Originally published in Financial Services Advisory Update, Volume 3, No. 1 February 2006

Agreement has been reached on revisions to the European Union (EU) Directive that will update rules on the audit of company accounts (Audit Directive). Once the text of the measure is available in all the EU’s official languages, it will be formally adopted by the European Council (Council), probably during the first quarter of 2006. The new Directive will have to be implemented by the 25 EU Member States within 24 months following its publication in the EU Official Journal.

EU legislation on Internal Market issues such as the Audit Directive must be adopted under the "co-decision" procedure, meaning that the European Parliament (Parliament), the voice of Europe’s citizens, and the Council, representing the Member States, must agree on the same text. This process normally entails two readings and amendment of the initial proposal by both the Parliament and the Council, with a conciliation procedure possible if no agreement is reached. However, in this case a deal was struck between the Parliament and the Council to allow for the adoption of one set of amendments in a single reading. Such a smooth process is rare.

The European Commission (Commission), which manages the daily implementation of EU policies, first proposed changes to the Audit Directive in March 2004 in the wake of US and EU auditing scandals. The proposal focused on every aspect of a European auditor’s life, including qualification, registration, ethical and auditing standards, independence, supervision, discipline and sanctions. It also affected third-country auditors who audited companies listed on a recognised stock exchange in the EU, or substantial subsidiaries of such companies. The proposal broadened the scope of EU legislation by introducing new requirements concerning the manner in which an audit should be carried out and the structures needed to ensure audit quality, as well as means for guaranteeing trust in the audit function.

Although large auditing firms and other members of the profession had been consulted by the Commission and national regulators before the proposal was published, the proposal nevertheless contained some elements which aroused major concerns for auditors, including an option for Member States to require firms that audited public interest entities (a defined term including such entities as listed companies, banks and insurance companies) to rotate off the engagement every seven years and to ban provision of non-audit services by auditors.

Following a series of meetings among the Parliament, the Council and the Commission, a number of compromises were proposed to reach a joint position. This was achieved during summer 2005 and the entire Parliament adopted the revised Audit Directive on September 28, 2005. On October 11, 2005, the Council adopted all of Parliament’s amendments, excluding the need for a second reading by either the Parliament or the Council.

As agreed to by the Parliament and the Council, major changes to the proposal included the following:

  • Commission proposals for all publicly-listed companies to have a separate audit committee to supervise financial reporting procedures were deleted. Member States will be free to determine how firms supervise their internal auditing reporting.
  • Parliament extended the examples of threats to the independence of a statutory auditor or audit firm to include a direct or indirect financial interest in the audited entity and the provision of additional non-audit services. The level of fees received from an audited entity and/or the structure of the fees also could threaten the independence of a statutory auditor or audit firm.
  • The safeguards to be applied to mitigate or eliminate these threats include prohibitions, restrictions, other policies and procedures and disclosure. Statutory auditors and audit firms should refuse to undertake additional non-audit services that compromise their independence.
  • Amendments were also made to the obligation for a public interest company to change auditors every five years and audit firms every seven years. The legislation now only requires Member States to ensure that key audit partners/statutory auditors are changed every seven years, not the audit firms themselves. The individual partners will be allowed to take part in auditing the entity again after a minimum of two years.
  • In cases of self-review or self-interest, where appropriate to safeguard the statutory auditor’s or audit firm’s independence, the Member State rather than the statutory auditor or audit firm should decide whether the auditor or firm should resign or abstain from an audit engagement with regard to its audit clients.
  • Any public supervision system over the auditing firms must be governed by non-practitioners who are knowledgeable in the areas relevant to statutory auditing, but Member States may allow a minority of practitioners to be involved in managing the system.

The text of the new Audit Directive is at http://europa.eu.int/comm/internal_market/auditing/news_en.htm.

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