Governing auditors – the balancing act

Date: 19/05/05

Two MEPs give their views on how to avoid more auditing scandals without over-regulating

There is a need for a mandatory internal rotation of auditors within a firm - but not rotation of entire audit firms, says Wolf Klinz

No legislation, as strict as it may be, can ever fully guarantee the prohibition of criminal activities. All that legislators can do is to make crime as difficult and unattractive as possible and thus ensure that a repetition of scandals such as Parmalat and Ahold becomes improbable.

In March 2004 the European Commission presented proposals for the revision of the 8th company law directive on 'annual accounts and consolidated accounts'. The main objectives are to restore confidence in audits and to raise the competitiveness of European companies. The main thrust of the Commission's proposal is to define auditors' responsibilities more clearly as well as to determine a code of professional practice to ensure impartiality and independence. One central aspect is that the auditor shall be globally responsible for the consolidated financial statements. Consequently, he has to check other auditors' reports (for example, those of subsidiaries). This is an additional check which can help avoid fraud and raise the quality of audits of financial statements. The Commission also hopes for an improvement in quality and more transparency from the introduction of international accounting standards (IAS) as well as application of international standards on auditing (ISA). Through the obligation to create an audit committee for listed companies, auditors are to be protected from pressure from managers. Furthermore, a guarantee of independence is to be achieved through various measures such as rotation.

The Parliament's decision on the Commission proposal is pending. Several committees are involved. The committee on legal affairs is the leading committee and the committee on economic and monetary affairs (ECON), of which I was draftsperson, is involved through enhanced co-operation. We voted on 15 March. The following aspects have been underlined by our committee:

ECON accepts that additional services can be provided to a company by the auditor or audit firm if an objective assessment would conclude that their independence is not compromised and if the level of remuneration does not threaten their independence.

ECON is in favour of the obligation to create an audit committee as it ensures independence, but special purpose vehicles might be exempted from this obligation by the member states. In small- and medium-sized enterprises the function assigned to the audit committee might be performed by the body as a whole, provided that the adequate competence of at least one member is given and provided that the chairman of the (supervisory) board is not the chairman of the audit committee.

ECON supports a mandatory rotation of auditors. It favours internal rotation of auditors within a firm. In contrast, ECON is not in favour of an obligation to rotate auditing firms as exists in Italy.

ECON is of the opinion that a limitation of liability is needed; the Commission did not touch upon the subject in its proposal while the Parliament has. Statutory audit firms are responsible for the quality of their work. But unlimited liability may force auditing firms to adopt risk mitigation strategies. Large audit firms can no longer purchase the professional indemnity insurance cover needed to satisfy their unlimited liability. Those who suffer damage as a result of poor quality might thus not recover their losses.

After the scandals, the markets need a positive signal. I am convinced that the upcoming directive can give this signal. To ensure that the directive will be transposed into national law as soon as possible, the Parliament is trying to achieve a single-reading agreement. Concerning liability, a compromise may be to ask for an impact assessment by the Commission, which should be published in a one-year term. The leading committee has not voted yet; the negotiations with the Council of Ministers and the European Commission are still ongoing.

• German Liberal MEP Wolf Klinz is co-ordinator for the ALDE group on Parliament's economic and monetary affairs committee.

Strict new rules must be limited to audits of firms that are listed on stock exchanges, argues Paul Rübig

Recent scandals in the US and the EU such as Enron and Parmalat showed that statutory audit is a key element in ensuring the credibility and reliability of companies' financial statements. The economy and capital markets have been greatly affected by these scandals.

The European Commission initiated a communication on "reinforcing the statutory audit in the EU" to provide a basis for effective and balanced international regulatory co-operation. Capital markets today are globally linked and therefore a basis for co-operation with third country oversight bodies had to be created.

The directive on statutory audit of annual accounts and consolidated accounts, which broadens the scope of the 8th company law directive, had been begun long before the recent scandals happened. But the proposal will now be adapted to the lessons learned and will be brought in line with new requirements.

With this proposal, the duties of statutory auditors and their independence and ethics should be clarified. Furthermore, public oversight over the audit profession will be ensured and co-operation between oversight bodies and the EU will be improved. A requirement of external quality assurance is also part of the proposal. When the document was submitted to the European Parliament last year, the legal affairs committee was appointed to be the lead committee and Bert Doorn was chosen to be the rapporteur. Three other committees were asked to contribute with an opinion and I was appointed to deliver the opinion for the industry, research and energy committee. In my function as rapporteur I want to point out three major points which are crucial for the directive.

First, the directive should address listed companies only, as the original scope of the directive was too broad and vague. The definition of public interest entities should refer to listed companies, which characteristically have anonymous shareholders or debenture holders, with access only to publicly available information. Small- and medium-sized enterprises would not be able to manage the costs and administrative burden of the obligations of the directive. Unlisted banks or insurance companies are already subject to more than adequate supervision.

Second, the audit committee, as a control body to whom the auditors have to report, should be composed of members of the supervisory board, non-executive management and furthermore members appointed by majority decision by the general meeting of shareholders. If an audit committee is established, it is important to guarantee independence to the executive management.

Third, the rotation of auditors. Two methods have been discussed, the internal and the external rotation. A system of internal rotation with a period of seven years, as adopted in the opinon of the ITRE committee, would at the same time increase the level of independence while avoiding a dramatic increase of costs.

This is due to the fact that the quality of the audit could decrease in a system of external rotation, as the new auditor lacks knowledge of the history of the company and experience with its operation. Referring to the Parmalat case, the external rotation system has failed. The audit company has changed, but also the auditing team has followed to the same auditing company and the same person has been responsible for the continued auditing of Parmalat.

It is foreseen that the Parliament will vote on the Doorn report in the plenary session in September. The input of the Parliament will contribute to preventing another audit scandal as the Parliament is demanding more transparency and independence in the triangle of owners, executive management and audit companies.

I want to point out that this is of utmost importance to guaranteeing well-functioning statutory audit.

• Austrian centre-right MEP Paul Rübig is the co-ordinator for the EPP-ED group on Parliament's industry, research and energy committee.

Two MEPs give their views on how to avoid more auditing scandals without over-regulating.