The reform of the EU audit sector - 21.02.2019

Droit de l’Audit - « The reform of the EU audit sector and the role of lawyers and auditors as gatekeepers »

« The reform of the EU audit sector and the role of lawyers and auditors as gatekeepers » par le Dr. Sajjad KARIM, Député du Parlement européen (pour le Nord-Ouest de l’Angleterre) rapporteur de la réforme sur la directive audit.

La conférence a été coorganisée avec le Jeune Barreau le 21 Février 2019 à 19h00 à la BGL BNP PARIBAS. L’introduction de la conférence a été donnée par le Président de l’Institut des Réviseurs d’Entreprises, M. Philippe MEYER.

Dear Colleagues,
Dear Hon Presidents,

I will start by saying that change is constant in history, but I will touch more upon this later.

First of all though, I would like to thank all of you for attending tonight’s conference on Reform of the EU Audit Sector. As a lawyer myself, it is a great honour to have been invited as this evening’s guest speaker, as I know that the organisers have a rich history of social, moral and spiritual values that promotes a lively and accessible vision for all practitioners of law.

Allow me to introduce myself. My name is Sajjad Karim ; I am a Member of the European Parliament for the British Conservatives - but I come in peace ! I was the rapporteur for the European Parliament’s Audit Reform package following the 2008 Financial Crisis. The 2014 reforms to the European audit market had a long history and my appointment as rapporteur came after 2011, when the proposals were presented to the Parliament and Council to begin the legislative process. The reform of statutory auditing was however formally under discussion prior to the presentation of the Commission’s proposals and from start to finish the whole process lasted more than five years.

Looking back to the beginning of the 2010s, it is clear why audit became a touchstone issue : in the midst of the financial crisis, many questions were asked of statutory auditors and of their opinions. Was it correct that the audit profession had allowed many financial institutions to engage in risky practices, without raising the alarm.

The Commissioner at the time, Michel Barnier – now a familiar figure to British (and Brexit-obsessed European) political observers – was deeply concerned with resolving confidence in the financial markets.

I can recall meetings with Mr Barnier where he would theatrically unfold his timeline of actions for the financial markets. It extended to many rows and covered a multitude of years. It is easy to forget just quite how broad the reforms were that the Commission at the time felt necessary in order to restore confidence in the markets.

With the audit reform we were at a junction between two aims : to positively contribute to financial market stability and sustainability ; and to tackle concerns about the competitive nature of the statutory audit market.

In some ways the two issues fed into each other ; however it was also clear throughout the five years that the discussion around market concentration were as much political as they were technical matters to improve auditor reporting.

Improving transparency

Now, my interest from the outset was to promote better quality auditing. That interest was pursued through three main pillars of the reform : the improvements to the auditor report ; clarifications on the role of the audit committee ; and better delineation of the boundaries between permissible and impermissible non-audit services.

The European reforms arose at a fortuitous time in the context of international developments in auditor reports. As the Parliament’s work began I struck up a close working relationship with the international bodies responsible for standard setting for auditors. Just as we sought to respond to the weaknesses the financial crisis exposed in our company law and practices, those international bodies were trying to respond in their own way.

This meant that there was an international effort on track to improve auditor reporting that could comfortably dovetail with the European reforms. Central to their efforts was the need to improve the final product of the auditor’s work : the auditor report. The tendency had been for auditor opinions to be expressed in boilerplate language. As such, auditor opinions gave reassurance insofar as they were not qualified. Yet the space between boilerplate language and a qualified opinion is vast. Auditors stood in a privileged position, as informed and independent persons who could add colour to the black and white of the company report and the auditor statement.

Until the audit reform, at least one obstacle stood in the way of the brave auditor, willing to “tell-all” about their client : lawyers !

The risk of litigation has always been a concern for disclosures in audit opinions. Audit firms are rightly concerned about their exposure and the risk of liability, particularly in modern times. For me though, it was important that the audit reform took the international best practice and turned it into European standard practice.

I wanted to ensure that the auditor opinion was a more informative piece of work. That it did not only offer assurance but that it also identified the elements of the audit work that gave rise to concern or required a particular focus.

It should, put simply, fill in the space between the green light reflected by boilerplate assurances and the red light of a qualified opinion.

This is important for two reasons.

Firstly, it allows the investor to gain a better understanding of the state of health of a particular company. Though issues may not be sufficiently serious to give rise to a qualified opinion, it is in the public interest that these emerging issues or areas attracting recommendations for action are highlighted.

An auditor’s work serves both the shareholder and the investor. A more comprehensive disclosure works to their benefit : supporting shareholder value and investor trust, by improving confidence in the robustness of the company statements.

Secondly, these “matters of emphasis” were needed also to respond to misapprehension and disagreement about what an audit report should do. The audit report is not a clean bill of health but rather a view on the correctness of the accounts.

By adding more background in the report about how such a view was reached and what the auditor considered most concerning, it would become possible to gain a greater understanding on the overall health of a company. This could be achieved without exposing auditors to an unbearable litigation risk, as it would be a clearer legal requirement rather than professional choice.

The second element or pillar related to the role of the audit committee. The interface between, on the one hand, the auditor and on the other, company management and board structure needed to be improved.

External corporate governance improvements also went hand in hand with this audit reform. The greater role envisaged for audit committees sat comfortably with improvements to structures elsewhere and emerging best practice for corporate governance.
In my view, the role that the audit committee can perform is extremely important.

The committee is needed to effectively manage the company audit and to ensure a good information flow between auditor and client company. The previous reform to auditing at the European level in 2006 had introduced audit committees as a standard requirement and so it was logical that the 2014 reform built on this work.

A key innovation I introduced was the audit committee report, which is a more detailed and comprehensive report to the audit committee about what the audit has uncovered when compared to the public audit report. This allows effective management of the audit engagement by the company governance structure.

In addition, the audit committee were given various tasks on the appointment and continuing engagement of the auditor. This ensured comprehensive oversight, e.g. the audit committee would be aware on how audit and non-audit services were provided and would take responsibility for tendering processes.

These measures strengthened the internal transparency of the audit engagement. It allowed the corporate structures to be confident that the audit process would be effectively managed and independent of the company’s day to day management. In turn, this supported responsible corporate governance, to the benefit of shareholders.

The final pillar is one that is managed by the audit committee, namely the engagement of the auditor for non-audit services by the audited entity.

This issue was a hot topic for all involved. It touched upon the competition driver that was a political priority for some and clearly had implications for the independence of the auditor in their engagement, thereon affecting the audit reporting.

As part of a package of compromises, the reform sought to divide those possible non-audit services into a blacklist of items, while also imposing a value cap on the total amount of services that could be provided.

The principle I tried to advance though was that the auditor must not correct their own substantive work. This meant that auditors can continue to provide services that are more “formulaic” or were not materially relevant to the financial statements, but those which present difficulties in the true presentation of an unbiased opinion would be forbidden.

This was in line with our objective, to support auditor reporting and trust in that reporting.

As I mentioned, many of my political colleagues and others wished to pursue structural improvements to the audit market. These are clearly long term objectives : the audit sector does not overnight become a marketplace with twenty players.

It is with this in mind that we also agreed to introduce mandatory rotation and systemic audit tender practices. This was intended to bring an end to long-standing audit relationships, where the length of the engagement could give rise to repeated risks of “correcting one’s own homework”.

To ensure that relations between the auditor and the audited company do not become too cosy, a “mandatory rotation” rule was introduced whereby an auditor can inspect a company’s books for a maximum 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.

It is worth noting that there has been consistent investor pressure in favour of reducing auditor terms and improving the critical and inquisitive nature of the auditor-client relationship.

This pressure continues today.

In the UK, recent auditor failures have brought the issues raised by the audit reform back to the fore. The collapse of Carillion, the construction and facilities management behemoth, has raised questions about how effective the audit oversight is. In that case a large company involved in significant government contracts fell almost overnight, yet it had been tendering for government contracts almost up until the shutters came down.

The political fallout in the UK has been significant. The chair of the Business Select Committee in the House of Commons noted during an inquiry : Auditing is a multi-million-pound business for the Big Four. On this morning’s evidence from KPMG and Deloitte, these audits appear to be a colossal waste of time and money, fit only to provide false assurance to investors, workers and the public. [...] Carillion staff and investors could see the problems at the company but those responsible – auditors, regulators, and, ultimately, the directors – did nothing to stop Carillion being driven off a cliff.

The pressure on the audit profession has only intensified with the recent collapse of the bakery chain Patisserie Valerie, where misstatements in the accounts were so serious that the company is now on life-support.

In response to Parliamentary questions, the chair of Grant Thornton stated that it was not expected that auditors should determine whether there is fraud, but rather that the accounts themselves are a reasonable representation of the accounts as a historical statement.

This was rightly contested by other audit companies, who reflected the stance I took in the audit reform. Namely, they underlined to Parliament that an audit should investigate those issues of material significance to the company and to report on them.

It is clear to me that the political atmosphere is changing for the audit profession. The many inquiries in the House of Commons and the current investigation by the Competition and Markets Authority may yet impose stronger restrictions on the audit contracts, including length of engagement and the non-audit services that may be used.

It would not surprise me if this attitude is reflected elsewhere on the Continent. The competition review that the European Commission are required to coinduct every three years as a result of the Regulation shows that the situation in the market has not changed significantly in the last few years.

This should not come as a surprise, as the requirements of the reform impose themselves gradually, as I noted earlier. Nevertheless, we politicians always seek quick results. If those results do not immediately materialise, the rules are often changed.

To close, I would argue that the value of the audit reform is only beginning to emerge and to revise course now would be a mistake. The requirements I pioneered at European level are beginning to unwind themselves now.

The basic requirements on auditor reporting, audit committees and national authority supervision have only been in effect for some two years. In terms of the corporate reporting cycle, we are only at the start in terms of the possible positive impact they bring.

Similarly, audit firms need time to adjust their practices to bring themselves up to scratch with the legal requirements and the audited entity needs to be more responsive to the levels of scrutiny we now expect.

At the same moment, the structural changes in the audit market are also gradually imposing themselves. I have always felt that an expansion from the Big 4 to a broader market base would be preferred, but that an artificial imposition of competition – via an engagement cap or otherwise – would be unwise.

Competitors need time to impose themselves on the market and the tendering requirements are already permitting that. Further consolidations in the lower end of the market will also contribute to this, but to expand the Big 4 to be a Big 6 simply by regulation was never a guarantor of audit quality.

The debate in the UK exposes the remaining central tension : does the audit respond to the popular understanding of what a “guarantee” on the accounts is, i.e. that the company is a good investment ; or the legal understanding, that the accounts themselves are materially correct.

The reforms I guided through the legislative process go some way to resolving that but what we need now is good practice from investors, audited entities, auditors and their supervisors to truly bridge that gap.

We also need to restore trust in small business investment. The financial crisis really undermined investment in small firms, with banks unwilling to lend and new regulations squeezing credit lines further. At the heart was a loss of trust – the same trust that auditing and confidence in financial reporting is supposed to provide.
We have spent a lot of time, political capital and legislative energy in trying to rebuild those investment streams and refuel the engines of the economy – our small businesses.

The risk we face during the turbulent times now is that trust has been eroded in so many of the institutions of our society, via misinformation, mismanagement and misplaced yearnings for « the good old days ». We will have a far harder time recovering from a crisis of the future if broader trust cannot be rebuilt, just as we had to previously rebuild – brick-by-brick, audit reform being one – in the aftermath of the financial crisis.

Pre-Financial Crisis though, there was more of a sense of optimism both economically and politically, with much stronger structures in place. Compare that to now with signs of manufacturing slowing down in Germany and an escalating trade war between the US and China, then with Brexit, Trump and the gradual undoing of all the structures we have worked so hard to build over the past decades - essentially the dismantling of the multilateral order - how are we going to deal with all of this ? This a defining question of our time, but I will say that right now, it does not bode well for our global economic outlook.

On top of this, we have the upcoming European Elections, which are at serious risk of malign foreign influence, as well as a significant populist surge in the number of far-right MEPs, funded by Russia and the so-called Alt-Right in America.

The legislative agenda of the next European Commission could be dangerously thwarted by a gridlocked European Parliament, which would affect all areas of EU policy, not just the Audit Sector.

I will finish where I began :- change is constant in history, but the pace of change is now such that citizens feel unsure, insecure and out of control, questioning the very basis of actualities, in effect devising their own audits where they no longer have confidence in regulators or governments. I will leave you on that note.

Thank you for your time.

 
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