EU audit reform proposals have raised a range of concerns from Luxembourg practitioners and regulators

Fine in principle, debated in the specifics

d'Lëtzebuerger Land du 22.06.2012

The European Commission’s proposed wide-ranging reform of the audit sector has raised a range of concerns from Luxembourg practitioners and regulators, the former questioning the proposals’s impact.

The proposed reforms were published at the end of November, 2011, after a Commission Green Paper entitled Audit Policy: Lessons from the Crisis launched a wide-ranging consultation process. Some of the headline measures include requirements for the regular rotation of auditors, open and transparent tendering for audit services, a prohibition on providing non-audit services to audit clients, European supervision of the sector, and a European passport enabling auditors to work across Europe. Small and medium sized firms are partially exempted from these measures.

The Commission claims its measures are addressing “considerable shortcomings in the European audit system,” by “clarifying the role of the auditors and introducing more stringent rules for the audit sector. The aim: strengthening the independence of auditors as well as increasing diversity into the current highly-concentrated audit market.” Given the level of dominance of the so-called Big Four firms – Pricewaterhouse Coopers, Deloitte, KPMG and Ernst[&]Young – in the local market, where, it is said, they share between 80 and 95 percent of business among them, they are careful to avoid appearing as though they support the status quo. “I think everyone throughout the audit profession accepts that there is a need to take a look at things, at how they have been done, what can be improved,” says Stephen Nye, KPMG audit partner. “And there is an overriding interest in paying attention to the quality of audits that are done, how they can be secure and, where necessary, improved.”

Since it’s Michel Barnier, the European Commissioner in charge of the single European market, who oversees the reforms, Nye points out, the process was always aimed at creating more competition too and avoiding a scenario where one of the Big Four collapses. As did former audit giant and then Big Five member Arthur Andersen in the early 2000s. However, states Nye, the concern for reforming the market has taken precedence despite the fact that the initial discussion “was very much more focused on what can be done to make sure that audits are done to a sufficient level of quality.”

The reforms will not have much impact, thinks Tom Pfeiffer, who works for one of the bigger of the small firms in the audit market not taken up by the Big Four, due to the low number of exchange listed companies, so called “public interest entities” in Luxembourg. Of the mea-sures, says Pfeiffer, a partner with PKF ABAX Audit, “I do not really see a lot of improvements possible for the audit market.” “They are trying to have more competition and reduce the audit fees, which is contradicted by all of the requirements they are putting in place . . .” adds Pfeiffer.

“A very good idea” is Jean-Jacques Soisson’s assessment of the propo-sals. Soisson is a partner at Clerc, another mid-tier firm, and founder of Ernst[&]Young in Luxembourg. “The Big Four firms became much too big when compared to the rest. There is indeed a problem as we could see with the Enron scandal (which led to Arthur Andersen’s end, note from the editor).” In his view, given the various scandals involving accounting problems “the measures would have a positive impact on the profession, also in Luxembourg, because any initiative taken to increase the trust people have in the profession is good for it.”

The financial watchdog CSSF has regulatory oversight of the profession since 2009 and Fréderik Tabak is head of the department overseeing auditors. According to him, the CSSF welcomes “those aspects that will demonstrably increase audit quality,” listing a variety of technical steps such as enhanced information exchange. This list largely excludes the “key elements” identified by the Commission.

The CSSF points out that despite its support for some of the lesser elements of the reform proposals, it finds it “regrettable” that audit oversight authorities “have not been operational for a long enough period of time to demonstrate the benefits of the measures already in place,” adding that it was “premature to envisage a new fundamental legislative change.”

Soisson of Clerc says the proposed measure will counteract the CSSF’s historic promotion of the largest firms. “They always pushed towards the Big Four firms, nearly going as far as saying that small firms are not capable of giving a good service,” he argues. “This may help the smaller firms to be recognised, because there are many good professionals in smaller firms, too.”

The proposed mandatory rotation of audit firms limits an audit firm’s service for a single “public interest entity” (or stock exchange listed company) to six years, in order to cut down on “familiarity” with the customer and involves a four year cooling-off period during which the auditor cannot work for the client. Audit firms can stay on for nine years if they are involved in a joint audit, where two or more firms audit the same company, a practice the Commission is trying to encourage, and which is only being carried out in France.

KPMG audit partner Nye says mandatory rotation is “clearly” the proposal that “causes the most obvious and direct impact on the firm.” He explaines that this will mean that “a fairly large part of our attention will be devoted to (...) marketing activities. Which again isn’t necessarily doing anything for the quality of the actual work we’re doing.” He points out that this proposal would generate additional costs for audit firms and for companies forced to change auditors.”

The rotation proposal also fails to gain support from PKF ABAX’s Pfeiffer. “As as an auditor”, he explains, “you need some time to learn about your client. And you need to have some time to earn your money on a client.” In any case, Pfeiffer indicates: with few public interest entities headquartered here, decisions on auditors will be taken abroad, with Big Four auditors preferred. “So there will be rotation between the Big Four companies, or perhaps the biggest six if you want.”

The CSSF doesn’t think much of the rotation proposal, and “is of the opinion that a mandatory internal rotation of each engagement partner after a period of seven years (...) is sufficient to the objective of independence,” says Tabak. An internal rotation would involve changing the audit personnel, not the audit firm. An ethics code and a more fully engaged audit committee would help address any potential independence risk, adds Tabak. According to him, the CSSF shares the auditors’ concerns about “the administrative burden and the information loss, especially on large and complex engagements.”

Another major objective of the Commission’s reform is to prevent audit firms from offering non-audit services to their audit clients in order to reduce conflict of interest. Nye says that, superficially, this proposal “would seem to be beneficial for the quality of audits”, but ignores the fact that staff doing complex audits rely on specialists from non-core audit services within the firm to assist them. For CSSF-representative Tabak a “strict ban is disproportionate,” and “audit committees should play a key role” in decisions on providing non-core services, thus retaining the flexibility to be able to offer them to audit clients in some cases.

Under the proposals, small to mid-sized firms would be encouraged to offer non-core audit services to help them prosper. His firm declines to offer non-audit services to audit clients, explains Pfeiffer from PKF ABAX. “You already have to be independent today and the rules are quite strict.” He is concerned that an exemption for small to medium-sized auditors from some of the measures would create two sets of rules. At the risk of creating the perception that firms such as his do less good work.

The European passport measure is a particular concern for the smaller firms because it could bring in unwelcome foreign competition into the small non-Big-Four-market in Luxembourg, warns Pfeiffer. It “would probably be the biggest problem we could have.”

As part of the Commission’s move to create pure audit firms and to provide a wider range of choices, it wants to modify the ownership rules by eliminating the requirement to keep an audit firms’ capital in the hands of auditors. “This will give audit firms more access to capital which may increase the number of audit providers and encourage new entrants into the market,” the Commission explains. The CSSF fears that this could harm audit quality as non-auditor investors would try to increase their return by minimising audit procedures.

What impact will these measures have on the the audit business as an economic sector counting 5 000 jobs in Luxembourg? Several of the measures including the “considerable expansion of the scope of audits” would “generate the need for more people to be working within audit than is currently the case” without necessarily increasing the quality of the audits, thinks Nye. But this, he says, would go alongside with significant cost increases which may “detract from the attractiveness of doing certain types of business in Luxembourg.”

The proposals are making their way through the European legislative process. They won’t come into effect for the next two or three years.
Mike Gordon
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