27 February 2013

EBF & AFME: Mandatory audit firm rotation requirement under the European Statutory Audit Directive

EBF and AFME express their concern that the proposed mandatory rotation of audit firms, under consideration in Council in the context of the Commission’s proposals for a Regulation on specific requirements regarding statutory audit of public-interest entities, would not achieve the desired objectives. Moreover, it could prove counterproductive given its potential to disrupt audits significantly and to reduce their overall quality. These risks are particularly severe in the case of the largest global companies (whether financial or non-financial), and are even more acute when the mandatory rotation period is as short as the proposed six years (or nine in the case of joint auditors).

Newly appointed auditors require a considerable amount of time to familiarise themselves with their new client, particularly clients with the high degree of complexity that is common in the financial sector. As a result there is a significant risk that the initial audits give a lower than acceptable level of assurance. Furthermore this initial phase ties up the resources of the audit firms and those of the client. There is also the risk that during the latter part of a fixed audit term there is less incentive to focus on longer-term issues with a concomitant reduction in audit quality. If audit firms were to be changed at regular short intervals, the risk of lower quality audits would substantially increase. This risk is even more material when the audit is of a large complex multinational group.

Auditors are less able to provide robust challenge when they are unfamiliar with the business being audited, in particular in relation to complex judgemental areas such as the valuation of illiquid instruments and the level of impairment provisions. Large financial institutions, like many other multinational groups, are complex businesses. Understanding of the business is lost on a change in the audit firm. It is important to note that a quality audit goes well beyond the audit report. Informed comment on topics such as the robustness of group reporting and control systems, and adherence to corporate policies is of great value to the Audit Committee and management and consequently to shareholders.

Mandatory rotation might force companies to change their auditor as well as their non-audit services providers, should the proposal to prohibit provision of non-audit services to audit clients be adopted, with reduced choice for both cases. Complex multinational financial institutions often rely on a single world-wide auditor and this severely restricts the choice of alternatives to firms that are able to deliver quality services at global level. Some of these firms are likely to be excluded given that they are major suppliers of non-audit services. The combination of these factors means that the Audit Committee of a large multinational financial group may be unable to identify more than a few alternative auditors which they consider have the necessary skills to tender, with the risk that this number will be further reduced during the tendering process. It is therefore questionable whether the proposed measure would meet the objective of decreasing concentration in the audit market.

EBF and AFME understand that one of the objectives of introducing mandatory audit firm rotation is to enhance independence. EBF and AFME believe there are better means in the area of corporate governance to achieve this objective such as change of the auditing team and its lead auditor or re-tendering.

EBF and AFME believe the requirements in the current European Statutory Audit Directive (2006/43/EC) successfully address independence concerns.

To conclude, EBF and AFME believe there is a significant risk that mandatory rotation would not contribute to reducing market concentration or improving audit quality. Moreover, they see no persuasive arguments for restricting the requirement to particular sectors. Specifically, for financial institutions EBF and AFME believe audit quality and market confidence could be particularly impaired given that their audit firms must have extensive knowledge of their clients and experience in the constantly evolving business environment in which they operate.

Full paper

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