-debate Point of View Options to enhance the quality of audits of banks & other financial institutions February 2015

Transcription

1 -debate Point of View February 2015 Options to enhance the quality of audits of banks & other financial institutions in the EU

2 institutions in the EU Why is this important? Independence, objectivity and professional scepticism are at the heart of the credibility of, and public trust in, the audit profession and the statutory audit. We wholeheartedly believe the statutory auditor should continually be looking at ways to improve independence safeguards and rules to increase market confidence in the quality of audits, companies financial reporting and trust in the statutory auditor. Regulators, supervisory authorities and legislators are considering ways to enhance the independence, objectivity and professional scepticism of auditors and to address market concerns of over-familiarity between the auditor and management. The financial crisis raised particular concerns about the robustness and quality of the audits of the banks. Some legislators and regulators have proposed or introduced mandatory audit firm rotation as a solution. Certain stakeholders contend that more proscriptive requirements regarding mandatory audit firm rotation should be adopted more widely specifically for banks because of their importance to the capital markets. Others suggest it for all financial institutions. Why not mandatory audit firm rotation? Mandatory audit firm rotation is not an appropriate or proportionate solution as it puts audit quality at significant and unnecessary risk without addressing the issues, because: It does not improve independence it threatens it by reducing choice and competition, reducing the role and responsibilities of the audit committee, and making achieving independence more complex and complicated. The latter increases the risk of breaches occurring and subsequent risks to the integrity of the audit and capital market confidence It does not improve the auditor s objectivity and scepticism to be truly objective the auditor has to have sufficient knowledge of the company s activities and approaches and confidence in the security of their relationship with the audit committee and management to effectively challenge decisions and argue judgements It does not address over-familiarity between management and the auditor this argument is flawed. It is based on two assumptions: that long tenure equates to increased over-familiarity resulting in a lower quality audit; and that the threat of the loss of a client incentivises the auditor to perform better. Neither have been proven It does not improve audit quality too frequent change can undermine the quality of the audit and ultimately its value to the capital markets by reducing the auditor s: o o Knowledge of the company, its processes and risks, increasing the risks of failure to detect misapplication of policies and processes by management, whether accidental or deliberate Incentive to invest in improvements to the audit process and in its skills and expertise Why more proscriptive rotation requirements would have more adverse consequences for financial institutions in the EU? We believe for larger, more complex companies, and in particular for financial institutions, that the adverse impact of more proscriptive requirements regarding mandatory audit firm rotation, and in particular substantially shorter periods, is likely to be the most severe, bringing even greater risks. Such measures: Go against the principle of good regulation Banks and financial services companies are already subject to a range of additional regulatory requirements to enhance reporting and oversight, including new measures currently being introduced and considered. This includes Basel III & the Fourth Capital Requirements Directive (CRDIV), the Dodd Frank Act, and the potential structural ring-fencing of certain wholesale and retail services, and more are anticipated. We believe these measures need time to become embedded and for supervisors and regulators to evaluate their effectiveness before more are introduced. This would avoid further unsettling of the capital markets, undermining any benefits secured, and unnecessarily distracting the bank s operational and risk management, its financial reporting leadership and those charged with governance. Undermine audit quality in systemically important entities, with risks outweighing any perceived benefits Unnecessary additional administrative burden and complexity - particularly the larger financial institutions tend to engage one accounting network that has 2

3 institutions in the EU Continued (1) common audit methodologies and communication tools to facilitate and enhance consistency and quality across all the countries where they operate. The scope in the new EU audit legislation for individual member states to introduce different rotation periods could result in an additional substantial bureaucratic burden for those financial institutions, including non-eu based entities, with subsidiaries (especially those which are EU PIEs in their own right 1 ) in multiple member states. When such institutions are required to rotate their statutory auditor in one or more countries, they may be forced to either engage multiple auditors across the group, or change their accounting network internationally on an arbitrary basis irrespective of who is best placed to do the work. Needing to meet a diverse set of requirements, particularly shorter rotation periods, exacerbates both the risks and the complexity of the issues faced. None of these options enhance audit quality. Particularly for the largest and most complex banks operating global businesses, having a number of auditors across their major operations is likely not feasible: the auditor has to have access to all major operations in order to have a sufficient understanding of cross-border transactions, management processes and risks and controls to deliver a quality audit. Even if multiple auditors were a realistic option (which in general we do not think it is), the increased risks of significant issues being missed is substantial. These risks increase with more frequent rotation. In this context, we support the European Commission s view that there should not be additional national proscriptions for types of entity, and that both the rotation term and the possibility of an extension to this, should be the same for all companies covered by the legislation. Loss of knowledge and expertise - the institutional knowledge, skills and experience needed to perform the high-quality audit of banks and financial institutions, particularly those which are international and large, are not easily or quickly replicated. Accounting firms must have sufficient experienced staff who can be deployed in all the countries where an institution operates to perform a quality audit and to meet partner rotation, quality review, and independence requirements. This is further complicated by the small scale of the population of such entities. A deep understanding of the businesses being audited is critical to audit quality particularly, for example, to audit the many complex judgements reflected in a bank s financial statements. These include, for example, the appropriate level of impairment allowance, the valuation of illiquid instruments, the accounting for structured transactions, and the assessment of disclosures of financial risks that are of themselves increasingly complex. Mandatory audit firm rotation results in the prior auditor s cumulative knowledge of an institution s risks, processes, controls and culture being lost. Newly appointed accounting firms do not generally have the detailed broad-based experience of the new company they are to audit and may not initially have all the expertise required to audit it. There is evidence that too frequent and regular changes of the accounting firm may put audit quality at significant and unnecessary risk and compromise the ability of the new firm to detect misapplication of policies and processes by management, by error or fraud. Whilst these risks could be managed for individual bank auditor changes that already occur, the impact of more proscriptive rotation rules, and particularly shorter rotation periods, would significantly increase transition risks as they would severely challenge the ability of banks and other financial institutions and the accounting firms to manage multiple auditor rotations on a global scale. Pose further challenges to audit committees in overseeing auditor independence, reduce the company s choice of audit firms and restrict competition in the audit market The challenges of achieving and maintaining independence are substantially more complex and costly for banks than for companies in other industries. The introduction of more proscriptive rules for financial institutions with multiple EU PIEs in their structure (each of whom are subject to the rotation requirements) could become unmanageable, and undermine the auditor s independence and market confidence. The independence rules are complex and inconsistent around the world. Major international banks typically provide banking services to the accounting firms that 1 Within the EU the following entities are categorised as a PIE: All entities that are both governed by the law of a Member State and listed on a regulated market All credit institutions in the EU, irrespective of whether they are listed or not All insurance undertakings in the EU, irrespective of whether they are listed or not and irrespective of whether they are life, non-life, insurance or reinsurance undertakings Note: these two categories exclude branches of non- EU based credit instructions and insurance undertakings 3

4 institutions in the EU Continued (2) are not their auditor, and often provide otherwise impermissible services to the partners, employees (and their spouses and other relatives) of these firms. Banks cannot provide these services to their audit firm no matter how insignificant the value. A change of auditor requires the new accounting firm, its partners and many of its employees, to establish alternative banking arrangements. In addition to restricting choice, too frequent changes of this nature are disruptive and could be a deterrent to recruiting the best quality staff. For large global banks, rotation already rules out one or more of the accounting networks. The introduction of more proscriptive requirements for financial institutions would further limit the choice of alternative audit providers, increase costs to the banks, perhaps significantly, and place an increased administrative burden on the audit committee. In all industries, mandatory rotation of audit firms reduces competition as the incumbent accounting firm cannot compete, even if it is the firm most likely to provide the highest quality audit. In banking and financial services, this is of particular concern because of the knowledge and skills required to deliver a highquality audit. Independence is also affected by the specialised non audit services that banks need to provide their complex services and meet regulatory requirements. The large accounting networks are (to the banks they do not audit) among the largest providers of these services because of their specific skills, principally in risk, regulation and controls. Independence rules already require the new accounting firm to immediately cease any services that conflict with auditor independence and in some cases require a specified cooling off period to achieve it. This often cannot be done quickly or may prevent an accounting firm from seeking the work altogether, further restricting choice in the market for these services. Equally, introducing shorter rotation requirements for banks and other financial institutions increases the difficulties of achieving independence and the risk of unintended breaches of the requirements adversely impacting the integrity of an audit with potentially substantial market impacts. Are unsubstantiated with no evidence, or prior experience, that it improves audit quality or prevents a financial crisis There is neither evidence nor experience that the consequences of the financial crisis would have been prevented or reduced by mandatory audit firm rotation or that it could have improved audit and financial reporting quality for banks. In fact, many countries, such as Brazil, Korea, and Singapore, have abandoned mandatory audit firm rotation either specifically for their major banks or for all companies, as a consequence of the disruption it causes to the institutions themselves and to the capital markets, and particularly during times of economic and financial upheaval and or substantial regulatory change. It could in this context, therefore, be argued that rotation, particularly on a shorter period, could have made the situation even worse. What do we propose? In addition to what we have outlined in our Point of View on Mandatory Firm Rotation, we believe a range of other measures to enhance the quality of the audits of financial institutions, and banking audits specifically, and which could be developed further alongside other measures of audit and financial reform, could include: 1. Additional powers and responsibilities for banking, financial and markets regulators / supervisors to assess: a) Audit committee oversight consistent assessment of the processes adopted by audit committees in their oversight of audit quality, including audit appointment processes. b) Individual bank-specific risks knowledge sharing and collaboration between auditors and supervisors relating to risks. c) Systemic, macro industry risks increased dialogue with audit firms at the national and supra-national level regarding specific accounting and auditing issues and emerging macro industry risks impacting financial stability. 2. Enhanced relevant financial reporting, disclosures and assurance for banks, including: a) Greater clarity about the information banks and their auditors provide to markets. Improvements in the current bank reporting framework, including our support for the Enhanced Disclosure Task Force (EDTF) of the Financial Stability Board (FSB), and more consistent and relevant information describing the risk management process and controls in place at a bank. c) Disclosures about matters that could affect the going concern assumption. 4

5 institutions in the EU Continued (3) 3. Increased dialogue between: a) Auditors and the risk committees of the financial institutions they audit, including regarding key judgements, decisions, inspection result findings, etc. b) Supervisory and oversight bodies, at both a national and EU level,including inspection methodologies and result findings. Why do we believe such measures would be better and more effective? We believe these measures would be more effective and less disruptive for banks and other financial institutions because they would: Reinforce independence and corporate governance by enhancing the oversight role of audit committees (and others responsible for oversight of the audit) while maintaining choice and enhancing competition Increase capital market confidence in the value and quality of financial statements by improving transparency and the relevance of reporting to market participants Provide financial and markets supervisors (and auditors) with better information thus enhancing the overall quality of financial supervision and oversight Not result in the loss of auditor knowledge and expertise Not impose further administrative burden and complexity on systemically important institutions We firmly believe that the benefits and advantages of these measures, weighed against the likely significant and detrimental effects of the introduction of more proscriptive requirements regarding mandatory audit firm rotation for banks and financial institutions, should be assessed and evaluated before introducing legislation to enforce change in such a systemically important industry. In conclusion Regulators and supervisory authorities are already working together to develop new and more effective ways to enhance oversight of the audit and of the audit market. We support such moves. Recent developments to enhance the availability of high quality, comparable and comprehensive data on the global financial network should be encouraged. These include: Adoption of the new so-called legal entity identifiers overseen by the FSB Development of a single, standard data model shared by regulators and industry to replace the current regulatory reporting systems with multiple returns and inconsistent definitions Wider consideration of the new going concern, risk management and internal control reporting requirements set out in the 2014 revision of the UK Corporate Governance Code We have serious reservations about the additional risks presented by the adoption within the EU of more proscriptive rotation requirements for large, complex banks and financial institutions. Such measures could: Undermine recent reforms that have improved audit quality (such as enhanced audit committee oversight of the relationship between company and auditor) Derail other regulatory changes being introduced to improve the strength and stability of the financial sector Have the opposite effect as they do not enhance auditor independence, objectivity or scepticism - and as a consequence, are not in the public interest. We believe alternative approaches, such as those we have set out, are more effective and less disruptive solutions, and have the added benefits of reinforcing independence and corporate governance, maintaining choice, and most important of all, enhancing audit quality. This Point of View forms part of a series which sets out our views on a range of key issues impacting the statutory audit. These are available at: and also include: Independence: at the heart of who we are. Auditor s scope of services. Governance and transparency of the audit: a critical role for the audit committee. Benefits of scale: the context and the explanation. Competition and choice in the audit market. Mandatory audit firm rotation. 5

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