The European Commission's Proposal for a Revised Directive on the Statutory Audit of Annual and Consolidated Accounts
The consultation paper issued by the DTI
Comments from ACCA
November 2004
Executive Summary
ACCA supports the strengthening of the rules governing the regulation of auditors as a means of helping to restore business and public confidence in the framework of financial reporting in the EU. We welcome the expansion of the range of contents of the directive to cover material such as continuing education and we support wholeheartedly the move towards express recognition of international accounting and auditing standards.
We support the Department's general view that the Directive should concentrate, where possible, on identifying the principles to be adopted by member states and then leave it to member states to decide on the detailed implementation of those principles. This is especially relevant in the case of the treatment of �independence and objectivity' in article 23: for the Directive to impose a hard and fast legal rule that the auditor of any regulated entity should be not in any involved in management decisions would be a disproportionate response to the issue.
In certain respects, we consider that the draft revised Directive moves too far away from its core areas of interest, viz the eligibility of auditors and the conduct of the audit, and loses focus as a result. We believe it would be preferable for the revised Directive to avoid addressing matters such as audit committees and the mode of appointment of auditors, both of which can be addressed more flexibly in instruments other than Directives.
There appears to be an assumption, in parts of the draft revised Directive, that the standard audit engagement will always involve a large or �public interest' entity. This impression comes across, for example, in the provisions on independence in article 23, the appointment of auditors in article 26 and the composition of the public oversight authority (article 31). The vast majority of entities to which the Directive will apply are classified as �small' under the Fourth Directive: even where national legislation has exempted many of these entities from the mandatory annual audit, it is still likely that the majority of statutory audits within the EU will be of smaller companies. The Directive needs to incorporate this reality.
Our responses to specific questions posed in the consultative document are set out in the following paragraphs.
Responses to Specific Questions
Q.1 Scope of the proposed Directive (article 1)
The only comment we would make on article 1 is that the scope of the revised Directive is significantly wider than the scope of the current Directive. To a great extent this expansion is justifiable, but the draft revision now touches on areas of company law and corporate governance which are not immediately relevant to the core issues of the eligibility of auditors or the conduct of the audit. The revised Directive loses some focus as a result. With respect to article 35 in particular, which deals with the mode of appointment of auditors, we believe it would be more helpful to member states to leave such provisions to other company law instruments.
Q.2 The definition of �network' (article 2)
The draft definition needs to be tightened. As it stands, the draft definition could conceivably be held to encompass a professional body to which the auditor or audit firm belonged, or other similar groupings of which they were members. This, clearly, is not the intention of the drafters in imposing requirements regarding �networks'. A definition on the lines of that contained in the 2002 Recommendation, being more closely tied to factors of control and association, would be more helpful and workable. Specifically, the definition needs to include a reference to entities which are �affiliated' with the auditor or audit firm, in line with the EU's own Recommendation and with the definition of �network firm' adopted by the UK Auditing Practices Board. The definition should also cover any person or organisation which an auditor or firm holds itself out as being associated with for the purpose of conducting audit work.
Q.3 The definition of �public interest entities' (article 2)
We note that the definition of this term is being reviewed at Government level. This is, in our view, a highly significant issue and there must be found a workable definition which is based on economic impact.
The provisions that apply only to public interest entities (PIEs) would impose a disproportionate burden on entities that are smaller than the average. While the business categories already identified are those in which public confidence is of a high priority, many individual entities within those categories may not, individually, be of material public significance.
It is not necessary to subject all entities within a sector to the same requirements in order to maintain confidence in that sector. We suggest that the eventual definition makes it clear that the nature of a business is not in itself the determining factor in determining its PIE status, but that its size or number of employees has also to be taken into account. The Department may wish, however, to support the view that listing on a main stock exchange and operation as a retail bank are two key indicators that an entity is a PIE.
With respect to the specific terms �other financial institutions' and �insurance undertakings' however, we consider that including all credit unions within the definition would mean that smaller unions would probably cease to operate � this would have social as well as economic costs.
Q.4 Comments on articles 3(3)(b) and 3(3)(c)
We have two points to make on this question.
Firstly, we consider that the control requirements set out in draft article 3 need to be tightened. As things stand, it appears that an audit firm could be controlled by non-auditors, especially if the firm was partly owned by another firm which was not itself controlled by qualified persons. It seems to us inconsistent that, when auditor independence is one of the main objectives of the revision exercise, the draft should apparently permit unsatisfactory arrangements of this kind.
The revision of the Directive in fact presents an excellent opportunity to strengthen the requirement that an audit firm should be properly controlled by qualified persons and free from undue influence from unqualified persons, whether within or outside the firm. In recent years, ACCA has dealt with a number of cases identified in monitoring visits where artificial arrangements have been made to establish firms which, on the surface, meet the existing criterion of control, but which in substance are under the control and direction of unqualified persons. We have also come across examples of �rubber stamping', where a registered auditor signs audit reports in his firm's name in respect of a client of an unqualified firm without undertaking audit work.
ACCA has dealt with both types of case by invoking its rule (based on a provision of Schedule 11 Companies Act 1989) which states that, for a firm to be eligible, it must have arrangements in place to prevent anyone without a relevant qualification exerting influence on the conduct of audit work. Without a rule of this kind, it would be difficult for competent authorities/member states to deal with the matter. We recommend therefore that a provision of this kind should be incorporated into the Directive.
Second, 3(b) refers to �voting rights' without specifying whether the passage refers to the voting rights of the owners of the firm or the managers of the firm. 3(c) does not define what is to be �the majority' where the management body consists of only two members. It would be sensible to provide for this by indicating that, where there are only two members, the member who has the audit qualification should be deemed to have a casting vote in the event of deadlock.
Q.5 In what language should the aptitude test be conducted (article 14)
The aptitude test must be made available to applicants in all official languages of the particular member state which is considering the application. If there is more than one official language in the state concerned, whether or not the applicant is proficient in the other language(s) of the state will affect his market competitiveness but should not be an issue for his legal authorisation. We query the need for the last sentence of the article, since it does not appear to add anything material.
Q.6 Will the RSBs have difficult in implementing article 15?
We do not envisage any problems complying with these provisions.
Q.7 Will the requirements of articles 16 and 17 impose burdens on statutory auditors and audit firms?
While providing the expanded range of information set out in articles 16 and 17 will impose new burdens on auditors and firms, it will be feasible for them all to comply . The reference in draft article 17 to the �business address' (of owners and shareholders) is an improvement on the terminology of current article 28. But there should be a separate definition of the term �owner' as used in article 17.
Q.8 General comments on articles 21 and 22
We agree with the Department that article 21 should concentrate on establishing the need for member states to identify ethical principles. We also agree that the text as drafted confuses the role of auditors by referring to their �overall responsibility � towards the public.' We suggest that the article could re-drafted more simply as follows:
�Member states shall ensure that all statutory auditors and audit firms are subject to principles of professional ethics which cover, at least, their integrity, objectivity, professional competence and due care.'
With regard to article 22, in our experience firms often use client confidentiality as a reason for not allowing regulators to access certain information. Firms are thus liable to interpret their obligations to co-operate with regulators as narrowly as legislation permits. A common issue is where a firm refuses to allow the regulator access to any documents other than those directly connected to audit work. Article 29 in fact requires competent authorities to assess the internal quality review system of the audit firm as well as to inspect individual audit files. This may involve access to documentation which the firm does not regard as relevant but the regulator does � e.g. general correspondence files. It should be generally understood by member states that information which the regulator regards as being relevant should be discloseable to a regulator without there being any breach of client confidentiality.
Q.9 Will article 23 have adverse costs for audit firms and/or audited entities?
We agree strongly with the Department's provisional conclusion that the current wording of draft article 23 needs to be amended in order to correspond more closely with the approach and terms of the 2002 Recommendation on auditor independence. As it stands, the article is disproportionate to the extent that it provides that an auditor should in no way be involved in management decisions. The APB in the UK has, recently, considered this issue at considerable length and concluded, provisionally at least, that, provided adequate safeguards are put in place, audits of small entities need not require an auditor to be totally without involvement with the entity's management. The Commission needs to acknowledge the particular circumstances of small entities and provide for the continuation of the threats and safeguards approach.
There are two elements in the first paragraph of article 23 as drafted. The first sentence says that it is the responsibility of member states to ensure that a statutory auditor or audit firm is �independent� of the audited entity and that the auditor or firm should be in no way involved with the entity's management decisions. The second element says that an auditor or firm must not carry out an audit if there are specified circumstances which �might' compromise the independence of the auditor or firm.
We have no problem with the basic idea that an auditor should be independent of the audited entity. We also support the recognition of the factors which have a bearing on whether or not an auditor can be independent in any given situation.
We have, however, two concerns about the final wording of this section. Firstly,
we would not wish to see a hard and fast legal rule which says that an auditor or firm must not be �in any way' involved in management decisions of the audited entity. Such involvement may occur as part of advice arising from the audit (such as journals to correct an error). It may also occur in relation to non-audit services, but in such cases it is reasonable, in our view, for there to be provision for auditors to put in place adequate safeguards to mitigate the threat to their independence. There is, in any case, no need to deal separately with one circumstance that may give rise to threats when other, potentially more serious circumstances are not singled out. There is a danger of unbalancing the requirements and causing confusion, as happened recently in the UK and Ireland, where the Auditing Practices Board has issued new ethical standards for auditors that refer to �management threat'. The drafting process for these new standards has, however, now accepted provisionally that, especially in the case of small companies, the perception of conflict of interest may be mitigated by disclosure of the reasons why the auditor considers the threats to independence have been adequately dealt with and resolved.
Secondly, the text must make clear that it is for the auditor or firm to make the decision as to whether or not independence is compromised, albeit after following clear guidelines as to how to assess this. We would prefer it if the article was re-drafted on the basis suggested by the Department, i.e. to reiterate the basic principle of auditor independence and then to refer to the threats and safeguards approach.
As regards the use of the term �might' in article 23.1, we do not see that the inclusion of this term is necessarily intended to preclude the auditor or firm from accepting an appointment if any of the specified circumstances apply. We do not think that it would prevent a member state from providing in its own national legislation that an auditor should not carry out an audit if, in his view , after carrying out specified checks, the appointment might or would have the effect of compromising his independence. Moreover, we would point out that there are several separate references to the provision of valid non-audit services in both draft articles 23.2 and articles 25, 38 and 40; their inclusion appears to accept implicitly that, in some circumstances, non-audit services will continue to be provided.
We do not have a problem with the basic rationale of the second paragraph of article 23, since we consider that it is reasonable to require auditors to record the facts relating to their decisions as regards threats and safeguards. The use of the word �all', however, is inappropriate. The objective, surely, should be to ensure that documentation is necessary only in respect of significant threats.
Q.10 Specific comments on article 25
We acknowledge the validity of the purpose of draft article 25 but agree with the Department's provisional view that sub-paragraph (a), as it stands, is misguided since it is not feasible to link directly in this way fee levels and audit quality. The passage should be re-worded so as to provide that the purpose of the rules to be set by member states should be to ensure that the quality of a statutory audit is not affected by the level of fees received for that engagement. When taken together with paragraph (b) of draft article 25, we consider that the drafters' purpose would be thereby achieved. The separate mentions in the text of contingent fees and influence or determination are not, in our view, necessary since these are just specific examples of threats to independence and objectivity.
Q.11 The �maximum harmonisation' approach (article 26)
We support the adoption of ISA for statutory audits in the EU and support also the proposed prohibition on imposing additional procedural requirements over and above those provided for in ISAs.
We query, however, the inclusion in article 26.2(c) of the condition that, to be adopted by the Commission, an individual standard must be �conducive to the European public good'. This criterion is vague and meaningless and could be used as a back-stop excuse to block the adoption of particular standards. It would be better in our view to delete this reference. The criteria set out in (a) and (b) should be adequate in their own right to determine whether or not individual standards should be adopted.
Q.12 Should member states be allowed to set additional standards?
The meaning of Article 26.3 is unclear. It refers to �audit procedures' whereas auditing standards contain requirements that are not simply described as �procedures'. More importantly, the phrase �if these follow from specific requirements relating to the scope of the statutory audit' is imprecise. It would be better to confine additions to those resulting from law or regulation.
The Department comments that �The Financial Reporting Council's Auditing Practices Board (APB) is currently in the process of adopting ISAs in the UK and Ireland on the so-called �ISA-plus� model, with additions to the international standards clearly identified.' This approach does not constitute adoption of ISAs but is a transitional measure to facilitate adoption of ISAs when the Directive is implemented in national law. Any prospect of EU member states continuing with �plusses' on a large scale would destroy the benefits of harmonisation and should be strongly resisted.
Q.13 What will be the costs of implementing article 27 (c)?
It is difficult to provide reliable cost estimates, but we agree with the Department's view that Article 27 (c) could result in excessive record keeping cost burdens and agree with the suggestion that firms be required to ensure that copies of documents are available to be produced as and when called for.
Q.14 Should an audit report be required to be signed by an individual statutory auditor?
We agree with the proposal in article 28 that, where the appointed auditor is a firm, the audit report should be signed by the qualified statutory auditor who carries out the audit on behalf of the firm. We consider that this will help to reduce the incidence of �rubber stamping' by auditors of the work of external, unqualified firms and ensure that audit reports are always signed by qualified auditors rather than unqualified staff. The signature must always be on behalf of the firm since it is the firm that takes ultimate responsibility for the audit, which is carried out in accordance with the internal quality control systems and procedures it has put in place.
With regard to article 28.2, we oppose the idea of allowing the Commission to adopt a common standard audit report for EU companies. We believe the evolution of reporting standards should remain a matter for the international auditing standard-setter, and the EU should not risk adopting measures which could conflict with this process.
Q.15 Are the requirements of article 29 likely to pose problems?
The passage in article 29.1(j) needs to be tightened. As it stands, it provides for regulators to make �recommendations' which stand to be �followed up' by auditors or audit firms. The use of these terms suggest, when taken together, that the auditor or firm has a degree of choice as to what action to take following the receipt of a communication from the regulator. In theory, a firm could hold a partners' meeting to consider recommendations made following a quality review, decide to do nothing and claim that such action constitutes �following up'. The wording in this section needs to be much tighter, along the lines of �the statutory auditor or audit firm shall implement any actions required as the result of a quality review within a reasonable period.' This would still allow for non-mandatory �recommendations' to be issued by a regulator. If our suggestion here is taken up, there would need to be a consequential change to the un-numbered paragraph at the foot of article 29, so as to refer to �requirements' rather then �recommendations'. This would be appropriate in any case, since it would not be in order for an auditor to be made subject to automatic disciplinary action for failing to comply with non-mandatory �recommendations'.
Q.16 Do you anticipate any difficulties or unintended consequences arising from articles 32 and 33?
We note that article 32 only requires member states to recognise the possibility of reviews of their public oversight systems by other member states. Given that such reviews would no doubt prove expensive, and serve no obvious purpose, we would recommend that the Department place material conditions on the circumstances in which such reviews would be contemplated in the UK .
With regard to article 33, we support the recognition of the primacy of �home state' regulation .
Q.17 Regulatory co-operation regarding investigations (article 34)
The proposals on cross-border exchange of information appear to be broadly sound. But with respect to paragraphs 3 and 4, the text needs to be clear as to whether a competent authority may request or requisition an investigation to be carried out in another member state. Paragraph 3 states that a competent authority in receipt of a communication from another competent authority shall take appropriate action, but subsequent text appears to assume that an investigation will be carried out. The text must therefore be clear as to the responsibilities of competent authorities in these circumstances.
Q.18 The appointment and dismissal of auditors (articles 35 -37)
We consider that the restriction of the right to appoint auditors to the general meeting is too rigid and will certainly conflict with prevailing UK provisions, including the right for companies to dispense with annual appointment and the right which may be delegated to directors to appoint auditors to fill casual vacancies. It will also, as the Department acknowledges, have implications for the scope of the current UK company law reform exercise. This article is in fact a good example of what we consider to be a general failure, in the draft Directive, to acknowledge the governance position and special circumstances of smaller companies. That being said, the provision as drafted would also be costly for large companies, which would be required to convene an EGM to fill any casual vacancy. We would also query whether it is essential to include this sort of provision in the revised Eighth Directive at all � the appointment of auditors is essentially a company law matter and unrelated to the main focus of the Directive.
If the provision is to remain in the Directive, however, we suggest that the first sentence be amended by a reference to the effect that �subject to the provisions of national law, [which may allow companies' articles of association to authorise directors to fill casual vacancies] the auditor or firm shall be appointed by the general meeting..'
With respect to article 36, we consider that the current UK provision, whereby dismissed auditors are entitled to bring the reasons for their dismissal to the attention of shareholders and others, achieves the desired effect � of bringing fatal technical disagreements to the attention of shareholders and the markets - adequately, without the need for a hard and fast rule which itself raises the question of what are �proper grounds' for dismissing and auditor? Also, while article 35 of the draft text specifies that only shareholders in general meeting are permitted to appoint the auditor, article 36 is silent on who may dismiss the auditor.
Q.19 Scope and content of the proposed annual transparency report (article 38)
We do not consider that audit firms (at least those which are likely to carry out the audits of public interest entities) will find it difficult to produce the statement set out in article 38. We would query, however, the need for firms to include in the report a statement on �the basis for the partner remuneration' (sic). In the context of independence, this is presumably intended to ensure that audit partners are not remunerated on the basis of the extent to which they, for example sell non-audit services. Whatever the underlying intention, however, it is likely to result only in boilerplate disclosures that serve no relevant purpose. The financial results of the firm overall will be disclosed elsewhere in the statement and we do not see what useful purpose would be served by disclosing details of personal remuneration. In fact, the use of the term �partner' itself should be changed to a more inclusive term since the largest audit firms, in the UK at least, are no longer partnerships.
Q.20 The transparency report and smaller audit firms
There is likely to be a proportionately higher compliance cost for smaller firms, but if they are auditing public interest entities this extra cost should be bearable.
Q.21 The audit committee (article 39)
Ideally, we would prefer audit committees to be regulated on a best practice/comply or explain basis, so that each company was able to operate its committee in accordance with its particular circumstances. The recent EC Recommendation has dealt with board committees on precisely that basis. We believe, however, that audit committees are becoming an indispensable element of the audit framework and we would accept their incorporation into law if the determination of PIE is determined on an appropriate basis.
Although reporting of matters of governance interest is important, we disagree with the inclusion of the statement, at the end of article 39.3, that it should be the responsibility of the auditor to assist the audit committee in its functions. The cause of auditor independence would be better served if there were no such requirement. In fact, the purposes of the audit would be served if there were an express requirement, on the lines of the provision in the Companies (Audit, Investigation and Community Interest) Bill 2004, for members of the board of the entity, executives and non-executives, to report material matters to the auditor. We acknowledge, however, that such a provision would best be introduced in some instrument other than the Eighth Directive.
Q.22 The drafting of article 40
We have two drafting points on article 40.
First, the wording of the article needs to be revised to clarify the applicability of the relevant text. There appears to be an assumption in the text as drafted, that it applies only to public interest entities. Wherever the intention is to apply provisions to PIEs only, this should be made clear.
Second, we query the wording of paragraph (b), which requires the auditor to annually �confirm' his independence. Given that the definition of independence in the 2002 Recommendation refers to the �appearance' of independence and the perception of the auditor's independence or otherwise by a hypothetical third party, we consider that this is not a matter on which it is reasonable to expect an auditor to give an absolute confirmation or guarantee. It would be more appropriate, in our view, for article 40 to expect the auditor to annually confirm that he has satisfied himself that he is independent in accordance with the requirements.
Q.23 The quality review (article 41)
We have no problems in principle with the three year review cycle mentioned in article 41 for auditors and firms which audit public interest entities. This will now be a resources issue for the Financial Reporting Council/Public Oversight Board.
Q.24 International aspects (articles 44, 45 and 46)
We have no specific comments to make on the articles as drafted, other than to say that any rules to govern the approval and registration of auditors from third countries must be fair, proportionate and transparent.
Q.25 Co-operation with competent authorities from third countries
We appreciate that the draft text provides that member states may allow the transfer to competent authorities of third countries of audit working papers or other documents held by auditors or audit firms. In the UK context, we believe that the Department is not in a position to regulate the transfer of what is auditors' private property and, accordingly, should not seek to take advantage of the projected option. In determining whether any information is transferable to a third country, chief among the concerns which need to be satisfied will be that country's data protection regime.
Q.26 The audit regulatory committee (articles 48 and 49
We see no problems with the proposed text.
Q.27 Timing and implementation (article 54)
No comment.
Other Comments
Article 6 � educational qualifications
We suspect that the provisions of article 6 of the revised Directive will be called into question at some stage during the negotiation process.
The draft text retains the provisions of current article 4, so as to require statutory auditors, inter alia, to have attained university entrance level and passed an examination of professional competence of university final level. We believe that these basic provisions are adequate for the purposes of ensuring that auditors are suitably trained to carry out the regulated work. We also consider that the examination requirements of the various RSBs in the UK are of a sufficiently high level to ensure that any person who is authorised to act as a statutory auditor will have demonstrated a high degree of intellectual ability in audit and related subjects.
We are aware, however, of concerns in some member states to impose a basic requirement for all applicants for statutory auditor status to have attained a university degree. We believe that it would be unnecessary and inappropriate to impose a standard, EU-wide rule on this matter. It would have particularly far-reaching consequences for the UK where the accountancy and audit professions have always been open to those who leave school with �A' levels as well as to those with a degree.
We do not accept that it is evident that a person who fulfils the Directive's other set authorisation requirements is less qualified or competent to be an auditor than a person who has fulfilled the very same requirements but also has a university degree. The only logical basis for imposing a degree entry standard would, in our view, be to insist that the degree achieved was in accountancy and audit. But only a small proportion of those graduates who go on to qualify as accountants do so after studying accountancy at university. We are satisfied that the educational requirements currently in place are sufficient to ensure that those who are authorised to act as auditors have adequate technical expertise in the relevant subjects.
We consider that Article 6 also needs to be more specific in one other respect. It provides that a person may be approved if they have attained �an examination of professional competence of university final level'. We believe the current draft text should be amended so as to refer to ��an examination of professional competence which is at least equivalent to university final examination level�.' (This form of words is of course currently incorporated in Schedule 12 of the Companies Act 1989). An amendment on these lines would enable those member states which wished to impose a Masters level examination threshold to do so if they wished, while not obliging the UK , with its arguably stronger tradition of professional as opposed to academic training, to do likewise.
Article 13 � continuing education
Article 13 could usefully be strengthened. As it stands, it only calls on member states to ensure that auditors are subject to �appropriate programmes' of continuous education. The requirements of IFAC's IES 7, which impose detailed rules on the structure and extent of continuing professional development, are, as from 2005, a mandatory regulatory requirement for all member bodies of the International federation of accountants (IFAC). We suggest that Article 13 could be improved by adopting a reference to the detailed requirements of IES 7.
Article 30 � systems of investigations and sanctions
We welcome the Department's assurance that it is querying the wording of article 30.3, which would, if enacted, require significant changes to be made the current practices of RSBs. Currently, orders made by ACCA's Admissions and Licensing Committee are not publicised unless the Committee considers that publicity would be desirable, for example in public interest cases. Disciplinary decisions are published, but only in ACCA's members' publications which are not, ordinarily, accessed by the public. Press releases referring to such decisions are sent to a range of external newspapers and journals, but publication is entirely at the discretion of the publication concerned. Unless the terms �appropriately disclosed' were taken to mean disclosure in some sort of official publication, the element of editorial discretion would still be an obvious inhibiting factor in any attempt to ensure that all relevant RSB decisions were publicised, particularly where �low-level' announcements were concerned.