20 December 2012

EuropeanIssuers/Institutional Investor Committee comment on EU audit proposals

Proposals to address the limited choice in the audit market

EU Proposals: Proposals to remove barriers to audit firm growth.

Investors’ views: The fact that the Big Four dominate the audits of practically all companies in the FTSE 350 is not healthy for competition or choice. The current lack of choice also impacts auditor independence and audit quality. Nor do investors believe it likely that there will be an organically developed competitor in the medium term. Furthermore, the situation could be exacerbated in that there is a risk that one of the Big Four could fail.

Thus investors support measures to remove barriers to audit firm growth and contingency planning as set out above. In particular, the European quality certificate and enhanced transparency around inspection findings could promote competition on quality. However, they do not necessarily consider that competition would be addressed by other proposals in the reforms, in that this is essentially an issue for the competition authorities.

Proposals for the mandatory rotation of audit firms

EU Proposals: To prevent the same firm being reappointed, firms are to be required to rotate after 6 years. The period before which rotation is obligatory can be extended to 9 years if joint audits are performed. Joint audits are not obligatory but are thus encouraged. There is to be a cooling off period of 4 years before the audit firm can be engaged again by the same client (Article 33 of the Regulation).

Investors’ views: The long periods auditors hold office can impact their independence and objectivity. The House of Lords Economic Affairs report1 into audit stated that a FTSE 100 auditor remains in place on average for about 48 years; and for the FTSE 250 it is 36 years. Nearly all these companies have Big Four auditors. For example, Barclays has used PwC or its predecessors since 1896.

However, the mandatory rotation proposed could be costly and disruptive. Mandatory rotation requirements could also mean that companies are forced to change auditor at a time when the existing auditor’s familiarity with the business would benefit the audit such as when there is a major acquisition or merger. It could also conceal the fact that an auditor has stood down for a particular reason and prevent auditors being reappointed when they are the preferred choice of both management and investors.

On the matter of joint audits, investors fear that either these or mandatory rotation could adversely impact audit quality - concerns run to accountability, the danger of missing issues, etc. Joint auditors could also lead to the smaller firms always becoming the junior party and consigned to this role in future.

Proposals on the appointment of audit firms and mandatory tendering

EU proposals: PIEs to have an open and transparent tender procedure when selecting a new auditor. The audit committee (of the audited entity) should be closely involved in the selection procedure. Any appointment of the auditor to a meeting of shareholders, other than a renewal, to include at least two choices excluding the incumbent (Article 32 of the Regulation). To promote choice, one of the firms to be a smaller firm. Auditors appointed for a two year minimum term which for a PIE could only be renewed once (Article 33 of the Regulation).

Investors’ views: Within the current framework a choice of two excluding the incumbent could be difficult to provide due to the limited number of firms – particularly those that could undertake the audit of major groups. In addition, currently in the UK auditors are appointed each year by shareholders. This is valued by investors but the two year minimum period does not appear to allow for this nor for the auditor resigning or being dismissed within this period.

Nevertheless, the level of directors’ control over the appointment and removal of auditors can give rise to issues, particularly where fee income is significant. Effectively the company - at the instigation of its Board - hires its own scrutineers and whilst shareholders ratify the appointment at the AGM, they are not involved in the process.

As an alternative to mandatory rotation investors support the introduction of a regime to ensure that audit appointments of more than, say, 10 years without tendering are given adequate scrutiny. This was proposed last year by the FRC and strikes the right balance and could help improve competition (other commercial relationships are subject to regular tendering). The current incumbent should be allowed to retender but there should be safeguards to ensure that the position whereby audit firms retain a FTSE 100 client on average for 43 years does not continue. There should be more accountability to investors and more transparency over the tendering process such that major investors have the opportunity to be involved with the appointment process should they wish.

Proposals on audit reports

EU proposals: Two pages of disclosures are proposed for the audit report within four pages or 10,000 characters (Article 22 of the Regulation).

Investors’ views: Investors would like to see a more enlightened audit opinion, but the disclosures proposed for the audit report are too onerous, would be costly to produce and would not necessarily benefit investors.

Undoubtedly the usefulness of the current audit report to investors is undermined by its binary opinion, pass or fail, and boilerplate, technical language. There are also questions as to whether auditors exercise sufficient scepticism and whether the audit represents value for money.

Investors would welcome more informative reporting, be it by the audit committee or the auditor. This could give them more confidence that auditors have challenged management in that auditors could highlight how scepticism is working in practice through the reporting of, say, the top ten contentious issues, including some commentary on what had arisen during the course of the audit process. For example:

• key areas of judgement;
• key estimates;
• any fraud identified, other than that which is petty;
• any significant weaknesses in the financial systems and controls identified during the course of the audit and the steps being taken to remedy them;
• the significant assumptions for determining fair values and whether the models and markets on which the valuations are based are sufficiently robust to give reliable valuations;
• the factors taken into account in agreeing any material write downs and that such write downs are sufficiently prudent;
• material securitisation arrangements and off balance sheet arrangements;
• the nature and level of non-audit services provided; and
• the length of time the auditor has held office.

Shareholders could then raise these with the company.

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