Europe takes step toward mandatory audit firm rotation

The European Union took a step toward requiring mandatory audit firm rotation Thursday when the European Parliament’s Legal Affairs Committee voted 15–10 in favor of a draft law that would require public-interest entities such as banks, insurance firms, and listed companies to rotate audit firms every 14 years.

That period could be extended to 25 years when certain safeguards are put into place.

Thursday’s vote resulted in a toned-down version of reforms previously proposed by the European Commission, which called for mandatory rotation every six years. A majority on the committee judged that period to be a costly and unwelcome intervention in the audit market, according to a committee news release.

The proposal still has to go through several steps before it becomes law. Negotiations with the European Council will commence soon. Sajjad Karim, a European Parliament member from the UK who drafted the reforms, said during a news conference that he hopes a final vote in Parliament will take place before the end of the year.

Mandatory audit firm rotation has been a subject of global controversy since politicians and regulators began exploring the issue following the start of the financial crisis. Opponents have said mandatory rotation would increase costs without improving audit quality.

Nick Topazio, head of corporate reporting at the Chartered Institute of Management Accountants (CIMA), said that CIMA does not agree with the proposal to introduce mandatory rotation of audit firms.

“There is simply no guarantee that the benefits of improved independence and objectivity that may result from changing audit firms will outweigh the costs of change,” Topazio said in a statement. “There is a high probability that a new auditor will have so much less knowledge about the company that it will take years for them to duplicate the understanding that previously existed with the incumbent auditor. As a result, investors and the public will be less, rather than more, protected.”

CIMA partnered with the AICPA to create the CGMA designation. AICPA President and CEO Barry Melancon also issued a statement.

“We will continue to monitor developments in Europe, with consideration to the overwhelming majority of stakeholders in the United States who oppose mandatory firm rotation because of cost and lack of evidence it will enhance audit quality,” Melancon said.

In addition to requiring term limits for audit firms, the draft law would:

• Prohibit “Big Four-only” contractual clauses that require a company’s audit to be done by one of the Big Four accounting firms (Deloitte, Ernst & Young, KPMG, and PwC).
• Require auditors of public-interest entities (PIEs) to publish audit reports according to international standards and provide shareholders and investors with a detailed understanding of what the auditor did and an overall assurance of the accuracy of the company’s accounts.
• Prohibit audit firms from providing nonaudit services that could jeopardize independence. The committee approved a list of services that would be prohibited. For instance, auditing firms would be able to continue providing certification of compliance with tax requirements, but would be prohibited from supplying tax advisory services that directly affect the company’s financial statements and may be subject to question by national tax authorities.

The proposed ban on only certain nonauditing services was less prohibitive than a European Commission proposal that would have prohibited audit firms from providing nonaudit consultancy services to their clients.

“The report which was voted through is a compromise,” Karim said during a news conference following the vote. “No one was able to get everything they wanted.”

Transition will be discussed in negotiations with the European Council, Karim said.

The idea of mandatory audit firm rotation also is being explored elsewhere. The UK Competition Commission is considering imposing term limits for large listed companies and will come to a final decision by Oct. 20.

In the United States, the PCAOB has been studying the issue of mandatory audit firm rotation for public companies since issuing a concept release that included the topic in August 2011. But PCAOB member Jay Hanson said in December that many obstacles make adoption of mandatory audit firm rotation unlikely.

Topazio said CIMA would prefer that rotation of audit firms be left to the discretion of audit committees.

“Mandatory rotation may also restrict competition in some market segments,” he said. “Certain sectors require specialist auditing skills and experience, and these are built up over a number of years of working in the particular industry. Mandatory rotation is likely to deter audit firms from making this investment and so reduce the effective choice available to audit committees.”

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.