At present, statutory audit practices in the EU are governed by a Directive (2006/43/EC). Accordingly, all public companies are required to have audited their half-year and annual financial statements by an independent external auditor. Statutory audits of publicly listed companies are conducted by audit firms –formed of audit partners. Due to great deal of discretion granted to the Member States, the Directive 2006/43/EC is implemented differently by the Member States. As a result, the laws on auditing are diverse across the EU. For instance, Directive 2006/43/EC requires the rotation of the key audit partner after a maximum of 7 years (Article 42(2)). However, there are different rules on auditor tendering in Member States (for examples see below).
In November 2011, the European Commission proposed a new Regulation on statutory audits of public-interest-entities (COM (2011) 779/3). Public-interest-entities (PIEs) include listed entities, credit institutions, insurance undertakings and other entities which are of significant public interest because of their business, their size, their number of employees. Because of their economic importance to the markets, the European Commission decided to govern the statutory audits of PIEs by a Regulation.
Unlike directives, regulations come into force as soon as they are passed and they are directly applied into the national laws of the Member States. It can be expected that a Regulation on statutory audits of PIEs can minimise the differences among EU Member States. In fact, the European Commission pursued the exact goal when issuing the regulatory proposal. It aimed to create a pan-European audit market in the EU.
The other primary objective of the European Commission is to change the status quo of the high concentrated audit market structure. Currently, the EU audit market is controlled by the Big Four audit firms, namely the PwC, Deloitte, EY, and KPMG. In the EU audit market of listed companies the average market share of the Big Four is above 90%, though in some Member States the concentration level is more moderate (e.g. 58% in France). The limited choice of auditors restricts the competition in the market. Also, if one of the Big Four withdraws from the market, the statutory audits are likely to be disrupted due to a possible systemic risk (i.e. the ‘too big too fail’ phenomenon).
How can the status quo in the audit market be changed? The European Commission proposed mandatory rotation in order to encourage the large public firms to choose non-Big audit firms. It is believed that the audit firm rotation will break the barriers to entry for the small and mid-sized audit firms and hence, reduce the concentration.
In the Regulation proposal COM (2011) 779/3, the European Commission proposed that all public companies should rotate the audit firm in every 6 years- in addition to the rotation of the key audit partners in every 7 years (Articles 32, 33). Nevertheless, the Legal Affairs Committee (known as JURI Committee) rejected this proposal as too “costly” and proposed a maximum of 14-year audit engagement with the same audit partner. If the limited number of players in the audit market is a real concern, can mandatory rotation rule be a remedy to reduce the concentration? Even it is possible, it seems harder when there is still no consensus between the Commission and the JURI on the matter. This disagreement also raises the question whether the proposed regulations is suitable for all EU Member States. European Member States have different standards for rotation. For instance, the UK requires that audit engagement should not exceed more than 5 years. In France, public companies are subject to mandatory rotation of audit partner every 6 years while joint audits are mandatory for credit institutions and certain political parties. Italy is the only Member State who requires mandatory rotation of audit firms in every 9 years. It seems that the European Commission’s proposal would reduce the rotation standards in certain Member States.
If the real concern of the Commission is the restricted competition in the market, rather than providing proxy arrangements like rotation may be it is better to leave this subject to the competition authorities. In October 2013, the UK Competition Commission issued a report following its investigations on the UK audit market. However, the UK Competition Commission also followed a similar approach with the European Commission and proposed a maximum of 10-year audit engagement with the same audit partner for FTSE 350 companies. The UK Competition Commission’s report does not promise any prominent change in the audit market structure with regards to the competition.
High-concentration in the market results in barriers to entry for small and mid-tier audit firms and limited choice in the audit market. The European Commission believed that the audit market would operate more efficiently if the markets were competitive. One the one hand, some of the proposals in Regulation COM (2011) 779/3, such as prohibition of contractual clauses that require a Big Four auditor for a company has merit (Article 32(7)). On the other hand, the creation of specialist audit firms (banning on non-audit services in Article 10(3)(a)) and mandatory rotation rules (Article 33) seems too restrictive. Moreover, it is questionable whether even these restrictive proposals are sufficient to change the status quo in favour of better quality audits. Although a Regulation is preferable to a Directive in terms of increasing the harmonisation level in auditing, it is not beyond doubt that the remedies submitted in the European Commission’s Regulation proposal are suitable for each Member State.
Hatice Kubra Kandemir
PhD Researcher, Durham Law School