial proposal to rotate the whole audit firm every five years. However, the Directive only represents a minimum standard and individual member states may still adopt more restrictive measures.
Responsibility for the audit
Group auditors will have to take full responsibility for the audit report in relation to the consolidated accounts of the group. In practice, this means that the group auditor’s responsibility may well extend to the work of other audit firms. The provision aims to prevent another Parmalat case, in which no audit firm was ultimately responsible for signing off the group accounts.
Public interest entities, such as banks and companies listed on stock exchanges, are required to establish an audit committee or similar body. This is clearly the issue that will concern companies most, as it will result in a financial and administrative burden. Based on this argument, the European Parliament rejected compulsory audit committees for all public interest entities. Where companies have a two-tier structure, the new Directive leaves the member states free to decide whether audit committees are mandatory or whether the audit committee function could be performed by an already existing supervisory board. Other exemptions exist for special purpose entities (SPEs) and undertakings for the collective investments of transferable securities (UCITS). However, in practice, most public interest entities will have to set up an audit committee or a similar body with clearly defined tasks and responsibilities.
Monitoring of the financial reporting process
The regulation aims to support the independent monitoring of the financial reporting process and prevent any undue influence or pressure by the executive management. For this reason, the audit committee must be composed solely of non-executive directors and at least one audit committee (or similar body) member must have financial expertise in accounting or auditing.
The audit committee has to monitor the effectiveness of the internal audit, internal controls and risk management systems. However, the responsibility for these control systems remains with the executive management.
Appointment and dismissal of auditors
According to the Directive, the audit committee is responsible for the appointment or dismissal of the statutory audit firm. The audit committee approves the fees and terms of the engagement. In the case of a dismissal, the committee must give a significant material reason why the statutory auditor cannot finish the audit and inform the national oversight authorities of the reasons.
Monitoring the audit
The audit committee must supervise the statutory audit and ensure the independence of auditors. Any reporting issues – in particular, material weaknesses with regard to financial controls – must be reported by auditors to the audit committee. It is still unclear whether the audit committee will then need to disclose this weakness publicly or whether it will have the option to remedy the problem without disclosure.
The 8th Directive will change the relationship between auditors and the management of public interest entities. For many companies and audit firms, the changes will not be major as many of the measures introduced by the Directive are already practiced by European companies and audit firms. However, once adopted in national law they will no longer be optional.
The main criticism of the 8th Directive has focused on some aspects of legal uncertainty that are due to the nature of EU Directives. The Directive will only result in a minimum standard. Should some EU member states choose to go beyond the instructions of the Directive and adopt more restrictive measures, this will lead to different legislation and regulations across the EU. Hence, it may lead to different interpretations of the same Directive. However, the EU Directive will set a minimum standard that is capable of minimising the risk of accounting scandals in Europe and it will give member states some flexibility in adapting the measures of the Directive to already existing national legislation.
At the same time, the Directive develops global standards for auditing and ensures that auditors in the EU are better qualified. The system of licensing and oversight of audit firms should also raise the standard of audits in the EU.
The most criticised point has been cost. Given that the role and responsibility of the auditor increases as a result of the Directive, it is likely that auditing fees are going to rise. The auditing committee itself is going to be a cost factor for public interest entities; and due to the extended responsibility and independence of the committee, it is not clear whether companies will find qualified non-executive directors willing to take on these positions.
The European Commission defended the problem of more regulation and higher costs with the costs caused by the Parmalat or Enron scandals. It suggests that efficient and reliable audits will have to come at a cost and points to the gains of restored investor confidence.
When is it going to be implemented
The Directive was adopted by the European Parliament in September 2005. However, the Directive will only come into effect after it has been translated into all 20 official languages of the EU and published in the Official Journal of the European Union. This is anticipated in the coming months and has been delayed as the translation of the Directive is taking longer than planned.
Once the Directive has been published, a two year transposition period begins during which the Directive has to be implemented in national law. This means that public interest entities will be affected by the 8th Directive by mid-2008 at the latest.