Commission Recommendation

of 16 May 2002

Statutory Auditors' Independence in the EU: A Set of Fundamental Principles

(notified under document number C(2002) 1873)

(Text with EEA relevance)

(2002/590/EC)

THE COMMISSION OF THE EUROPEAN COMMUNITIES,

Having regard to the Treaty establishing the European Community, and in particular Article 211, second indent thereof,

Whereas:

(1) The independence of statutory auditors is fundamental to the public confidence in the reliability of statutory auditors' reports. It adds credibility to published financial information and value to investors, creditors, employees and other stakeholders in EU companies. This is particularly the case in companies which are public interest entities (e.g., listed companies, credit institutions, insurance companies, UCITS and investment firms).

(2) Independence is also the profession's main means of demonstrating to the public and regulators that statutory auditors and audit firms are performing their task at a level that meets established ethical principles, in particular those of integrity and objectivity.

(3) Council Directive 84/253/EEC(1) on "the approval of persons responsible for carrying out the statutory audits of accounting documents" establishes the minimum qualifications required of persons who are allowed to carry out statutory audits.

(4) Articles 24 and 25 of this Directive require EU Member States to prescribe that statutory auditors do not carry out statutory audits, either in their own right or on behalf of an audit firm, if they are not independent. Article 26 of the Directive requires Member States to ensure that statutory auditors are liable to appropriate sanctions when they do not carry out a statutory audit in an independent manner. Furthermore, Article 27 of the Directive requires Member States to ensure, at a minimum, that the members and shareholders of an audit firm do not intervene in the conduct of statutory audits in any way which jeopardises the independence of the natural persons performing the statutory audit on behalf of that audit firm. This requirement also applies to those members of the administration, management and supervisory body of the audit firm who are not personally approved as statutory auditors.

(5) Member States' national rules on statutory auditors' independence currently differ in several respects such as: the scope of persons to whom independence rules should apply, both within an audit firm and outside the firm; the kind of financial, business or other relationships that a statutory auditor, an audit firm or an individual within the firm may have with an audit client; the type of non-audit services that can and cannot be provided to an audit client; and the safeguards which need to be put in place. This situation makes it difficult to provide investors and other stakeholders in EU companies with a uniformly high level of assurance that statutory auditors perform their audit work independently throughout the EU.

(6) At present there is no internationally accepted ethics standard for statutory auditors' independence that could be used as a benchmark for national independence rules throughout the EU.

(7) The issue of statutory auditors' independence was addressed by the Commission's 1996 Green Paper(2) on "The Role, Position and Liability of the Statutory Auditor in the EU" that received the support of the Council, the Economic and Social Committee and the European Parliament. As a result of the Commission's 1998 Communication "The Statutory Audit in the European Union, the way forward"(3) the EU Committee on Auditing was created. This Committee established statutory auditors' independence as one of their priorities. Finally, the Commission's Communication "EU Financial Reporting Strategy: the way forward"(4) underlines the importance of a statutory audit carried out to uniformly high levels across the EU, including a common approach to professional ethics standards.

(8) The scope of this initiative on statutory auditors' independence applies to the EU statutory audit profession as a whole. It aims at setting a benchmark for Member States' requirements on statutory auditors' independence throughout the EU.

(9) Agreement was reached in the Committee on Auditing that each Member State should provide statutory auditors, regulators and the interested public with a common understanding of the independence requirement by the application of fundamental principles. This will bring about consistency in interpreting and addressing facts and circumstances which threaten a statutory auditor's independence throughout the EU. The existence of such principles should also help to provide a level playing field for the provision of statutory audit services within the single market. The principles should be comprehensive, rigorous, robust, enforceable and reasonable. They should be consistently interpreted and applied by professional bodies, supervisors and regulators, as well as by statutory auditors, their clients and other interested parties.

(10) Agreement was also reached in the Committee on Auditing to build on this initiative in order to develop common independence standards. This will contribute to the creation of a single EU capital market as outlined by the Financial Services Action Plan(5) and endorsed by the Stockholm European Council(6). However, whilst work to achieve harmonisation continues, the setting of national independence rules that are complementary to EU fundamental principles is to be left to the discretion of Member States. Such rules would apply in particular to statutory audits of companies operating in regulated industries. Member States may also decide to require the application of the same independence standards to unlisted companies as applicable to listed companies.

(11) A principles-based approach to statutory auditors' independence is preferable to one based on detailed rules because it creates a robust structure within which statutory auditors have to justify their actions. It also provides the audit profession and its regulators with the flexibility to react promptly and effectively to new developments in business and in the audit environment. At the same time, it avoids the highly legalistic and rigid approach to what is and is not permitted which can arise in a rules-based regime. A principles-based approach can cater for the almost infinite variations in individual circumstances that arise in practice and in the different legal environments throughout the EU. Consequently, a principles-based approach will better serve the needs of European capital markets, as well as those of SMEs.

(12) The benefits of safeguarding the statutory auditors' independence include efficiencies and other positive effects that, ultimately, contribute to the overall efficiency of the capital markets. On the other hand, maintaining statutory auditor independence creates a variety of additional costs that have to be borne by various parties. These include the costs that are related to developing, maintaining, and enforcing safeguards to independence. When seeking to impose a certain safeguard on statutory auditors, Member States and regulators need to take into account the anticipated costs and benefits in particular circumstances. For example, a particular safeguard may bring substantial public benefits at a modest cost when applied to the audits of public interest entities. But if applied to the audit of a small company with relatively little public interest, the same safeguard may result in costs that are disproportionate to the associated benefits to the users of this company's financial statements.

(13) Establishing fundamental principles is not in itself sufficient to ensure public confidence that the EU statutory auditor applies proper standards of integrity and independence. Appropriate systems of quality assurance are necessary in order to check that the principles are properly applied by EU statutory auditors. In this regard the Commission Recommendation on "Quality Assurance for the Statutory Auditor in the EU"(7) provides for external quality reviews of statutory auditors, including a review of compliance with independence standards. Such quality assurance systems are subject to public oversight.

(14) This Recommendation is an important step towards assuring audit quality. Further steps may be necessary. The Commission intends to come forward with a broader strategy on auditing which will address issues such as the use of International Standards on Auditing (ISAs), the establishment of a public oversight on the audit profession and the role of audit committees.

(15) This Recommendation emphasises the responsibility of the audit profession to uphold auditor independence. If this Recommendation does not bring about the desired harmonisation, the Commission will review the situation three years after the adoption of this Recommendation taking into account international developments. This review will specifically address the question to what extent this Recommendation has had an impact on auditor independence where auditors have provided non-audit services to audit clients.

(16) There is general agreement in the EU Committee on Auditing and in the Contact Committee on the Accounting Directives on the fundamental principles of this Recommendation.

(17) This Recommendation provides a framework within which all of the general issues of statutory auditors' independence are considered. Its Section A sets out the overarching independence requirements for statutory auditors and discusses the scope of persons to whom independence rules should apply. Section B then reviews a range of specific circumstances in which threats to independence could arise and provides guidance on the measures a statutory auditor should take to mitigate such threats in relation to a particular statutory audit. It is to be noted that Section B is not intended to provide an exhaustive list of all the circumstances where threats to auditor independence might arise, but that statutory auditors should be alert to any such threat and take whatever action is necessary in accordance with the principles and guidance in this Recommendation. The basic principles in Section A and the essential safeguards that are provided in Section B for specific circumstances are supported by an annex, which provides related explanations and guidance. Important terms are defined in the Appendix,

HEREBY RECOMMENDS:

That rules, standards and/or regulation on statutory auditors' independence in the Member States of the European Union should implement the following set of fundamental principles:

A. FRAMEWORK

When carrying out a Statutory Audit(8), a Statutory Auditor(9) must be independent from his Audit Client(10), both in mind and in appearance. A statutory auditor should not carry out a Statutory Audit if there are any financial, business, employment or other relationships between the statutory auditor and his client (including certain non-audit services provided to the audit client) that a reasonable and informed third party would conclude compromise the statutory auditor's independence.

1. Objectivity, integrity and independence

1. Objectivity and professional integrity should be the overriding principles underlying a statutory auditor's audit opinion on financial statements. The main way in which the Statutory Auditor can demonstrate to the public that a Statutory Audit is performed in accordance with these principles is by acting, and being seen to act, independently.

2. Objectivity (as a state of mind) cannot be subjected to external verification, and integrity cannot be evaluated in advance.

3. Principles and rules on statutory auditors' independence should allow a reasonable and informed third party to evaluate the procedures and actions taken by a Statutory Auditor to avoid or resolve facts and circumstances that pose threats or risks to his objectivity.

2. Responsibility and scope

1. It is the responsibility of the Statutory Auditor to ensure that the requirement for statutory auditors' independence is complied with.

2. The independence requirement applies to:

(a) the Statutory Auditor himself; and

(b) those who are in a position to influence the outcome of the Statutory Audit.

3. Those in a position to influence the outcome of the Statutory Audit are:

(a) all persons who are directly involved in the Statutory Audit (the Engagement Team(11)), including

(i) the Audit Partners(12), audit managers and audit staff (the Audit Team(13));

(ii) professional personnel from other disciplines involved in the audit engagement (e.g., lawyers, actuaries, taxation specialists, IT-specialists, treasury management specialists);

(iii) those who provide quality control or direct oversight of the audit engagement;

(b) all persons, who form part of the Chain of Command(14) for the Statutory Audit within the Audit Firm(15) or within a Network(16) of which the firm is a member;

(c) all persons within the Audit Firm or its Network who, due to any other circumstances, may be in a position to exert influence on the Statutory Audit.

3. Independence threats and risk

1. Statutory auditors' independence can be affected by different types of threats, including self-interest, self-review, advocacy, familiarity or trust, and intimidation.

2. The level of risk that a Statutory Auditor's independence might be compromised will be determined by reference to the significance of these threats, either individually or in combination, and their impact on the Statutory Auditor's independence. This determination will need to consider the specific circumstances that relate to the Statutory Audit concerned.

3. A Statutory Auditor's independence risk assessment should have due regard to both:

(a) the services provided to the Audit Client in recent years and the relationships that existed with that Audit Client before the appointment as Statutory Auditor; and

(b) the services provided to, and the relationships that exist with, the Audit Client during the course of the Statutory Audit.

4. Systems of safeguards

1. Different types of safeguards - including prohibitions, restrictions, other policies and procedures, and disclosures - have to be established in order to mitigate or eliminate threats to statutory auditors' independence (see A. 3).

2. The existence and the effectiveness of various safeguards affect the level of independence risk.

4.1. Audited entities' safeguards

4.1.1. Governance structure's impact on independence risk assessment

The Statutory Auditor should consider whether the governance structure of the audited entity provides safeguards to mitigate threats to his independence and how these safeguards are operated. Such safeguards include:

1. the appointment of the Statutory Auditor by persons other than the audited entity's management; and

2. oversight and communications within the audited entity regarding the Statutory Audit and other services provided to it by the Audit Firm or its Network.

4.1.2. Involvement of the Governance Body

1. Where a Public Interest Entity has a Governance Body (see A. 4.1.1), the Statutory Auditor should at least annually:

(a) disclose to the Governance Body, in writing:

(i) the total amount of fees that he, the Audit Firm and its Network members have charged to the Audit Client and its Affiliates for the provision of services during the reporting period. This total amount should be broken down into four broad categories of services: Statutory audit services; further assurance services(17); tax advisory services; and other non-audit services. The category of other non-audit services should be further broken down into subcategories so far as items in them differ substantially from one another. This break-down into subcategories should at least provide information on fees for the provision of financial information technology, internal audit, valuation, litigation and recruitment services. For each (sub-)category of service, the amounts charged and contracted for, as well as existing proposals or bids for future services contracts should be separately analysed;

(ii) details of all relationships between himself, the Audit Firm and its Network member firms, and the Audit Client and its Affiliates(18) that he believes may reasonably be thought to bear on his independence and objectivity; and

(iii) the related safeguards that are in place;

(b) confirm in writing that, in his professional judgement, the Statutory Auditor is independent within the meaning of regulatory and professional requirements and the objectivity of the Statutory Auditor is not compromised, or otherwise declare that he has concerns that his independence and objectivity may be compromised; and

(c) seek to discuss these matters with the Governance Body of the Audit Client.

2. Where Audit Clients other than Public Interest Entities have a Governance Body, the Statutory Auditor should consider whether similar measures are appropriate.

4.2. Quality assurance

Quality assurance systems which meet the minimum requirements of the Commission Recommendation on "Quality Assurance for the Statutory Audit in the EU"(19) are required mechanisms contributing to safeguard statutory auditors' compliance with the independence requirement at a Member State level.

4.3. The Statutory Auditor's overall safeguards

4.3.1. Ownership of and control over Audit Firms

If the Statutory Auditor is an Audit Firm, at least the majority of the firm's voting rights (50 % plus one vote) must be held by persons who are authorised to perform Statutory Audits within the European Union (statutory auditors(20)). The Statutory Auditor's legal statutes should contain provisions to ensure that a non-auditor owner could not gain control over the Audit Firm(21).

4.3.2. The Audit Firm's internal safeguarding system

1. A Statutory Auditor should set up and maintain a safeguarding system that is an integral part of his firm-wide management and internal control structure.

2. The functioning of such a system should be documented so that it can be subject to quality assurance systems (see A. 4.2).

3. Generally, the safeguarding system of an Audit Firm would include:

(a) written independence policies which address current independence standards, threats to independence, and the safeguards related thereto;

(b) active and timely communication of the policies, and any changes to them, to each Partner, manager and employee, including regular training and education thereon;

(c) appropriate procedures to be applied by Partners, managers and employees in order to meet independence standards, both on a regular basis and in response to particular circumstances;

(d) designation of top-level audit professionals (Partners) responsible for updating the policies, timely communication of those updates, and overseeing the adequate functioning of the safeguarding system;

(e) documentation for each Audit Client that summarises the conclusions that have been drawn from the assessment of threats to the Statutory Auditor's independence and the related evaluation of the independence risk. This should include the reasoning for these conclusions. If significant threats are noted, the documentation should include a summary of the steps that were, or are to be, taken to avoid or negate the independence risk, or at least reduce it to an appropriate level; and

(f) internal monitoring of compliance with safeguarding policies.

5. Public disclosure of fees

1. Where a Statutory Auditor or, if the Statutory Auditor is a natural person, a firm of which he is a member or Partner has received fees from an Audit Client for (audit and non-audit) services provided during the client's reporting period, all these fees should be publicly and appropriately disclosed.

2. Member States or their regulatory bodies should require this disclosure to the extent that an Audit Client's audited financial statements have to be published in accordance with their national law.

3. The total fee income should be broken down by four categories: statutory audit services; further assurance services; tax advisory services; and other non-audit services. The fees for other non-audit services should be further broken down into subcategories so far as items in them differ substantially from one another. This break-down into subcategories should at least provide information on fees for the provision of financial information technology, internal audit, valuation, litigation and recruitment services. In respect of each (sub-)category item, the figure relating to the corresponding (sub-)category item for the preceding reporting period should be shown as well. Furthermore, a percentage break-down for the (sub-)categories should be provided.

4. Where a Statutory Audit of consolidated financial statements is concerned, the fees received by the Statutory Auditor and his Network members for the services they provided to the Audit Client and its consolidated entities should be disclosed accordingly.

B. SPECIFIC CIRCUMSTANCES

1. Financial interests

1. An actual or impending, direct or indirect financial interest in the Audit Client or its Affiliates, including any derivative directly related thereto, may threaten the Statutory Auditor's independence, if it is held by the Statutory Auditor or any other person being in a position to influence the outcome of the Statutory Audit (any person within the scope of A. 2).

The Statutory Auditor has to assess the significance of any such threat, identify whether any safeguards would mitigate the independence risk it presents, and take any action necessary. This may include refusal of, or resignation from, the audit engagement or exclusion of the relevant person from the Audit Team. Where applicable, and especially with regard to Public Interest Entity clients, the Statutory Auditor should seek to involve the Governance Body in this process.

2. Financial interest in the Audit Client or its Affiliates will be incompatible with the Statutory Auditor's independence, if:

(a) the Statutory Auditor, the Audit Firm, or any member of the Engagement Team or the Chain of Command, or any Partner of the firm or its Network who is working in an "Office"(22) which participates in a significant proportion of an audit engagement, holds

(i) any direct financial interest in the Audit Client; or

(ii) any indirect financial interest in the Audit Client which is significant to either party; or

(iii) any (direct or indirect) financial interest in the client's Affiliates which is significant to either party;

(b) any other person within the scope of A. 2, holds any (direct or indirect) financial interest in the Audit Client or its Affiliates which is significant to either party.

Accordingly, the persons concerned should not hold any such financial interests. Where such an interest is acquired as a result of an external event (e.g. inheritance, gift, merger of firms or companies) it must be disposed of as soon as practicable, but no later than one month after the person has knowledge of, and the right to dispose of, the financial interest. In the meantime, additional safeguards are needed to preserve the Statutory auditor's independence. These could include a secondary review of the relevant person's audit work or exclusion of the relevant person from any substantive decision making concerning the Statutory Audit of the client.

3. The Statutory Auditor's independence may also be threatened by an apparently insignificant financial interest in an Audit Client or its Affiliates. The level of threat will be higher, and likely to be unacceptable, if the interest is neither acquired or held on standard commercial terms nor negotiated on an arm's length basis. It is the responsibility of the Statutory Auditor to assess the level of risk that such an interest presents and to ensure that any necessary mitigating action is taken.

2. Business relationships

1. Business relationships between the Statutory Auditor, the Audit Firm or any other person being in a position to influence the outcome of the Statutory Audit (any person within the scope of A. 2) on the one hand, and the Audit Client, its Affiliates, or its management on the other hand, may cause self-interest, advocacy or intimidation threats to the Statutory Auditor's independence.

2. Business relationships, or commitments to establish such relationships, should be prohibited unless the relationship is in the normal course of business and insignificant in terms of the threat it poses to the independence of the Statutory Auditor.

Where applicable, and especially with regard to Public Interest Entity clients, the Statutory Auditor should seek to discuss with the Governance Body of the Audit Client any cases where doubt arises whether or not a business relationship is in the normal course of business and insignificant in relation to his independence.

3. Paragraphs 1 and 2 above do not apply to the provision of statutory audit services. However, neither the Audit Firm nor any of its Network member firms should provide statutory audit services to:

(a) any owner of the Audit Firm; or

(b) an Affiliate of such an owner where the owner may be in a position to influence any decision-making of the Audit Firm which affects its statutory audit function; or

(c) an entity where any individual who has a supervisory or managerial role in that entity may be in a position to influence any decision-making of the Audit Firm which affects its statutory audit function(23).

3. Employment with the Audit Client

1. Dual employment of any individual who is in a position to influence the outcome of the Statutory Audit both in the Audit Firm (a person within the scope of A. 2) and in the Audit Client or its Affiliates should be prohibited. Loan staff assignments(24) to an Audit Client or any of its Affiliates are also regarded as dual employment relationships. Where an Audit Firm's employee has worked with an Audit Client under a loan staff assignment and is to be assigned to the audit Engagement Team of that client's Statutory Audit, this individual should not be given audit responsibility for any function or activity that he was required to perform or supervise during the former loan staff assignment (see also B. 5 below).

2. Where a member of the Engagement Team is to leave the Audit Firm and join an Audit Client, policies and procedures of the Audit Firm (see A 4.3) should provide:

(a) a requirement that members of any Engagement Team immediately notify the Audit Firm of any situation involving their potential employment with the Audit Client;

(b) the immediate removal of any such Engagement Team member from the audit engagement; and

(c) an immediate review of the audit work performed by the resigning or former Engagement Team member in the current and/or (where appropriate) the most recent audit. This review should be performed by a more senior audit professional. If the individual joining the client is an Audit Partner or the Engagement Partner, the review should be performed by an Audit Partner who was not involved in the audit engagement. (Where, due to its size, the Audit Firm does not have a Partner who was not involved in the audit engagement, it may seek either a review by another statutory auditor or advice from its professional regulatory body.)

3. Where a former Engagement Team member or an individual within the Chain of Command has joined an Audit Client, policies and procedures of the Audit Firm should ensure that there remain no significant connections between itself and the individual. This includes:

(a) regardless of whether the individual was previously involved in the audit engagement, that all capital balances and similar financial interests must be fully settled (including retirement benefits) unless these are made in accordance with pre-determined arrangements that cannot be influenced by any remaining connections between the individual and the Audit Firm;

(b) that the individual does not participate or appear to participate further in the Audit Firm's business or professional activities.

4. A Key Audit Partner leaving the audit firm to join the audit client for a Key Management Position(25), would be perceived to cause an unacceptably high level of independence risk. Therefore, a period of at least two years should have elapsed before a Key Audit Partner can take up a Key Management Position.

4. Managerial or supervisory role in Audit Client

1. An individual who is in a position to influence the outcome of the Statutory Audit (a person within the scope of A. 2) should not be a member of any management body (e.g. board of directors) or supervisory body (e.g. audit committee or supervisory board) of an Audit Client. Also, he should not be a member of such a body in an entity which holds directly or indirectly more than 20 % of the voting rights in the client, or in which the client holds directly or indirectly more than 20 % of the voting rights.

2. When a former member of the Engagement Team takes a managerial or supervisory role in an Audit Client, B. 3(3) and (4) will apply.

5. Establishing employment with Audit Firm

Where a director or manager of the Audit Client has joined the Audit Firm, this person should not become a member of the Engagement Team at any time in the two year period after leaving the Audit Client. If the person is a member of the Chain of Command, he should not take part in any substantive decisions concerning an audit engagement with this client or with one of its Affiliates at any time in the two year period after leaving the Audit Client. This requirement also applies to a former employee of the Audit Client unless the responsibilities he held and the tasks he performed at the Audit Client were insignificant in relation to the statutory audit function.

6. Family and other personal relationships

1. An individual who is a Statutory Auditor should not accept an audit engagement if one of his close family members:

(a) holds a senior management position with the Audit Client;

(b) is in a position to exert direct influence on the preparation of the Audit Client's accounting records or financial statements;

(c) has a financial interest in the Audit Client (see B. 1) unless it is insignificant; or

(d) has a business relationship with the Audit Client (see B. 2) unless it is in the normal course of business and insignificant in terms of the threat it poses to the independence of the Statutory Auditor.

2. Within an Audit Firm or Network an individual should not be assigned to the Engagement Team if one of his close family members meets any of the criteria under (1)(a) to (d) above, nor should an Audit Partner who is working in an "Office" where any of the other Partners in it has a close family member who meets these criteria.

Appropriate safeguards should ensure that a member of the Chain of Command does not participate in any decisions that directly relate to the audit engagement if one of his close family members meets any of the criteria under (1)(a) to (d) above, or if he is working in an "Office" where any of the Partners in it has a close family member who meets these criteria.

3. The Statutory Auditor should consider whether he or any other individual in the Engagement Team or Chain of Command, or any person working in an "Office" which includes himself or such an individual, has any other close personal relationships where similar safeguards would be needed.

4. Assessment of the facts of a relevant individual's close personal relationship should be based upon the knowledge of the Statutory Auditor and the individual concerned. The individual should be responsible for disclosing to the Statutory Auditor any fact and circumstance which might require safeguards to mitigate an unacceptable level of independence risk.

7. Non-audit services

7.1. General

1. Where a Statutory Auditor, an Audit Firm or one of its Network member firms provides services other than statutory audit work (non-audit services) to an Audit Client or to one of its Affiliates, the overall safeguarding system (A 4.3) of the Statutory Auditor has to ensure that:

(a) the individuals employed by either the Audit Firm or its Network member firm neither take any decision nor take part in any decision-making on behalf of the Audit Client or one of its Affiliates, or its management while providing a non-audit service; and

(b) where an independence risk remains due to specific threats which may result from the nature of a non-audit service, this risk is reduced to an acceptable level.

2. Even if not involved in the decision-making of the Audit Client or any of its Affiliates, the Statutory Auditor should consider, amongst others, which of the following safeguards in particular may mitigate a remaining independence threat:

(a) arrangements to reduce the risk of self-review by compartmentalising responsibilities and knowledge in specific non-audit engagements;

(b) routine notification of any audit and non-audit engagement to those in the Audit Firm or Network who are responsible for safeguarding independence, including oversight of ongoing activities;

(c) secondary reviews of the Statutory Audit by an Audit Partner who is not involved in the provision of any services to the Audit Client or to one of its Affiliates; or

(d) external review by another statutory auditor or advice by the professional regulatory body.

3. Where applicable, and especially with regard to Public Interest Entity clients, the Statutory Auditor should seek to discuss the provision of non-audit services to an Audit Client or to one of its Affiliates with the client's Governance Body (see A. 4.1.2).

7.2. Examples - analysis of specific situations

7.2.1. Preparing accounting records and financial statements

1. A self-review threat exists whenever a Statutory Auditor, an Audit Firm, an entity within a Network of firms or a Partner, manager or employee thereof participates in the preparation of the Audit Client's accounting records or financial statements. The significance of the threat depends upon the spectrum of these persons' involvement in the preparation process and upon the level of public interest.

2. The significance of the self-review threat is always considered too high to allow a participation in the preparation process unless the assistance provided is solely of a technical or mechanical nature or the advice given is only of an informative nature.

3. However, where Statutory Audits of Public Interest Entity clients are concerned, the provision of any such assistance other than that which is within the statutory audit mandate would be perceived to cause an unacceptably high level of independence risk, and should therefore be prohibited.

7.2.2. Design and implementation of financial information technology systems

1. The provision of services by the Statutory Auditor, the Audit Firm or an entity within its Network to an Audit Client that involve the design and implementation of financial information technology systems (FITS) used to generate information forming part of the Audit Client's financial statements may give rise to a self-review threat.

2. The significance of the self-review threat is considered too high to permit a Statutory Auditor, an Audit Firm or one of its group member firms to provide such FITS services unless:

(a) the Audit Client's management acknowledges in writing that they take responsibility for the overall system of internal control;

(b) the Statutory Auditor has satisfied himself that the Audit Client's management is not relying on the FITS work as the primary basis for determining the adequacy of its internal controls and financial reporting systems;

(c) in the case of an FITS design project, the service provided involves design to specifications set by the Audit Client's management; and

(d) the FITS services do not constitute a "turn key" project (i.e., a project that consists of software design, hardware configuration and the implementation of both), unless the Audit Client or its management explicitly confirms in the written acknowledgement required under (a) that they take responsibility for

(i) the design, implementation and evaluation process, including any decision thereon; and

(ii) the operation of the system, including the data used or generated by the system.

These provisions shall not limit the services a Statutory Auditor, an Audit Firm or a member of its Network performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls, provided these persons do not act as an employee or perform management functions.

3. In cases not prohibited under (2) the Statutory Auditor should consider whether additional safeguards are needed to mitigate a remaining self-review threat. In particular whether services that involve the design and implementation of financial information technology systems should only be provided by an expert team with different personnel (including engagement partner) and different reporting lines to those of the audit Engagement Team.

7.2.3. Valuation services

1. A self-review threat exists whenever a Statutory Auditor, an Audit Firm, an entity within a Network or a Partner, manager or employee thereof provides the Audit Client with valuation services that result in the preparation of a valuation that is to be incorporated into the client's financial statements.

2. The significance of the self-review threat is considered too high to allow the provision of valuation services which lead to the valuation of amounts that are material in relation to the financial statements and where the valuation involves a significant degree of subjectivity inherent in the item concerned.

3. In cases not prohibited under (2) the Statutory Auditor should consider whether additional safeguards are needed to mitigate a remaining self-review threat. In particular, where a valuation service should only be provided by an expert team with different personnel (including engagement partner) and different reporting lines to those of the audit Engagement Team.

7.2.4. Participation in the Audit Client's internal audit

1. Self-review threats may arise in certain circumstances where a Statutory Auditor, an Audit Firm or an entity within a Network provides internal audit services to an Audit Client.

2. To mitigate self-review threats when involved in an Audit Client's internal audit task, the Statutory Auditor should:

(a) satisfy himself that the Audit Client's management or Governance Body is at all times responsible for

(i) the overall system of internal control (i.e., the establishment and maintenance of internal controls, including the day to day controls and processes in relation to the authorisation, execution and recording of accounting transactions);

(ii) determining the scope, risk and frequency of the internal audit procedures to be performed; and

(iii) considering and acting on the findings and recommendations provided by internal audit or during the course of a Statutory Audit.

If the Statutory Auditor is not satisfied that this is the case, neither he, nor the Audit Firm nor any entity within its Network should participate in the Audit Client's internal audit.

(b) not accept the outcomes of internal auditing processes for statutory audit purposes without adequate review. This will include a subsequent reassessment of the relevant statutory audit work by an Audit Partner who is involved neither in the Statutory Audit nor in the internal audit engagement.

7.2.5. Acting for the Audit Client in the resolution of litigation

1. An advocacy threat exists whenever a Statutory Auditor, an Audit Firm, an entity within a Network or a Partner, manager or employee thereof acts for the Audit Client in the resolution of a dispute or litigation. A self-review threat may also arise where such a service includes the estimation of the Audit Client's chances in the resolution of litigation, and thereby affects the amounts to be reflected in the financial statements.

2. The significance of both the advocacy and the self-review threat is considered too high to allow a Statutory Auditor, an Audit Firm, an entity within a Network or a partner, manager or employee thereof to act for an Audit Client in the resolution of litigation which involves matters that would reasonably be expected to have a material impact on the client's financial statements and a significant degree of subjectivity inherent to the case concerned.

3. In cases not prohibited under (2) the Statutory Auditor should consider whether additional safeguards are needed to mitigate a remaining advocacy threat. This could include using personnel (including engagement Partner) who are not connected with the audit Engagement Team and who have different reporting lines.

7.2.6. Recruiting senior management

1. Where a Statutory Auditor, an Audit Firm, an entity within a Network or a Partner, manager or employee thereof is involved in the recruitment of senior or key staff for the Audit Client, different kinds of threats to independence may arise. These can include self-interest, trust or intimidation threats.

2. Before accepting any engagement to assist in the recruitment of senior or key staff, the Statutory Auditor should assess the current and future threats to his independence which may arise. He should then consider appropriate safeguards to mitigate such threats.

3. When recruiting staff to key financial and administrative posts, the significance of the threats to the Statutory Auditor's independence is very high. As such, the Statutory Auditor should carefully consider whether there might be circumstances where even the provision of a list of potential candidates for such posts may cause an unacceptable level of independence risk. Where Statutory Audits of Public Interest Entities are concerned the independence risk would be perceived to be too high to allow the provision of such a short-list.

4. In any case, the decision as to who should be engaged should always be taken by the Audit Client.

8. Audit and non-audit fees

8.1. Contingent fees

1. Fee arrangements for audit engagements in which the amount of the remuneration is contingent upon the results of the service provided raise self-interest and advocacy threats which are considered to bear an unacceptable level of independence risk. It is therefore required that:

(a) audit engagements should never be accepted on a contingent fee basis; and

(b) in order to avoid any appearance of contingency, the basis for the calculation of the audit fees must be agreed each year in advance. This should include scope for variation so as to take account of unexpected factors in the work.

2. Threats to independence may also arise from contingent fee arrangements for non-audit services which the Statutory Auditor, the Audit Firm or an entity within its Network provides to an Audit Client or to one of its Affiliates. The Statutory Auditor's safeguarding system (see A. 4.3.2) should therefore ensure that:

(a) such an arrangement is never concluded without first assessing the independence risk it might create and ensuring that appropriate safeguards are available to reduce this risk to an acceptable level; and

(b) unless the Statutory Auditor is satisfied that there are appropriate safeguards in place to overcome the independence threats, either the non-audit engagement must be refused or the Statutory Auditor must resign from the Statutory Audit to allow the acceptance of the non-audit work.

8.2. Relationship between total fees and total revenue

1. The rendering of any (audit and non-audit) services by a Statutory Auditor, an Audit Firm or a Network to one Audit Client or its Affiliates should not be allowed to create a financial dependency on that Audit Client or client group, either in fact or in appearance.

2. A financial dependency is considered to exist when the total (audit and non-audit) fees that an Audit Firm, or a Network receives or will receive from one Audit Client and its Affiliates make up an unduly high percentage of the total revenues in each year over a five-year period.

3. The Statutory Auditor should also consider whether there are certain fee relationships with one Audit Client and its Affiliates which may appear to create a financial dependency in respect of a person who is in a position to influence the outcome of the Statutory Audit (any person within the scope of A. 2).

4. In any case, the Statutory Auditor, the Audit Firm or the Network should be able to demonstrate that no financial dependency exists in relation to a particular Audit Client or its Affiliates.

8.3. Overdue fees

Where fees for audit or other work become significantly overdue and the sum outstanding, or that sum together with fees for current assignments could be regarded as a significant loan (see also B. 2), the self-interest threat to independence is considered to be so significant that a Statutory Auditor should not accept reappointment or, where appropriate and practicable, should resign from the current audit engagement. The situation should be reviewed by a Partner not involved in the provision of any services to the client. Where such a review cannot be performed, the situation should be subjected to an external review by another statutory auditor. Alternatively, advice should be sought from a professional regulatory body.

8.4. Pricing

A Statutory Auditor must be able to demonstrate that the fee for an audit engagement is adequate to cover the assignment of appropriate time and qualified staff to the task and compliance with all auditing standards, guidelines and quality control procedures. He should also be able to demonstrate that the resources allocated are at least those which would be allocated to other work of a similar nature.

9. Litigation

1. Both a self-interest and an advocacy threat may arise where litigation takes place, or appears likely to take place, between the Statutory Auditor, the Audit Firm or any other person being in a position to influence the outcome of the Statutory Audit (any person within the scope of A. 2) and an Audit Client or its Affiliates. All of the audit and non-audit services provided to the client have to be considered in order to assess these threats.

2. Where the Statutory Auditor sees that such a threat my arise, he should discuss the case with the Audit Client's Governance Body or, where such a body does not exist, with his professional regulatory body. The threats to the Statutory Auditor's independence are likely to become significant where there is a serious likelihood of litigation which is material to any of the parties involved, or of litigation which calls into question a prior Statutory Audit, or where material litigation is in progress. The Statutory Auditor should cease to act as soon as such circumstances become evident, subject to the requirements of national law.

10. Senior personnel acting for a long period of time

1. Trust or familiarity threats may arise where certain members of the Engagement Team work regularly and for a long period of time on an Audit Client engagement, particularly where Public Interest Entity Audit Clients are concerned.

2. To mitigate these threats, where the audit of a Public Interest Entity is concerned, the Statutory Auditor is required:

(a) as a minimum to replace the Key Audit Partners(26) of the Engagement Team (including the Engagement Partner) within 7 years of appointment to the Engagement Team. The replaced Key Audit Partners should not be allowed to return to the Audit Client engagement until at least a two years period has elapsed since the date of their replacement; and

(b) to consider the independence risk which may arise in relation to the prolonged involvement of other Engagement Team members, and to adopt appropriate safeguards to reduce it to an acceptable level.

3. Where Audit Clients other than Public Interest Entities are concerned, it is preferable that the procedures set out at (2) above should also apply. However, where the Audit Firm is unable to provide for rotation of Key Audit Partners, the Statutory Auditor should determine what other safeguards should be adopted to reduce the independence risk to an acceptable level.

This Recommendation is addressed to the Member States.

Done at Brussels, 16 May 2002.

For the Commission

Frederik Bolkestein

Member of the Commission

(1) OJ L 126, 12.5.1984, p. 20.

(2) OJ C 321, 28.10.1996, p. 1.

(3) OJ C 143, 8.5.1998, p. 12.

(4) COM (2000) 359, 13.6.2000.

(5) COM (1999) 232, 11.5.1999.

(6) Presidency Conclusions, Stockholm European Council, 23 and 24 March 2001.

(7) C (2000) 3304, 15.11.2000.

(8) Defined in the glossary.

(9) Defined in the glossary. The term "statutory auditor" refers to all natural or legal persons, or other types of company, firm or partnership who, in accordance with the provisions of the 8th Company Law Directive (84/253/EEC), are approved by the authorities of the Member States to carry out Statutory Audits.

(10) Defined in the glossary.

(11) Defined in the glossary.

(12) Defined in the glossary.

(13) Defined in the glossary.

(14) Defined in the glossary.

(15) Defined in the glossary.

(16) Defined in the glossary.

(17) Defined in the glossary.

(18) Defined in the glossary.

(19) C (2000) 3304, 15.11.2000.

(20) For the purpose of this section in particular, the term "statutory auditors" refers to all natural or legal persons, or other types of company, firm or partnership who, in accordance with the provisions of the 8th Company Law Directive (84/253/EEC), are approved by the authorities of the Member States to carry out Statutory Audits.

(21) This paragraph does not apply to an Audit Firm for which the relevant Member State, in accordance with Article 2.1 (ii) 2nd phrase of the 8th Directive, does not require a majority of voting rights to be held by statutory auditors, and of which all the shares are registered and can be transferred only with the agreement of the firm and/or with the approval of the national authority competent for the approval of statutory auditors.

(22) Defined in the glossary.

(23) Paragraph 3 lit. (a) and (b) do not apply to an Audit Firm for which the relevant Member State, in accordance with Article 2.1 (ii) 2nd phrase of the 8th Directive, does not require a majority of voting rights to be held by statutory auditors, and of which all the shares are registered and can be transferred only with the agreement of the firm and/or with the approval of the national authority competent for the approval of statutory auditors; provided that an Audit Client of such an Audit Firm is not in a position to influence any decision making of the firm which affects its statutory audit function.

(24) An individual who is engaged under a loan staff agreement, works under the direct supervision of the client and does not originate any accounting transaction or prepare original data that is not subject to review and approval by the client.

(25) Defined in the glossary.

(26) Defined in the glossary.

ANNEX

The following comments provide additional guidance for the interpretation of the fundamental set of principles set out in the Recommendation.

A. FRAMEWORK

The basic test for the effectiveness of the approach adopted by a statutory auditor to mitigate threats and risks to his independence in respect of a particular audit engagement is whether a reasonable and informed third party, knowing all the relevant facts and circumstances about a particular audit engagement, will conclude that the statutory auditor is exercising objective and impartial judgement on all issues brought to his attention.

The statutory auditor should have a clear understanding of what is meant by objectivity, which is a state of mind, and independence as a matter of both fact and appearance. Accordingly, when addressing the issue of whether he can conduct an objective and independent audit, he should consider a wide range of factors and issues. These should include: the range of persons, besides himself, who may influence the result of the audit in question; whether there are any existing or potential threats or risks which a reasonable and informed third party might regard as compromising his independence; and what system of safeguards would eliminate or mitigate any such threat or risk and demonstrate his independence. In some cases, the only safeguard certain to demonstrate his independence will be to decline certain relationships with the audit client.

1. OBJECTIVITY, INTEGRITY AND INDEPENDENCE

Public understanding of the ethical requirements that apply to statutory auditors is a prerequisite for the public confidence in the public interest role of statutory audits, the reliability of audited financial statements, and the ability of the audit profession to play its proper part in the audit process. This also includes an understanding of the ways in which compliance with such requirements can be monitored. It is therefore important that there should be a common understanding of what is meant by the "statutory auditor's independence requirement"(1), how it relates to the ethical requirements of "objectivity" and "integrity"(2), and how, and to what extent, compliance with these requirements can be objectively assessed.

The ultimate goal of the Statutory Audit is to express an objective audit opinion. The main means by which the Statutory Auditor demonstrates that he can express such an opinion is by demonstrating that he performs the audit process in an objective manner. To achieve this he must act with fairness, intellectual honesty, integrity (which implies fair dealing and truthfulness) and without any conflict of interest which might compromise his independence.

Neither objectivity nor integrity can easily be tested or subjected to external verification. As such, the Member States and the audit profession have developed rules and guidance that both uphold the pre-eminence of these principles and clarify the ethical responsibilities of statutory auditors.

The requirement that a Statutory Auditor should be independent addresses both:

- independence of mind, i.e. the state of mind which has regard to all considerations relevant to the task in hand, but no others; and

- independence in appearance, i.e. the avoidance of facts and circumstances which are so significant that a reasonable and informed third party would question the Statutory Auditor's ability to act objectively.

The concept of statutory auditor independence requires a test which looks first at the relevant circumstances in which the Statutory Auditor finds himself, especially at any relationship or interest which has any relevance to his task.

Independence is not an absolute standard which Statutory Auditors must attain, free from all economic, financial and other relationships that could appear to entail dependence of any kind. Such a state is manifestly impossible as everyone has some dependency or relationship with another person.

Nevertheless, it is possible objectively to test a Statutory Auditor's compliance with the concept of independence through a monitoring process: This would look first at the relevant circumstances in which the Statutory Auditor finds himself, and especially at any relationship or interest that he may have with respect to his task. Secondly, it would look at whether such an interest or relationship would cause a reasonable and informed third party, knowing all these circumstances, to conclude that the Statutory Auditor is independent, i.e. is capable of exercising objective and impartial judgement on all issues encompassed within the statutory audit engagement. In this sense, independence could be seen as a proxy for integrity and objectivity and be verified by a reasonable and informed third party.

2. RESPONSIBILITY AND SCOPE

Responsibility

It is the responsibility of statutory auditors, whether natural or legal persons, generally to comply with national law and national professional rules in respect of Statutory Audits. This includes rules on independence.

In the case of a particular Statutory Audit, it is the appointed Statutory Auditor who is responsible for ensuring that the requirement for statutory auditors' independence is complied with. This requirement applies not only to himself and to the organisational entity forming the Audit Firm (assuming it is not the same legal person as the Statutory Auditor), but also to any other person who is in a position to influence the outcome of the Statutory Audit.

A Statutory Auditor, or - if the Statutory Auditor is an individual - the Audit Firm that carries out the audit work, should have adequate systems to take all reasonable steps to ensure that individuals within the firm comply with its independence policies and procedures (see also A. 4.3). These systems could encompass, among others, such matters as internal organisation, employment contracts and sanctions.

If a Statutory Auditor is a member of a Network, he should take all reasonable measures to ensure that, in as far as they are in a position to exert influence on the Statutory Audit, the entities within this Network, their owners, shareholders, partners, managers and employees all comply with the independence rules that apply in the jurisdiction where the audit opinion is to be issued. This could, for example, be achieved by:

- contractual agreements which allow the Statutory Auditor to impose independence rules on his Network member firms, their Partners(3), managers and employees with regard to his particular Audit Clients, including inter-firm quality review procedures, and external quality assurance access;

- providing his Network member firms with regular information on Audit Clients, and requiring these firms to provide regular information on their own business and financial relationships with such clients. This two-way flow of information is necessary to identify all relationships that his network member firms may have with an Audit Client and its Affiliates that might be affected by the Statutory Auditor's independence policies;

- obligatory intra-firm consultation procedures in any case where there are doubts as to whether the Statutory Auditor's independence could be compromised by his Audit Client's relationship with one of the Network member firms.

These instruments may also be appropriate to safeguard independence in situations where subcontractors or agents of the Statutory Auditor or the Audit Firm are involved in the audit, other than its Network member firms.

For any particular audit engagement where the Statutory Auditor is an Audit Firm, the responsibility for determining the scope of persons to whom the independence requirement applies, and what instruments and rules it may be appropriate to apply to them, generally lies with the audit Engagement Partner(4). This individual will need to exercise adequate professional judgement in order to fulfil this task since it is his responsibility to assess whether or not the independence requirement is complied with. He should also be informed of any audit and non-audit relationship which the Statutory Auditor, the Audit Firm or the Network has with the client (see also "Audit Firm's Independence Policies" under A. 4.3.2).

Determination of the scope

A Statutory Auditor must recognise that threats to his independence may arise not only from his own relationships with the Audit Client but also from other direct or indirect relationships with other individuals and firms within his practice and in the audit environment. The Statutory Auditor has to assess actual and potential threats arising from client relationships with the natural and legal persons within the Engagement Team, within the Audit Firm and any Network of which it is a member. He also has to consider relationships with other persons, such as sub-contractors or agents for the Audit Firm or the Audit Client, including those engaged on non-audit matters, with relationships to another. In summary, he has to identify any person who is in a position to influence the outcome of the Statutory Audit.

When considering the range of persons to whom independence requirements should apply, the Statutory Auditor must be sensitive to a variety of factors. These can include the size and legal and organisational structure of the Audit Client, the size, structure and internal organisation of the Audit Firm and of any of the Networks of which it is a member. The Statutory Auditor should also consider the volume and nature of services provided to the Audit Client by the Audit Firm or any of its Network member firms.

For example, for a small Audit Firm of four or five Partners which is the Statutory Auditor to a company with three branches all in the same Member State, the independence rules would usually apply to:

- the Engagement Partner, the Audit Team, and any Partner in their Chain of Command;

- any Partner with responsibility for non-audit services to the same client; and

- any other person within the firm who is, or might be seen to be, in a position to influence the outcome of the Statutory Audit.

However, when the Statutory Auditor of a medium-sized multinational company is one firm in a Network, the scope of the rules might extend to:

- the Engagement Partner and Audit Team in the Statutory Auditor;

- any Partner and Audit Team member in the same firm or in another firm in the Network who participates in the audit of the client's overseas entities, including any in centralised services or specialist discipline units which contribute to such work;

- any Partner in the same firm or in another firm in the Network who participates in the provision non-audit services to the client;

- any Partner in the Chain of Command (either in the jurisdiction where the audit opinion is to be delivered or in an overseas country where audit or non-audit work is done for the Audit Client); and

- any other person within the firm or another firm in the Network who is in a position to influence the outcome of the Statutory Audit.

In either case, the independence requirements apply equally to everyone falling within their scope; the difference lies in the number of people the Statutory Auditor may need to consider for inclusion within it.

Persons other than members of the Engagement Team or the Chain of Command

The Statutory Auditor should give further consideration to other persons who, even if they are not part of the Engagement Team or the Chain of Command, might influence the outcome of the Statutory Audit. These might include:

- owners or shareholders of the Audit Firm with potential influence by virtue of the significance of their voting rights. Where, for example, there are only a few owners or shareholders of an Audit Firm, every owner or shareholder might be considered as being in a position to influence the outcome of the Statutory Audit;

- individuals who have supervisory or direct management responsibility for the audit function at successive levels in any location where members of the Audit Team are employed;

- other audit and non-audit Partners with potential influence by virtue of their working relationship with a member of the Audit Team. Depending on factors such as the size and the internal organisation of an office, practice unit, Audit Firm, or even Network, all Partners of such an entity might be considered as being in a position to influence the outcome of the Statutory Audit.

The Statutory Auditor must also consider whether, there might be persons outside the Audit Firm or its Network who, due to their relationship with persons within the firm or group, have or appear to have an ability to influence the outcome of the Statutory Audit. Examples might include:

- family members or other close personal contacts of members of the Engagement Team or Chain of Command who hold significant financial interests in the Audit Client or who hold a key position with the client or an entity with significant interests in it (see B. 6); or

- individuals or entities with financially significant commercial relationships with either the Statutory Auditor and his firm or the Audit Client. These could include major suppliers, customers or contractors.

The Statutory Auditor will need to identify those individuals in the Audit Firm or the Network whose involvement in the audit engagement might be affected by such an external influence, either in fact or in appearance, taking into account the fact that he would not be able to impose his independence rules on persons outside the Audit Firm or its Network.

3. INDEPENDENCE THREATS AND RISK

In order to avoid or resolve facts and circumstances that might compromise a Statutory Auditor's independence, it is essential firstly to identify the threats to independence which arise in specific circumstances. Secondly, one must evaluate their significance so as to determine the level of risk that a Statutory Auditor's independence may be compromised.

The more clearly a Statutory Auditor is able to identify the nature of the threats, the more clearly he can judge the level of risk to his independence that they create. Based on their general nature the following types of threats to independence have been recognised:

- Self-interest threat: the Statutory Auditor's independence may be threatened by a financial or other self-interest conflict (e.g., direct or indirect financial interest in the client, over-dependence on the client's audit or non-audit fees, the desire to collect outstanding fees, fear of losing the client);

- Self-review threat: relates to the difficulty of maintaining objectivity in conducting self-review procedures (e.g., when taking decisions, or taking part in decisions, that should be taken wholly by the Audit Client's management; or when any product or judgement of a previous audit or non-audit assignment performed by the Statutory Auditor or his firm needs to be challenged or re-evaluated to reach a conclusion on the current audit);

- Advocacy threat: the Statutory Auditor's independence may be threatened if the Statutory Auditor becomes an advocate for, or against, his client's position in any adversarial proceedings or situations (e.g. dealing in or promoting shares or securities in the client; acting as an advocate on behalf of the client in litigation; when the client litigates against the auditor);

- Familiarity or trust threat: a risk that the Statutory Auditor may be over-influenced by the client's personality and qualities, and consequently become too sympathetic to the client's interest through, for example, too long and too close relationships with client personnel, which may result in excessive trust in the client and insufficient objective testing of his representations.

- Intimidation threat: covers the possibility that the auditor may be deterred from acting objectively by threats or by fear of, for example, an influential or overbearing client.

The significance of a particular threat depends on a variety of (quantifiable and non-quantifiable) factors such as its force, the status of the person(s) involved, the nature of the matter causing the threat, and the overall audit environment. When evaluating the significance of a threat the Statutory Auditor also has to consider that different kinds of threats may arise in one set of circumstances. With regard to one certain set of circumstances a threat can be considered significant if, considering all of its quantitative and qualitative aspects, both alone and in combination with others, it increases the level of independence risk to an unacceptably high level.

4. SYSTEMS OF SAFEGUARDS

Where threats to statutory auditors independence exist, the Statutory Auditor should always consider and document whether safeguards are appropriately applied to negate or reduce the significance of threats to acceptable levels. The safeguards to be recognised relate to different responsibilities in the audit environment, including the governance structure of the Audit Client (see A. 4.1), the entire system of self-regulation, public regulation and oversight of the audit profession including disciplinary sanctions (see A. 4.2), and the Statutory Auditor's system of internal quality control (see A. 4.3).

Level of independence risk

The level of independence risk can be expressed as a point on a continuum that ranges from "no independence risk" to "maximum independence risk." Although it cannot be measured precisely, the level of independence risk for any specific activity, relationship, or other circumstance that may pose a threat to a Statutory Auditor's independence can be described as being within, or at one of the endpoints, on the independence risk continuum.

The Statutory Auditor and any other person involved in a decision concerning the independence of the Statutory Auditor in relation to his client (e.g., regulatory bodies, other statutory auditors who are consulted for advice) need to evaluate the acceptability of the level of independence risk that arises from specific activities, relationships, and other circumstances. That evaluation requires these independence decision makers to judge whether existing safeguards eliminate or adequately mitigate threats to independence posed by those activities, relationships, or other circumstances. If they do not, a further decision has to be made on which additional safeguard (including prohibition) or combination of safeguards would reduce independence risk, and the corresponding likelihood of compromised objectivity, to an acceptably low level.

4.1. Audited entities' safeguards

4.1.1. Governance structure's impact on independence risk assessment

When analysing governance responsibilities in the Audit Client which may help to safeguard its Statutory Auditor's independence, it is appropriate to differentiate between the governance structure of a Public Interest Entity client(5) and that of an Audit Client with relatively little public interest. This differentiation is relevant both to the corporate governance task, which is to particularly protect actual and potential investors, and to the appearance of the Statutory Auditor's independence.

Audit Clients of public interest

With regard to the appearance of independence in relation to a Public Interest Entity(6) client, the Statutory Auditor has to consider the whole variety of possible perceptions of the national, regional or even international public. In this respect corporate governance plays an important role in safeguarding statutory auditors' independence.

Statutory auditors are formally appointed by a majority vote of the shareholders at the Annual General Meeting. Shareholders often appoint the Statutory Auditors recommended to them by management. This is particularly the case if no additional approval is required by any Governance Body(7) of the Audit Client other than management (e.g. supervisory board, non-executive directors, audit committee) or by any regulatory body (e.g. regulatory authority of a certain industry)(8). This does not necessarily protect the interests of minority shareholders or potential investors, nor does it contribute to the safeguarding of statutory auditors' independence.

Accordingly, governance structures within an entity being audited should ensure that the appointment of the Statutory Auditor is made in the interests of its shareholders, and that during the engagement the Statutory Auditor performs his work in the same interests. If, for example, a supervisory board or an audit committee is to be effective in accomplishing its task of over-seeing the financial reporting process, it must rely in part on the work, guidance and judgment of the Statutory Auditor. Integral to this reliance is the requirement that the Statutory Auditor performs his service independently.

In order to determine the significance of a threat to independence and to evaluate the level of the independence risk (see A. 3 and A. 4), the Statutory Auditor should carefully consider whether the audited entity's governance structure provides an appropriate infrastructure to generally safeguard its statutory auditors independence. The analysis of such an infrastructure may include issues such as:

- the involvement of a Governance Body in the Statutory Auditor's appointment (e.g., formal approval of management's recommendation only or. active participation in negotiations with the potential Statutory Auditor);

- the duration of the Statutory Auditor's appointment (one audit vs. long-term contract);

- the involvement of a Governance Body in commissioning non-audit services from the Statutory Auditor, the Audit Firm or from any entity within the Network of which it is a member (e.g., no involvement or active participation when negotiating significant engagements);

- the existence of oversight and communications regarding the Statutory Audit and other services provided to the audited entity by the Statutory Auditor, the Audit Firm or its Network, and the frequency of such communications with the Statutory Auditor.

Other Audit Clients

When auditing clients other than Public Interest Entities, the Statutory Auditor should still analyse whether the governance infrastructure of the Audit Client provides general safeguards to his independence. Where the client has no Governance Body, the Statutory Auditor should analyse whether the Audit Client's management policies provide safeguards to his independence and whether there are specific threats which could be addressed by appropriate policies within the entity. Such policies might include internal procedures for objective choice in commissioning non-audit services. The Statutory Auditor should also consider the quality and quantity of staff in the Audit Client. This may be particularly relevant when assessing the risk of taking managerial decisions on behalf of the client. For example, where the client has an insufficient number of staff, the Statutory Auditor may find himself taking such decisions without meaning to.

4.1.2. Involvement of the Governance Body

As stated under A. 4.1.1, to some extent it is the responsibility of the Audit Client to safeguard the independence of its Statutory Auditor. Discussions between the Statutory Auditor and the Governance Body of the client are the main means to establish a link between the Statutory Auditor's own safeguards and those of the Audit Client. To protect himself and to allow the quality assurance regime (see A. 4.2) to verify his compliance with this requirement, whenever deemed necessary, but at least annually the Statutory Auditor should initiate the process by writing to the Audit Client to invite him to discuss these issues.

Disclosure of fees

The disclosure to the Governance Body of fee relationships between the Statutory Auditor, the Audit Firm and its Network members and the Audit Client and its Affiliates will help the Governance Body to evaluate the impact of these relationships on the Statutory Auditor's independence. If necessary, the Governance Body may require additional measures to safeguard the independence of the Statutory Auditor. In this regard, the disclosure should be made on a regular basis, but at least annually, before the audit engagement is accepted or renewed. In addition, the disclosure should be more detailed and wider than required for publication purposes (see A. 5). In particular, it should extend to the amounts charged and contracted for, to the value of outstanding service contracts or arrangements, to current proposals or bids for future service engagements, and to compensation received or expected from contingent fee arrangements on non-audit services (see B. 8.1), each broken down by type of service.

4.2. Quality assurance

To ensure that Statutory Auditors comply with professional standards, including the independence requirement, a control or enforcement system is needed. Safeguards and procedures to be considered include the effectiveness of the overall control environment. This starts with a professional approach towards matters of quality and ethics and takes account of the levels of assurance provided by a regularly monitored and evidenced control system. One way to enforce independence requirements is the Member State system for quality assurance on Statutory Audits. The Commission Recommendation on "Quality Assurance for the Statutory Audit in the EU" recommends that statutory auditors' compliance with ethical principles and rules, including independence rules, should be subjected to quality review procedures. As the recommended systems of quality assurance include public oversight, they are also able to address the public perception of independence issues.

4.3. The Statutory Auditor's overall safeguards

4.3.1. Ownership of and control over Audit Firms

Need to safeguard control over the Audit Firm

For an Audit Firm to be authorised to carry out Statutory Audits, Article 2.1 b) ii) of the 8th Company Law Directive requires the majority of the Audit Firm's voting rights to be held by statutory auditors. These persons must be approved by a competent authority of any of the EU Member States, i.e., natural persons or firms who satisfy at least the minimum conditions of that Directive.

Without any further restrictions, this would allow Audit Firms to raise capital on capital markets by either private or public offerings. Some Member States regard such funding as raising serious concerns about statutory auditor independence. As a result, they have imposed more restrictive rules on the ownership of Audit Firms (e.g. allowing a maximum of 25 % ownership by individuals who are not statutory auditors, or restricting minority ownership to members of certain regulated professions only).

There is a concern as to whether holding majority voting rights is sufficient to ensure that statutory auditors control the firm. For example, if one non-auditor held 49 % of the voting rights and the other 51 % were divided amongst a number of statutory auditors, the non-auditor owner could have effective control of the Audit Firm. In this respect, careful attention should be paid to the resulting threats to statutory auditors independence. Consideration should also be given to the safeguards needed to avoid such situations. These might include, for example, limiting the voting rights of a single non-auditor owner to 5 % or 10 % of the whole. Where only a few statutory auditors hold the majority of the voting rights in an Audit Firm, it may be appropriate to allow certain individuals to hold a higher proportion than this. In particular, this may be appropriate if these individuals are members of a regulated profession (e.g., lawyers, notaries), or other persons (e.g., management or other professional consultants) whose professional activities rest with the Audit Firm or with one of its Network members.

The risks that relationships between the Statutory Auditor, the Audit Firm and a non-auditor owner of the Audit Firm and an Audit Client might compromise the Statutory Auditor's independence should be addressed by reference to A. 2, which sets out the scope of persons to which the independence requirement applies, and B. 1 and B. 2, which consider the financial and/or business links which may exist between them.

4.3.2. The Audit Firm's internal safeguarding system

As far as the Statutory Auditor is concerned, he has to comply with independence standards, regardless of whether those are imposed by law or regulators, or by professional bodies as part of a self-regulatory regime, or adopted voluntarily by the Audit Firm as part of its own policies. In order to ensure his compliance the Statutory Auditor needs to set up a system of related safeguards, or - if the Statutory Auditor and the Audit Firm are not identical legal persons - at least require the Audit Firm to do so.

Audit Firm's independence policies

An Audit Firm should develop independence policies covering activities that are acceptable and not acceptable when performed for Audit Clients or their Affiliates.

Regardless of the way in which detailed independence standards are developed, the objective is to enforce appropriate implementation and maintenance of Statutory Auditors' safeguards and to encourage their continuous improvement. Accordingly, an Audit Firm's independence policies should be flexible enough to allow for their regularly update. Such an update could arise due to changing circumstances and facts or when independence standards themselves change due to a change in public expectations.

The design and documentation of the Audit Firm's independence policies should reflect the immediate practice environment (e.g., size and organisational structure of the Audit Firm). It should also reflect the audit environment (e.g., client and business portfolio of the Audit Firm and others outside the Audit Firm who are involved in Audit Firm's assignments).

An Audit Firm must have appropriate policies and procedures in place to ensure that the relevant Engagement Partner is notified of any other relationship which exists between the firm and its Network member firms, and the Audit Client and its Affiliates. This includes the requirement that the Engagement Partner has to be consulted prior to acceptance of any assignment from the Audit Client or its Affiliates. It is then the responsibility of the Engagement Partner to assess whether any such relationship may reasonably be thought to affect the independence of the Statutory Auditor. For practical reasons, particularly with regard to group audit situations, this assessment may be partially delegated to other Audit Partners. For example, an Audit Partner of the Audit Team in a particular country should be notified of, and should assess the impact of, all (existing and potential) relationships in that country. However, the Engagement Partner should always be involved in the independence risk assessment of any significant relationship. In cases where the Audit Client has a Governance Body (see A. 4.1), it will be appropriate to involve that body in the process of assessing the independence risk.

Where persons other than the Audit Firm, its Partners, managers and employees are involved with the Audit Client or in the audit assignment (e.g.; subcontracted specialists, Network member firms), the Audit Firm's independence policies should also address requirements and consultation processes needed to prevent these persons from causing an unacceptable level of independence risk for the Statutory Auditor.

In order to ensure that its Partners, managers and employees comply with its independence policies, the Audit Firm will need to communicate its policies appropriately, and to train these individuals on a regular basis. This should also include informing them about sanctions for independence policy violations.

Procedures to be applied

In accordance with the independence policies adopted by an Audit Firm and depending on its size, the procedures to be applied by Partners, managers and employees may vary. For a small Audit Firm it might be appropriate to consider its independence only on a case by case basis, and then to decide on certain procedures to mitigate the independence risk. However, for a large Audit Firm it might be necessary to establish routine procedures in order to detect even hypothetical threats to the Statutory Auditor's independence. For example, to detect a self-interest threat resulting from financial or business relationships, it might be necessary for such an Audit Firm to maintain a regularly updated database (e.g., restricted entity list). Such a database could provide all Partners, managers and employees with information on all Audit Clients that may give rise to a self-interest threat if they fulfil certain criteria. This database should be available to anyone within the Audit Firm who may be in a position to influence the outcome of any Statutory Audit. The operation of this safeguarding system will require these individuals to regularly provide the Audit Firm with certain personal and client information.

Depending on its size and structure, it might also be appropriate for an Audit Firm or Network to establish internal procedures to ensure that there is appropriate consultation across the firm or Network about any client where the significance of an independence threat is unclear. This consultation would involve experienced Partners who are not involved in the Audit Client's affairs and who are not impacted by the independence threat in question.

Documentation of independence assessment

The main purpose of the Statutory Auditor's documentation of his independence assessment on a certain Audit Client is to provide evidence that he performed his assessment properly. It is appropriate for such documentation to be included in the audit files.

Internal monitoring of compliance

The monitoring of compliance with the Audit Firm's independence policies should be an integral function of the Audit Firm's quality review structure. Large Audit Firms may designate this task to quality control specialists, or even independence specialists. This may not be appropriate for small and medium sized Audit Firms which generally only assess their independence on a case by case basis. However, such firms should at least have their individuals' compliance reviewed by a Partner who is not a member of the particular Engagement Team. In the case of sole practitioners and of small partnerships where either all Partners are in the Engagement Team or the involvement of any other Partner outside the Engagement Team would increase the level of independence risk (e.g., when this Partner provides significant non-audit services to the Audit Client), the Statutory Auditor should either seek advice from his professional regulatory body or ask for a review by another statutory auditor.

5. PUBLIC DISCLOSURE OF FEES

A Statutory Auditor should be able to demonstrate that his independence has not been compromised by providing non-audit services to an Audit Client for which the remuneration he receives is disproportionate to the fees he was paid for the Statutory Audit. This should also be in the interest of the relevant Audit Client (see also A. 4.1.2), since it will add credibility to its published financial information. Public disclosure requirements imposed by Member States through national law or their relevant regulatory bodies should enable a reasonable and informed third party to take a view on the extent of any imbalance between statutory audit and other fees. To assist such assessment, the fees received for other than statutory audit services should be broken down into three broad categories (further assurance, tax advisory and other non-audit services) reflecting the different kinds of services which may have been provided. Regarding the category other non-audit services, at least the minimum information about the provision of financial information technology, internal audit, valuation, litigation and recruitment services should be given. It may also be appropriate to identify particular engagements which make up a significant proportion of a particular (sub-)category.

B. SPECIFIC CIRCUMSTANCES

1. FINANCIAL INTERESTS

The term "financial interest" would usually comprise the whole variety of financial interests that the Statutory Auditor himself, his Audit Firm or any other person within the scope of section A. 2 may have in an Audit Client or in any Affiliate of the client. The term includes "direct" and "indirect" financial interests such as

- direct or indirect shareholding in the Audit Client or its Affiliates,

- holding or dealing in securities of the Audit Client or its Affiliates,

- accepting pension rights or other benefits from the Audit Client or its Affiliates.

Commitments to hold financial interests (e.g. contractual agreements to acquire a financial interest) and derivatives which are directly related to financial interests (e.g., stock options, futures, etc.) should be dealt with in the same way as would an already existing financial interest.

Direct financial interests

When a person who is directly involved in the conduct of the statutory audit (the Statutory Auditor, the Audit Firm, an individual in the Engagement Team or within the Chain of Command) holds a direct financial interest in the Audit Client, such as shares, bonds, notes, options, or other securities, the significance of the self-interest threat is considered to be too high to enable any safeguards to reduce the Statutory Auditor's independence risk to an acceptable level.

In such a case the Statutory Auditor either has to withdraw from the engagement or, if an individual of the Audit Firm holds the direct financial interest, has to exclude this individual from the engagement.

Where a direct financial interest in the Audit Client is held by a Partner of the Audit Firm or its Network who works in an "Office" the perception of self-interest is considered as being too high to allow this situation to be maintained.

Indirect financial interests

The term "indirect financial interest" refers to situations where, for example, a person within the scope of A. 2 has investments in non-client entities that have an investment in the Audit Client, or in companies in which an Audit Client also has invested.

A person within the scope of A. 2 should not hold such an indirect financial interest where the self-interest threat resulting from this financial involvement is significant. This is particularly the case when an indirect shareholding in the Audit Client allows or appears to allow that person to influence management decisions of the Audit Client (e.g., by significant indirect voting rights), or when the direct shareholder due to any circumstance could or appears to be able to influence the outcome of the Statutory Audit. In addition, an unacceptable level of independence risk can also arise in situations where the Statutory Auditor or any other person within the scope of A. 2 serves as a voting trustee of a trust or executor of an estate containing securities of an Audit Client. However, this will only be the case when there are no appropriate safeguards to mitigate this risk such as supervision and control by beneficiaries, governmental authorities or courts.

On the other hand, the potential self-interest threat to the Statutory auditor's independence may be regarded as insignificant to the independence risk if, for example, when holding indirect financial interests in the Audit Client

- the financial interest is directly held by an investment fund, pension fund, UCITS or an equivalent investment vehicle, and

- the person holding the indirect interest is not directly involved in the audit of the fund manager, nor able to influence the individual investment decisions of the fund manager.

External events

If a financial interest is acquired as a result of an external event (e.g. inheritance, gift, merger of firms or companies) and a further holding of that interest would create a significant threat to the Statutory Auditor's independence, it must be disposed of as soon as practicable, but no later than one month after the person has knowledge of and the right to dispose of the financial interest. Where the interest is in a listed company and has been acquired by way of inheritance, for example, the shares should be sold within a month after having both the knowledge of the inheritance and the right to sell the shares in accordance with applicable stock exchange regulations that govern the disposal or sale of shares by those with insider knowledge.

Until the financial interest is disposed of, additional safeguards are needed to preserve the Statutory Auditor's independence. For example, where a Statutory Auditor becomes aware that a member of the Engagement Team has acquired shares in a client as the result of inheritance, that individual should not continue to be a member of the Engagement Team until the shares have been sold. He should also be excluded from any substantive decision making concerning the Statutory Audit of the client until the shares have been sold.

Inadvertent violations

There will be occasions where the Statutory Auditor becomes aware that an individual in his Audit Firm inadvertently holds a financial interest in an Audit Client or in one of its Affiliates which, in general, would be regarded as a violation of independence requirements. Such inadvertent violations will not compromise the Statutory Auditor's independence with respect to an Audit Client, provided that the Statutory Auditor

- has established procedures that require all professional personnel to report promptly any breaches of the independence rules resulting from the purchase, inheritance or other acquisition of a financial interest in an Audit Client by such individuals (see also A. 4.3.2);

- promptly notifies the individual to dispose of the financial interest at the earliest opportunity after the inadvertent violation is identified; and

- takes particular care when reviewing the relevant audit work of this individual.

Where it proves impossible to compel the individual to dispose of the financial interest, the individual should be removed from the Engagement Team. Where an individual other than a member of the Engagement Team inadvertently holds a financial interest that may compromise the Statutory Auditor's independence, this individual should be excluded from any substantive decision making concerning the Statutory Audit of the client.

Whatever financial involvement exists, it is primarily the Statutory auditor's safeguarding system (see A. 4.3) which should provide evidence that the threats to independence have been identified and investigated. Where appropriate, the evidence should also refer to the involvement of the client's Governance Body in this process. In addition, wherever a decision has been taken about whether or not the threats are significant, the reasons behind that decision should be recorded.

2. BUSINESS RELATIONSHIPS

Business relationships

Business relationships are relationships that involve a commercial or financial common interest between the Statutory Auditor, the Audit Firm or any other person being in a position to influence the outcome of the Statutory Audit (any person within the scope of A. 2) on the one hand and the Audit Client, an Affiliate of the client, or the management thereof on the other. The following are examples of such relationships that would, if significant to the auditor or conducted outside the normal course of business, cause a self-interest, advocacy or intimidation threat:

- having a financial interest in a joint venture with the Audit Client, or with an owner, managing director or other individual who performs senior management functions of that client;

- having a financial interest in a non-audit client that has an investor or investee relationship with the Audit Client;

- giving a loan to the Audit Client or guarantees for the Audit Client's risks;

- accepting a loan from an Audit Client or having borrowings guaranteed by the Audit Client;

- providing services to a managing director or another individual performing a senior management function of the Audit Client in respect of the personal interest of such individual;

- receiving services from the Audit Client or its Affiliates which concern underwriting, offering, marketing or selling of securities issued by the audit firm or one of its group member firms.

Commitments to establish such relationships should be dealt with in the same way as an already established relationship.

In the normal course of business

In the normal course of its business, a Statutory Auditor may not only provide audit or non-audit services to the Audit Client or to its Affiliates, but may also purchase goods or services from these entities. Examples could include insurance and bank services, commercial loan agreements, the purchase of office equipment, EDP software, or company cars. If these transactions are performed at arm's length (as between third parties), they generally do not threaten the Statutory Auditor's independence (e.g. purchase of goods which are offered under normal wholesale discount terms, and are available to the whole of the client's other customers). However, the Statutory Auditor should carefully consider the risk that even an arm's length transaction could reach a magnitude which threatens his independence by creating financial dependencies, either in fact or at least in appearance.

Accepting any goods or services on favourable terms from an Audit Client is not considered to be within the normal course of business, unless the value of any benefit is insignificant.

Significance of independence risk

Whether a business relationship should be regarded as a significant threat to the Statutory Auditor's independence depends on whether a reasonable and informed third party would assume that such a relationship could have an influence on the outcome of the Statutory Audit. Objective criteria are therefore needed in order to evaluate the significance of a relationship to the Statutory Auditor, as well as to the Audit Client. With regard to the financial statements and the audit task, the relationship should not result in the Statutory Auditor, the Audit Firm or one of its Network members being able to influence management decisions of the Audit Client. Conversely, the relationship should not enable the Audit Client, or one of its Affiliates to influence the outcome of the Statutory Audit, either in fact or in appearance.

Whatever business relationship exists, it is primarily the Statutory auditor's safeguarding system (see A. 4.3) which should provide evidence that the threats to independence have been identified and investigated. Where appropriate, the evidence should also refer to the involvement of the client's Governance Body in this process. In addition, wherever a decision has been taken about whether or not the threats are significant, the reasons behind that decision should be recorded.

Provision of statutory audit services

The threat to independence is considered too high to permit a Statutory Auditor, an Audit Firm or any member of its Network to provide statutory audit services to an owner of the Audit Firm. The provision of audit services to an Affiliate of such an owner is also considered incompatible with the independence requirement when that owner is, or appears to be, in a position to influence any decision-making of the Audit Firm that impacts on its statutory audit function. Such an influence may arise, for example, due to the percentage of the voting rights that the owner holds in the Audit Firm. It could also arise due to the nature of the position held by the owner or one of the owner's representatives in the Audit Firm. A position of potential concern might include a director or senior manager of the owner being a member of the Audit Firm's supervisory board. Furthermore, the Statutory Auditor should also consider whether the provision of audit services to those clients could compromise his independence where the clients officers, directors or shareholders either hold a significant amount of voting rights of the Audit Firm or, otherwise, are, or appear to be, in a position to influence the firm's decision-making with regard to its statutory audit function.

3. EMPLOYMENT WITH THE AUDIT CLIENT

Dual employment and loan staff agreements

The risk to the Statutory Auditor's independence is considered too high to permit a person within the scope of A. 2 who is employed by the Audit Firm and/or its Network member firm to also be employed by the Audit Cl