Canada: Summary Of The EC Legislative Proposals On Audit Policy

Last Updated: August 6 2012
Article by Neil Manji


This briefing provides an update on the proposed legislation being considered by the European Commission (EC) and debated in the European Parliament (EP) and the Council of Ministers (Council) which could significantly affect the relationship between businesses and their auditors in Europe.

The proposals were released by the EC on November 30, 2011 and affect Public Interest Entities (PIEs) as defined below. We have provided a summary of these proposals below. These are important issues for us as auditors but also for you and all stakeholders in the capital markets. This document provides a short summary of the EC Legislative Proposals and some of our thoughts on these proposed changes.


While the enactment of these or other proposals into law would have no direct impact in Canada, Canadian regulators and standards setters are closely monitoring the developments in Europe, as well as those in the U.S. coming from the Public Company Accounting Oversight Board, and considering the implications, if any, for Canada. The views and experience of the Canadian business and investor communities will be important input into those considerations.

At this stage, these are only proposals.The process for approval involves substantial dialogue and discussion which we expect will change the final form of any legislation. The Legislative Proposal on Audit Policy forms part of a 'suite' of proposed legislation put forward by the EC to address perceived weaknesses in the financial services sector in the wake of the financial crisis. The proposals also include measures relating to corporate governance, reporting practices and credit rating agencies (CRAs).

Key points:

  • The proposed Regulation is radical in terms of its scope and the measures proposed. We expect that some of the proposals will be discarded altogether and others will be substantially revised.
  • The proposals have generated significant levels of opposition across a broad stakeholder group, including industry bodies, the EP, the governments of the EU Member States, the audit profession and a number of regulators.
  • The European proposals do not reflect the views of the majority of those consulted on the Green Paper on Audit Policy (issued in 2010) nor those of the EP.
  • The EC proposes legislation but it does not have the power to enact it - this is a joint decision between the Parliament and the Council.

Summary of the Legislative Proposal

The following summarizes the key proposals set out by the EC. The proposed legislation would affect PIEs in the EU. A copy of the full proposals can be found at: auditing/reform/index_en.htm. The Audit Policy reforms are set out in a Regulation and a Directive.

The key measures set out in the proposed Regulation include:

  • Mandatory firm rotation: Public Interest Entities (PIEs) may not engage the same audit firm for longer than six years. The initial mandate should be for a minimum of two years, renewable only once (with a four year cooling off period). Where a PIE has voluntarily appointed two statutory auditors or audit firms (joint auditors), the maximum duration of the engagement is nine years. The key audit partner shall cease participation in the audit after seven year with three year cooling off period before participating again in the audit. (PIEs generally consist of listed entities and financial institutions and intermediaries.)
  • Mandatory tendering: PIEs would be required to undertake a tendering process involving at least two audit firms, one of which must have no more than 15% of its total audit fees earned from PIEs in the previous year. As part of the appointment process, the audit committee must provide a report on the conclusions of the (re)appointment to the administrative or supervisory board. A 'credit institution' or 'insurance undertaking' must also submit its report to the competent authority.
  • The audit report: The report would be expanded to cover matters including the methodology used (for example a statement of how much of the balance sheet has been directly verified and how much has been based on system and compliance testing), any variation compared to the previous year in the weighting of substantive and compliance testing, key areas of risk of material misstatement, the extent to which the audit was designed to detect irregularities (for example fraud and details of the level of materiality applied to perform the audit). The report would not be longer than four pages or 10,000 characters. In addition, the report would identify each member of the audit engagement team and state that all members remain independent.
  • Audit committee report: The auditor would provide a longer report to the audit committee detailing information on the results of the audit carried out, including for example a statement relating to 'going concern' and the material findings of the audit.
  • Audit committee: With certain limited exemptions, each PIE would be required to have an audit committee. At least one member of the audit committee would have competence in auditing and at least two members of the committee would have competence in accounting and/or auditing. The committee members as a whole would have competence relevant to the sector in which the audited entity is operating.
  • Audit only firms: Any audit firm with more than a third of its audit revenue from large PIEs would be prohibited from providing other services. There are special definitions on how this market and market share are calculated.
  • Related financial audit services: Audit firms would only provide statutory audit to PIEs. Audit fees for related audit services would be capped at 10% of the total audit fee. Related audit services are defined by the EC as:
    • Audits of interim financial statements
    • Assurance on corporate governance statements, Corporate Social Responsibility (CSR) matters, regulatory returns and any other statutory duty imposed by EU legislation
    • Providing certification on tax requirements compliance where requested by national law
    • Any other statutory duty related to the audit imposed by EU legislation on the statutory auditor/audit firm

In addition, certain non-audit services would specifically be prohibited for audit clients:

  • Expert services unrelated to the audit, tax consultancy, general management and other advisory services
  • Bookkeeping and preparing accounting records and financial statements
  • Designing and implementing internal control or risk management procedures related to the preparation and/or control of financing information included in the financial statements and advice on risk
  • Actuarial and legal services, including acting for the audit client in litigation
  • Designing and implementing financial information technology systems
  • Participating in the audit client's internal audit and providing services related to the internal audit function
  • Broker or dealer, investment adviser, or investment banking services By exception, certain non-audit services could be provided subject to prior approval of the audit committee:
  • Human resources services, including recruiting senior management
  • Comfort letters in connection with the issuance of securities

Also, by exception, the following services could be provided subject to prior approval of the competent authority (a specified regulator):

  • Due diligence services on potential mergers and acquisitions
  • Certain services relating to the design and implementation of financial information technology systems

PwC principles

We believe the time is right to consider changes in the role of the public company auditor. We have assessed these proposals against the following guiding principles, which we have found to be useful in identifying constructive changes and avoiding any that will inadvertently do harm to audit quality.

  • Changes should:
  • Maintain or improve audit quality
  • Enhance the value of the audit to users
  • Increase the reliability of information the entity provides in public reports.
  • Changes should maintain or enhance the effectiveness of the relationships and interactions of auditors with those charged with governance (e.g. audit committees) and management.
  • Auditor reporting should be sufficiently similar to facilitate users' comparison of the underlying economic reality/state of affairs of different entities.
  • Auditor reporting can provide greater insight based on the audit but the auditor should not be an original source of factual data or information about the entity.

Summary of PwC views

The PwC network of firms strongly supports changes which enhance competition and transparency, independence and audit quality, and where the benefits of which outweigh the corresponding increase in costs or red tape. We support:

  • Augmenting the already well established practices of audit committees in Canada to act as the main representatives of shareholders by overseeing the appointment of auditors, the execution of the audit and the provision of any non-audit services supplied by the auditor and consideration of enhanced communication by audit committees to shareholders on these matters.
  • Increased auditor assurance on certain financial information relevant to the market place
  • Prohibiting contractual clauses which require the use of a large network audit firm
  • Development of national level plans (living wills) to ensure continuity of audit service in the event of failure of an audit firm
  • Changing the rules governing ownership of audit firms and liability reform
  • Improving two-way communication between financial institution regulators and auditors
  • Ways in which audit reporting might be made more relevant to evolving market needs. We believe these should be dealt with through the consultations of the International Auditing and Assurance Standards Board (IAASB) and the Public Company Accounting Oversight Board (PCAOB).

We are concerned about other aspects of the Commission's proposals because there is little or no empirical evidence of benefits to support them, they would be unduly costly, or could have negative unintended consequences especially at a time of economic weakness and poor growth. We do not support:

  • Mandatory rotation of audit firms - which has been shown through various studies to diminish audit quality, increase costs and not provide any corresponding benefits to small firms.
  • Restrictions on the tenure of audit firms - evidence shows this increases costs for businesses and restricts their ability to determine the most suitable service provider but does not improve quality.
  • Restrictions on services audit firms can provide to their audit clients - this restricts companies' abilities to determine the most suitable service provider, and audit firms are already subject to detailed ethical and performance standards and codes of conduct.
  • Audit-only firms - which decreases quality of audits and restricts businesses from selecting the most efficient and effective service provider, and would, over time, negatively impact the ability of audit-only firms to attract and retain suitably skilled and qualified staff which is only sustainable within multidisciplinary firms.
  • Joint audit (now proposed on a voluntary basis) - which has been tried and abandoned in some countries, and has not been widely adopted in countries where it is already available on a voluntary basis.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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