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Navigating the Complex, Impending EU Auditor Rotation Rules

Robert Herz | February 25, 2014

New European Union audit regulations could affect a number of U.S. companies, particularly those with subsidiaries with listed securities in the European Union or those that have European banking or insurance operations.

The impending EU rules include requirements for mandatory audit firm rotation, as well as restrictions on certain non-audit services and overall caps on the level of non-audit services external auditors can provide to their clients.

The subject of mandatory audit firm rotation has been discussed many times over the past 35 years, both in the United States and in other parts of the world, most recently in the wake of the financial crisis of 2008. In the United States he Public Company Accounting Oversight Board issued a concept release in 2011 seeking public comment on ways to enhance the independence, objectivity, and professional skepticism of external auditors. The release specifically raised the possibility of mandatory audit firm rotation as one way to achieve these objectives.

The PCAOB received over 680 comment letters and held three public roundtables on the concept release. Most commentators opposed mandatory audit firm rotation on various grounds, including that it would not, in their view, improve audit quality and could have the opposite effect. Last July, the U.S. House of Representatives weighed in as well when it passed a bill that would prohibit the PCAOB from requiring mandatory firm rotation. So while the project on auditor independence, objectivity, and professional skepticism is still on the PCAOB's agenda, it currently seems unlikely that it will lead to mandatory audit firm rotation here in the United States.

The European Union, on the other hand, is close to finalizing its rules on mandatory audit firm rotation and new prohibitions on non-audit services. A good deal of the discussion in Europe has focused on ways to increase competition in the market for audits and reduce the concentration of audits performed by the Big 4 accounting firms within the European Union.

These new rules will apply to the statutory audits of “public interest entities.” PIEs include all companies in the European Union (including subsidiaries of non-EU companies) with listed securities in the European Union and other entities with a significant public interest, including banks and insurance companies.

Under the new law, which the European Parliament is expected to pass in the next few months, each EU member state must require its PIEs to rotate their audit firm at least every 10 years. The law will enable EU member states, however, to extend the maximum period for audit firm rotation by an additional 10 years for PIEs that put the audit out for competitive bids, or by an additional 14 years for PIEs that are subject to a joint audit, meaning two or more independent audit firms share responsibility for the audit.

The new law will also contain prohibitions on auditors providing certain tax, consulting, and advisory services to their audit clients that are more extensive and in some cases more proscriptive than current SEC rules on non-audit services. It will also cap permitted non-audit services provided by the audit firm at 70 percent of the average of the audit fees paid in the last three years and will require audit committees to approve all non-audit services provided by the company's audit firm.

The new EU law could take effect as early as July 2016, with transitional rules on mandatory audit firm rotation in order to spread the initial round of auditor changes over a reasonable period. Where a PIE has had the same audit firm for 20 years or more from the date the new rules are enacted, for example, it will not be able to reappoint that audit firm after July 2020, while PIEs that have changed their auditor more recently will have a longer transition period.

Another important point is that EU laws effectively operate as minimum requirements, as individual member states are able to prescribe stricter rules. A particular member state could, for example, decide that it should require mandatory audit firm rotation every 7 years or could limit extensions for public tenders of the audit or for joint audits.

Global Implications

Beyond EU companies,  the new rules could also mean changes for those based in the United States and in other parts of the world that have operations within the European Union that qualify as PIEs, most notably major financial institutions.

Companies with global operations may have already had to deal with these issues, as countries including Italy, Brazil, and South Korea already require periodic audit firm rotation. Because the new EU rules will apply across many more countries and because each EU member state is able to apply the EU law somewhat differently, however, the rules may pose a new level of challenges, complexity, and added costs for affected companies in managing their global audit relationships. For example, France, which requires joint audits, might opt to allow the extension on mandatory audit firm rotation only for joint audits, while Britain might only permit it for entities that put the audit out for bid, or Italy might decide to retain its current 9-year period for mandatory audit rotation.

Frequent audit firm rotation may be undesirable for many reasons, including the potential additional cost and disruption to companies, a reduction in audit quality that can occur when there is a change in auditor, and added difficulties in ensuring compliance with auditor independence rules.

So while the effects of the new EU law may not be felt for a number of years, what kinds of issues and potential courses of action should affected U.S. companies and their audit committees and boards begin to consider? While the new EU rules are complex and there are many open questions and uncertainties, some broad considerations may be in order. The first step, of course, is to explore whether and how the new EU law and related individual member state regulations apply to the company's subsidiaries and operations within the EU.

There would seem to be various potential alternative courses of action available to companies on mandatory audit firm rotation, each of which may pose different challenges and relative pros and cons. A U.S. company that operates in many countries, for example, and wants to have a single audit firm perform the audit of its consolidated financial statements and the statutory audits of all its foreign subsidiaries might consider periodically changing its worldwide audit firm.

Yet that route may present a number of other challenges and concerns. If different countries stipulate different periods for mandatory audit firm rotation, the worldwide auditor change would need to occur based on the requirements of the country or countries that have the shortest period for mandatory audit firm rotation. Frequent audit firm rotation may be undesirable for many reasons, including the potential additional cost and disruption to companies, a reduction in audit quality that can occur when there is a change in auditor, and added difficulties in ensuring compliance with auditor independence rules.

Alternative Options

Another course of action might be to have one audit firm conduct the global audit for the company's consolidated financial statements, but to rotate the audit firm or firms performing the various statutory audits in order to comply with the rules in each country. While the firms doing the statutory audits may be able to leverage the work of the global audit firm, this approach can result in added costs, effort, and complexity to a company in managing its worldwide audit relationships.

Another option, having joint audits of particular foreign subsidiaries between the company's global audit firm and one or more audit firms may enable companies to significantly extend the period for mandatory audit firm rotation. But again, joint audits can result in added costs and pose challenges to coordination and compliance with independence rules and in some instances might negatively impact audit quality.

Extending the time frame for mandatory audit firm rotation might also be achieved by periodically tendering the worldwide audit or the statutory audits in particular countries. This could provide benefits to the company, such as receiving new ideas and potential fee reductions from the competing audit firms. The process of developing requests for proposals, however, and vetting and evaluating the proposals can be time consuming and disruptive, even where the company decides to retain its current auditor.

Still another approach might be to have multiple audit firms, with each firm performing both the statutory audit in a particular country or countries and the audit work on those operations relating to the overall worldwide audit of the consolidated financial statements. Again, though, this may raise significant cost, coordination, and quality issues and may preclude any one firm from qualifying as the “principal auditor” that takes overall responsibility for the audit of the consolidated financial statements. There may be other strategies and combinations of different alternatives, and the evaluation of the relative merits and disadvantages of different courses of action will likely differ from company to company depending on factors such as the number and significance of a company's PIEs in Europe.

This is complex area and I would advise companies with European operations to consult with their accounting and law firms. It's yet another example of the kind of challenges encountered by multinational companies in complying with the myriad of different national and regional laws, rules, and regulations.