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  • The audit reforms in Europe one year on - a bullet dodged or a trick missed?

The audit reforms in Europe one year on - a bullet dodged or a trick missed?

25 août 2017

Noel Clehane , Global Head of Regulatory & Public Policy Affairs

Late 2008, the financial crisis is in full flow, and one financial institution after another is collapsing. Before long, the whole financial services’ industry came under scrutiny – first banks and insurance companies, then credit rating agencies and finally auditors, some of whom were seen as having vouched for the financial status of financial institutions as “going concerns” not long before they went bust. Many commentators suspected auditors would end up ‘taking a beating’ once the scrutiny process was completed. Others, including some in the audit profession, saw it as a chance to make auditing more effective and fit for 21stcentury purpose.

Nearly six years later, two pieces of legislation were adopted by the European Parliament and the European Council, responding to the scrutiny of auditors by the EU. After publication in the Official Journal of the European Union in June 2014, the ‘new’ Audit Directive and Audit Regulation came into effect two years later – on 17 June 2016. We are now twelve months on from this date and commentators generally agree that for Europe’s larger companies the reforms have substantially changed the markets for audit and non-audit services. But as yet, there is precious little real data on the resulting impacts on audit firms. The evidence is still anecdotal and just like with the French Revolution, maybe it’s just too early to say!


PIEs required to tender and rotate

The most eye-catching element of the legislative changes was the introduction of mandatory periodic tendering and mandatory rotation of audit firms for public interest entities (or PIEs). In relation to PIEs, there is little doubt that more tendering is taking place and the audit market has seemingly become more fluid as a result of this coupled with mandatory rotation, although some practical obstacles remain to be sorted out.


More competition or not?

In the UK the national regulator reported in February 2017 that over a quarter of companies sampled had put their audit out to tender in the last twelve months. As 70% of those companies went on to change their audit firm, the reforms have seemingly achieved the objective of preventing auditors from becoming too cosy with their clients. But although there is now more competition and fluidity, the PIE audit market remains dominated by the four largest firms. Two or three other firms (prominently including BDO) are regularly invited to tender, but in truth, rarely win the audits of larger PIEs. Is this because audit committees are just making up the numbers by inviting BDO and other audit firms to tender, being as they are, required to consider a mix of potential audit firms?

Or does it reflect the strong relationships the largest firms have developed with the PIE community over many years where they are often considered the ‘safe option’? Difficult to say. Most likely, it is a mix of the two together with a strong dose of natural conservatism. As former UK Prime Minister David Cameron famously said at a conference a few years ago, ‘nobody ever got fired for hiring PwC’. He could well have added ‘or Deloitte or KPMG or EY’!


Growth in non-audit services

The real question for BDO and other ambitious ‘mid-tier’ audit networks is whether the above trend will continue, or audit market shares will be more broadly distributed in years to come. This is where another aspect of the reforms becomes important. The EU restriction on the provision of non-audit services by the auditor to audit clients (including much tax and consulting work) is leading PIEs to develop relationships with multiple suppliers of professional services, including BDO. Providing these new relationships work well, confidence in our work will be enhanced and, over time, we will be seen as credible challengers for all PIE audit appointments. Although such assignments are well within our skills and capabilities, market conditions have hitherto often excluded us from them. Apart from the impact of the reforms on audit revenues, the inroads made by BDO into providing additional non-audit services, have undoubtedly been beneficial in their own right. Nonetheless, it is difficult to pin down how much of our growth over the last year is directly due to the EU-originated audit reforms in this area.


Impact on companies

It is even harder to gauge the impact on companies, and PIEs in particular although greater costs as a result of tendering, tracking non-audit services and considering complex rotation rules, seems to be one common outcome. It is to likely that many of these costs are front-loaded or one-off and will be justified in time by greater competition and by the increased trust of investors in auditing and financial reporting with the consequent effect on cost of capital etc.

The stiffer requirements for audit committees are also clearly challenging, particularly in economies where they weren’t previously the norm or corporate governance was less developed than in larger EU member states. Many affected companies still seem to be unaware that the European Commission is now required to monitor the performance of audit committees. When there is greater clarity about this monitoring process, we might see a degree of belated concern that this area of corporate activity has effectively become regulated. Nevertheless, companies everywhere are getting to grips with the tendering and rotation processes, even though many tenders don’t appear to be following the quite specific legal requirements in transparency and content terms.


Effective reforms?

Of course little of this legislation was enacted for the benefit of audit firms, or even companies. The ultimate aim was to improve the quality of and confidence in audit processes across the capital markets and among investors.

Has it done its job? The desired outcome ought to be enhanced confidence in corporate reporting through greater trust in audits as a result of increased auditor independence, more professional scepticism and more competition [spurring innovation] in the PIE audit market. The reforms have certainly increased tendering and may have further stimulated the drive for technological advances in auditing (most notably in data analytics), a field in which BDO is also heavily investing. Though the reforms may well lead to higher levels of innovation, one year on it is still too early to tell if they will achieve the EU policymakers’ original objectives. At this stage, all we can say for certain is that though the reforms have generally benefitted BDO across Europe, they haven’t been transformational.


The way ahead

To assess, year on year, the real impacts of the EU reforms, and see what is really happening in the audit market in each member state, we need data. The structures established by the EU audit reforms will make this possible. Unfortunately, the number of ‘member state options’ contained in the adopted reforms has resulted in varied implementation of certain measures across the EU, leading to a patchwork effect which has affected consistency and in some cases led to differing implementation between member states. Doubtless this will need to be addressed in future assessments of the recent reforms but of course the reforms will need more time to become embedded and for their effectiveness to be fully assessed. Only once such hard evidence exists will legislators be in a position to assess what further changes if any, may still be required.


Bullet dodged or trick missed?

In retrospect, my personal opinion is that the audit profession as a whole could have responded more positively to the European Commission’s original proposals (or at least the overarching objectives) and contributed to a final set of reforms that were more cohesive and impactful. So from that point of view the profession possibly did ‘miss a trick’ and the opportunity to remake auditing in Europe.

On the other hand, in the early stages of the EU legislative process, there was a very real threat that the European audit profession would be dramatically shaken up with very extreme proposals being put forward by policymakers who were clearly under pressure to respond and be seen to be responding, to the financial crisis. Early suggestions included the big four networks being broken up, mandatory joint audit being imposed for all PIE audits and the provision of all non-audit services being completely banned. Many of these proposals were unrealistic or unnecessary so in that regard, it could be said that the profession managed to ‘dodge a bullet’when such proposals were deleted or softened.

As we mark the one-year anniversary of the implementation of the much-trumpeted EU audit reforms, I predict that it will take several more years before one can categorically conclude on whether they have achieved what they set out to do or have fallen short!


In any case, ‘happy 1st birthday’ to those same EU audit reforms!