GREEN PAPER - THE ROLE, THE POSITION AND THE LIABILITY OF THE STATUTORY AUDITOR WITHIN THE EUROPEAN UNION
Date: 1996-07-24
Institutions: European Commission
Subjects: accounting, auditing, harmonisation of standards, job description, professional qualifications

COMMISSION  OF THE  EUROPEAN  COMMUNITIES 

Brussels,  24.07.1996 
COM(96) 338  final 

GREEN PAPER 

THE ROLE, THE POSITION AND THE LIABILITY OF THE 
STATUTORY AUDITOR WITHIN THE EUROPEAN UNION 

(presented  by the  Commission) 

CONTENTS 

1.  INTRODUCTION 

2. REGULATION OF STATUTORY AUDIT AT EU LEVEL 

AND NEED FOR EU ACTION 

3. THE ROLE OF THE STATUTORY AUDITOR 

A definition  of statutory audit 

•  The accuracy of financial statements 

•  The going concern status/solvency  of the company 

•  The existence of fraud 

•  The respect by the company of its legal obligations 

Para. no. 

1.1-1.15 

2.1 - 2.10 

3.1 - 3.7 

3.8-3.13 

3.14 - 3.21 

3.22 - 3.29 

3.30 - 3. 32 

•  Responsible  behaviour  by  the  company  with  regard 

to  3.33 - 3.35 

environmental and societal matters 

•  Priorities for action and possible methods 

3.36 - 3.38 

The audit report 

•  Contents of the audit report 

•  Priorities for action and possible methods 

4.  THE POSITION OF THE STATUTORY  AUDITOR 

The competence of the statutory  auditor 

•  Competence in the Eighth Directive 

•  Priorities for action and possible methods 

The independence of the statutory auditor 

•  Definition  of independence 

•  Priorities for action and possible methods 

The position of the statutory auditor within the company 

•  The statutory audit and corporate governance 

•  Priorities for action and possible methods 

The role of governmental and professional  bodies 

•  Quality control 

3. 39 - 3.44 

3.45 - 3.47 

4.1 - 4.4 

4.5 - 4.6 

4.7-4.15 

4.16-4.17 

4.18 - 4.26 

4.27 - 4.28 

4.29 - 4.33 

•  Priorities for action and possible methods 

4.34 - 4.36 

5.  AUDITOR'S CIVIL LIABILITY 

Towards a limited liability ? 

Priorities for action and possible methods 

6.  THE STATUTORY AUDIT IN SMALL COMPANIES 

The small company audit 

Priorities for action and possible methods 

7.  GROUP AUDIT ARRANGEMENTS 

The statutory audit in groups of companies 

Priorities for action and possible methods 

5.1 - 5.5 

5.6 - 5.7 

6.1 - 6.6 

6.7 

7.1 - 7.3 

7.4 

8. THE FREEDOM OF ESTABLISHMENT AND THE 

8.1 - 8.2 

FREEDOM TO PROVIDE SERVICES 

Freedom  of  establishment  and  freedom  to  provide  services  for  8.3 - 8.5 
individuals 

Freedom of establishment and freedom to provide services for audit  8.6 - 8.9 
firms 

Priorities for action and possible methods 

9.  CONCLUSION 

Bibliography 

8.10 - 8.13 

9.1-9.5 

1. 

INTRODUCTION 

1.1  The requirement to have the annual and consolidated  accounts of certain  companies 
audited  by  a qualified  professional,  which was  introduced  for  the  Community  as  a 
whole  by the Accounting  Directives,  is designed  to protect  the public  interest.  The 
assurance  offered  by  audited  accounts  should  enhance  the  confidence  of  all  parties 
which  are  concerned  with  the  affairs  of  companies.  The  increased  transparency 
resulting  from  the  harmonisation  of  the  financial  information  published  by 
companies  together  with  the  increased  reliability  of  that  information  as  a  result  of 
the  audit  by  an  independent  and  qualified  professional  were  regarded  as  an 
important contribution to the completion of the Single Market. 

1.2  The role of the statutory auditor has recently been the subject of much debate world 
wide. As a result in particular of a number of important financial failures,  questions 
have been raised concerning the function  of the statutory audit and the  independence 
of  the  auditor.  At  EU  level,  it  has  been  difficult  to  respond  to  these  questions 
because the regulatory framework which surrounds the statutory audit at EU level is 
incomplete. There  is no common view at EU level  on the role, the position  and  the 
liability of the statutory auditor. The absence of such a common view has a negative 
impact on audit quality and on the freedom of establishment and freedom  to provide 
services in the audit field. 

1.3  Against  this  background  and  in response  to  requests  from  the  auditing  profession, 
the  Commission  considers  it  desirable  to  organise  a wide-ranging  reflection  on  the 
scope and need for  further  EU level action in this area. Since the European  Council 
of  Birmingham,  the  Green  Paper  has  become  one  of the privileged  instruments  for 
the consultation of Member States and interested parties. The present Green Paper is 
intended  to raise the awareness of all interested  parties  in the issues  at stake  and  to 
elicit their comments. 

1.4  In  drafting  this  document,  the  Commission  took  account  of  various  studies  which 
level1.  The 
have  been  produced  in  this  field  at  national  and  international 
Commission  itself launched  a study  on the role, the position  and the  liability  of the 
statutory auditor, which was carried out by the Maastricht Accounting  and  Auditing 
Research  Center  (MARC), in order to establish  a clear picture  of the way  in  which 
the statutory  audit is dealt with in the legislation of Member  States. It is intended  to 
discuss  some  of the  issues raised  in this document  and the  comments  received  at  a 
Conference  which  the  Commission  is  organising  on  5  and  6  December  1996 
concerning the role, the position and the liability of the statutory auditor. 

1 See bibliography annexed 

1.5  After a short description of the existing regulation of the statutory audit at EU level 
and  the  reasons  why  renewed  action  at  EU  level  may  be justified,  the  document 
discusses  the  main  issues  relating  to  the  role  and  the  position  of  the  statutory 
auditor,  his  liability,  the audit  in  small  companies,  group  audit  arrangements  and 
freedom  of establishment  and freedom  to provide  services  in the audit field. Each 
chapter concludes with a short section suggesting possible priorities for action and 
ways and means to tackle the issues at EU level. It is particularly  on those points 
that comments from interested parties would be welcome. 

2.  REGULATION  OF  STATUTORY  AUDIT  AT  EU LEVEL  AND  NEED  FOR 

EU ACTION 

2.1  In accordance  with the  Fourth  Council  Directive  (78/660/EEC)  of  25 July  1978 on 
the  annual  accounts  of  certain  types  of  companies,  all  companies  covered  by  the 
Directive  must  have  their  annual  accounts  audited  by  a qualified  professional.  The 
statutory  auditor  must  also  see  to  it  that  the  annual  report  is  consistent  with  the 
annual  accounts  for  the  same  financial  year.  Member  States  may  exempt  small 
companies  as  defined  in  the  Directive  from  the  obligation  to  have  their  accounts 
audited. 

2.2  The  Seventh  Council  Directive  (83/349/EEC)  of  13  June  1983  on  consolidated 
accounts  has  extended  the  audit  requirement  to  all  entities  which  draw  up 
consolidated  accounts  on  the  basis  of  the  Directive.  Similarly,  the  Council 
Directives  86/63 5/EEC  of  18  December  on  the  annual  accounts  and  consolidated 
accounts of banks  and  other  financial  institutions  and  91/674/EEC  of  19 December 
1991  on  the  annual  accounts  and  consolidated  accounts  of  insurance  undertakings 
have  introduced  a requirement  for  all  entities  covered  by  those  Directives  to  have 
their annual accounts and consolidated accounts audited by a qualified  professional. 

2.3  Member  States may only approve as auditors the persons who satisfy  the  conditions 
of the Eighth  Council  Directive  (84/253/EEC) of  10 April  1984 on the  approval  of 
persons  responsible  for  carrying  out  the  statutory  audits  of  accounting  documents. 
The conditions  of approval  concern professional  qualifications  on the  one hand  and 
personal integrity and independence on the other. 

2.4  While  the  Eighth  Directive  defines  the  minimum  qualifications  of  the  statutory 
auditor  it  does  not  contain  any  specific  guidance  concerning  the  independence 
requirement.  At  the  time  of  adoption  of  the  Directive,  the  Commission  stated  that 
this  situation  was  not  satisfactory  and  that  they  reserved  the  right  to  come  back  to 
this  issue at a later  stage. This has not yet been done. Similarly, the  Proposed  Fifth 
Directive  concerning  the  structure  of public  limited  companies  and  the powers  and 
obligations  of their  organs, which contains provisions  dealing  with the  appointment 
and dismissal of the statutory  auditor, the audit fee, the audit report  and the  liability 
of the statutory auditor, remains on the Council table. Some of the issues  concerned 
are  regulated  at  national  level  or  are  the  subject  of  self-regulation  through  the 
accountancy  profession.  There  are  however  inevitable  differences  in  the  way  they 
are dealt with and there is often  no legislative backing. 

2.5  The justification  for EU interest and action in this area rests in the Single Market. 
The audited financial statements of a company  established  in a Member  State are 
used  by  third  parties  in  other  Member  States,  such  as  investors,  creditors  and 
employees. These third parties not unreasonably assume a certain level of assurance 
and a certain coverage of the audit. Just as there have been pressures to standardise 
these aspects of audits at a national level, partly in response to market forces, there 
is also demand for some standardisation of these aspects of the audit at a European 
level.  It  would  of  course  be  necessary  to  ensure  that  any  standards  which  are 
developed  can  be  kept  up  to  date  in  the  face  of  changes  emanating  from  the 
development of the Information Society 

2.6  There are also arguments related to the free  movement of services and freedom  of 
establishment.  Several  studies 
the  Commission,  notably  on 
launched  by 
Competition  in  European  Accounting  completed  in  1992  and  on  the  Role,  the 
Position and the Liability of the Statutory Auditor completed  in  1996, have shown 
that  there  is  not  yet  a  European  market  in  audit  services  and  that  important 
differences  remain  between  the  national  laws  and  regulations  of  Member  States 
which deal with the statutory audit. 

2.7  The 1992 study concludes that the need for the service provider to be located in the 
same place as the client, coupled with various legal and professional obstacles, rules 
out  true  cross-border  trade.  Measures  taken  towards  harmonisation  and  mutual 
recognition have some way to go in order to bring about significant  changes in this 
situation. The 1996 study concludes that if there is to be a European market for audit 
services, initiatives are needed at EU level in two areas  : freedom of establishment 
notably of audit firms and freedom to provide services in the audit field on the one 
hand and audit quality on the other hand. The report also concludes that  differences 
between  the  liability  regimes  in the  Member  States  are  likely  to  have  a  negative 
impact on intra-Union trade in audit services. 

2.8  Similar concerns were expressed in a position paper presented by the Fédération des 
experts-comptables  européens (FEE)  in  February  1996.  In  this  document  the 
accountancy  profession  asks the Commission to look at a number of issues which 
are particularly relevant for them and on which they believe that action at EU level 
is  necessary.  These  issues  concern  particularly  the  freedom  of  establishment  of 
statutory auditors and the freedom to provide cross-border audit services, as well as 
professional liability. 

2.9  Finally, the lack of a harmonised  view at EU level  concerning  the role, the position 
and  the  liability  of  the  statutory  auditor  risks  becoming  a  serious  handicap  in  the 
negotiations  which are taking place  at international  level  with  a view of  improving 
the access of the European companies to the international  capital market.  Last  year, 
the  Commission  presented  a  Communication  to  the  Council  and  to  the  European 
Parliament  on  "Accounting  Harmonisation  : a  new  strategy  vis-à-vis  international 
harmonisation"  (COM(95)508). In this Communication, the Commission  announced 
a new strategy  which would  allow global players  in Europe to obtain capital  on the 
international  capital  market  without  having  to  comply  with  different  requirements 
on financial reporting.  The  Commission  announced  its support  for  the  international 
harmonisation  process  led  by  the  International  Accounting  Standards  Committee 
(IASC)  together  with  the  International  Organisation  of  Securities  Commissions 
(IOSCO),  aiming  at  the  establishment  of  a  core  set  of  accounting  standards  which 
will  be  accepted  in  capital  markets  world-wide.  Steps  are  being  taken  in  order  to 
increase  the  influence  of  the  EU  in  this  international  accounting  harmonisation 
process. 

2.10 There  is  however  a  significant  risk  that  the  accounts  and  consolidated  accounts 
prepared  by  European  companies  will  not  be  accepted  in  international  capital 
markets  unless  these  accounts  have  been  audited  by  an  independent  and  qualified 
professional  in accordance  with  auditing  standards which  are regarded  as  generally 
acceptable  world-wide.  The  International  Auditing  Practices  Committee  of  the 
International  Federation  of  Accountants  (IFAC)  has  developed  a  number  of 
international  auditing  standards.  The  EU  will  have  to  decide  whether  it  wants  to 
support these  standards and if so, how and on what basis the European  influence  in 
the development of international auditing standards can be increased. 

3.  THE ROLE OF THE STATUTORY  AUDITOR 

A definition  of the statutory  audit 

3.1  Although  the  Fourth  and  Seventh  Directives  require  annual  and  consolidated 
accounts  to  be  audited  by  a  qualified  professional,  the  Directives  do  not  contain  a 
definition  of  the  statutory  audit.  Similarly,  the  Bank  Accounts  and  Insurance 
Accounts Directives require a statutory audit without defining  what this means. 

3.2  According  to the definition  adopted  by the International  Federation  of  Accountants 
(IFAC), the  objective  of  an  audit  is to  enable  the  auditor  to  express  an  opinion  on 
whether the financial statements are prepared, in all material respects, in  accordance 
with an identified financial reporting  framework. 

3.3  Numerous  studies have  shown that there are considerable  differences  between  what 
the public  expects  from  an  audit  and  what the  auditing  profession  believes  that  the 
auditor  should  do.  The  expectation  gap  resulting  from  this  is  a  major  problem  for 
auditors  since  the  greater  the  gap  in  expectations,  the  lower  is  the  credibility  and 
prestige associated with their work. It is an issue for the public  at large, because the 
proper  functioning  of a market  economy  depends  heavily  on  confidence  in  audited 
financial statements. 

3.4  Any definition  of the statutory  audit should  consider the needs and the  expectations 
of users to the extent that they  are reasonable, as well  as the ability  of the  statutory 
auditor to respond to those needs and expectations. 

3.5  As far  as the needs and expectations  of users are concerned, they  can be  considered 

reasonable if : 

the tasks have been prescribed by law ; 

there  are  stakeholders  who  are willing  to pay  for  the  service  ( i.e. there  is  an 
effective  demand) ; 

there  exists  a  statutory  auditor  who  is  willing  to  supply  the  service  (  for  a 
price  which  reflects  notably  his  level  of  qualification,  the  difficulty  of  the 
task, the number of hours and the risk involved) and is competent to do so. 

3.6  What  statutory  auditors can supply  will depend  not only  on what clients  are willing 
to pay  for, but also on the auditors' technical  skills and attitude to risk.  Some of the 
demands  placed  on  auditors  may  be  unreasonable  in  that  auditors  cannot  be 
expected to possess the skills necessary to do the work. 

3.7  The public  expects the  statutory  auditor  to have  a role  in protecting  the interests  of 
shareholders,  creditors  (e.g.  suppliers,  banks  and  credit  institutions),  pensioners, 
employees and the public generally by providing them with reassurances  concerning 

the accuracy of financial  statements 

the going concern status / solvency of the company 

the existence of  fraud 

the respect by the company of its legal obligations 

the  responsible  behaviour  of  the  company  with  regard  to  environmental  and 
societal matters. 

It is useful  to examine briefly the reasonableness of these expectations. 

The accuracy of financial  statements 

3.8  There  seems to  be  a widely  held  view among  users  of financial  statements, that  an 
unqualified  audit report guarantees the material accuracy of the financial  statements. 

3.9  There  are  two  misconceptions  inherent  in  this  expectation.  The  first  is  that  it  is 
possible to prepare financial  statements that are "accurate" and the second is that the 
financial  statements are the responsibility of the auditor. 

3.10 As  to  the  first  misconception,  it  is  generally  agreed  among  those  who  are  well 
informed  about  accounting  that  financial  statements  cannot  be  "accurate"  in  the 
sense  that  there  is  only  one  set  of  figures  that  correctly  expresses  the  results  of  a 
company's  operations  and  its  financial  status.  The  choices  available  for  the 
accounting  treatment  of  complex  business  operations  and  the  uncertainties  implicit 
in  management  decision-making  defeat  any  attempt  to  develop  a  set  of  financial 
statements that all informed  observers would regard as "accurate". 

3.11 In  the  EU,  legal  recognition  that  no  set  of  financial  statements  can  be  uniquely 
"right"  is  embodied  in  the  requirement  that  the  annual  and  consolidated  accounts 
should give a true and fair view, which is incorporated  in the Accounting  Directives. 
The strength of the true and fair requirement, which is an overriding principle in the 
Accounting Directives, is that it allows for the inevitably judgmental nature of many 
accounting figures. 

10 

3.12 There has been considerable criticism of auditors for not taking a stronger  line when 
dealing  with  financial  statements  that  comply  "creatively"  with  the  rules.  When,  in 
the  auditors'  opinion,  the  financial  statements  are  misleading  as  a  result  of  the 
directors'  accounting  choices  and  disclosure  practices,  auditing  guidelines  require 
the auditor to issue a qualified  opinion that states clearly all the factors  giving rise to 
the  disagreement,  the  implications  for  the  financial  statements  and,  whenever 
practicable,  a  quantification  of  the  effect  on  the  financial  statements.  Moreover, 
when  the  auditor  considers  that  the  effect  of  the  disagreement  is  so  material  or 
pervasive  that  the  financial  statements  as  a  whole  are  misleading,  auditing 
guidelines require him to issue an adverse opinion. 

3.13 The  second  misconception  is  that  it  is  the  statutory  auditor  who  prepares  the 
financial statements  and is responsible  for them. On this issue there  is no doubt that 
it is the Board of Directors and not the statutory  auditor which has the  responsibility 
to  adopt  financial  statements  (prepared  by  management)  showing  a  true  and  fair 
view. It is the directors and not the statutory  auditor which determine the  accounting 
treatment  and disclosure  practices  adopted  in the  financial  statements.  Directors  are 
in the best position to know the affairs  of their company, to maintain  its records and 
to  prepare  its  accounts.  Auditors  should  be  independent  of  and  separate  from  the 
management  and  supervisory  boards  of  their  clients.  Their  duties  would  therefore 
seem quite distinct.  They  should  state whether,  in his view, the financial  statements 
have  been  prepared  in  accordance  with  the  law  and  whether  they  show  a  true  and 
fair  view. 

The going concern status / solvency of the company 

3.14  Several  surveys have  shown that there  is an expectation  on the part  of  a  significant 
proportion  of  the  general  public  that  the  statutory  auditor's  report  guarantees  the 
financial  soundness of a company. 

3.15 Amiual accounts are prepared on the basis that the company will continue as a going 
concern. Directors are entitled to adopt this basis only if they are satisfied  that this is 
indeed  the  case.  (If  it  is  not,  different  accounting  rules  apply.)  Some  countries  are 
considering  a  requirement  for  directors  to  comment  explicitly  on  the  ability  of  the 
company  to  continue  as  a  going  concern  and  to  take  the  necessary  steps  to  ensure 
that such comment is well  founded. 

3.16 Auditors have a duty to be alert to factors  that may  increase the company's  financial 
strength  or  decrease  its  resources,  thus  allowing  them  to  assess  whether  the  going 
concern basis is appropriate. They  should warn the directors or supervisory  board  as 
soon  as  they  become  aware  of  matters  that  may  threaten  the  going  concern  basis. 
Acceptance  of the  going  concern  basis  implies  solvency,  that  is, that  at the  balance 
sheet date the company's position  was  such that  it would  have been able to meet  its 
liabilities  in  full  as  they  fell  due.  Users  expect  the  audit  report  to  contain  the 
auditor's opinion on solvency  where the going concern basis is accepted. 

11 

3.17 Requiring  this of the auditor  would not relieve directors of the responsibility  placed 
on them  by company  law for  determining  whether  or not  a company  is solvent,  nor 
mitigate  the  seriousness  of their  offence  were they  to continue  trading  while  it  was 
insolvent2.  Directors'  responsibilities  are  a  continuing  one,  while  the  auditors' 
opinion is based on the position as seen at a particular date. 

3.18 Auditors need to be cautious  in the way they report publicly  any  concerns that they 
may  have.  Continuance  of  a  company  may  depend  upon  the  rest  of  the  world  not 
knowing  that  its  status  as  a  going  concern  is  open  to  any  doubt.  If,  for  example, 
auditors  report  that  a  company  will  continue  as  a  going  concern  only  if  the  bank 
continues  to roll  over  its loans and  its suppliers  continue to grant normal  periods  of 
credit,  this  may  result  in  the  bank  insisting  on  immediate  repayment  and  the 
suppliers insisting on cash on delivery. 

3.19 On the other hand, some companies might still be in existence and shareholders' and 
creditors'  money  saved  if problems  had  been  identified  earlier.  Moreover,  there  are 
examples  of  companies  that  are  able  to  continue  trading  despite  its  being  public 
knowledge  that  they  suffer  from  liquidity  problems  and  are  subject  to  discussions 
about  financial  reconstruction.  Indeed,  certain  studies  have  found,  comparing  a  set 
of  companies  having  a  going  concern  qualification  with  a  matched  set  having  no 
qualification  that the survival rates were indistinguishable. 

3.20  Some  Member  States  have  laid  down  specific  procedures2  to  be  followed  by 
directors  and  auditors  when  the  going  concern  assumption  is  called  into  doubt 
Different  reports on corporate governance focus  on this issue and some propose that 
directors  should  provide  auditors  with  a written  statement  confirming  that,  in  their 
view, the company  will remain a going concern for the twelve months from  the date 
the  directors  approve  the  financial  statements.  The  directors  should  provide  the 
auditors  with  evidence  to  support  that  view.  Auditors  will  have  a responsibility  to 
perform  procedures specifically  designed to test the directors' view that the company 
is  a  going  concern.  The  Cadbury  Report3  and  the  Vienot  Report3  propose  that 
directors should be required to satisfy  themselves that the going concern  assumption 
is  reasonable  and  that  they  should  report  accordingly  to  shareholders.  Auditors 
should  have  a responsibility  to test the  directors'  view  that  the  company  is  a  going 
concern and to give their opinion on the matter. 

v 

These procedures  go beyond what  is presently  required by virtue of Article  17 §  1 of the 2nd  Council 
Directive  (77/91/EEC)  of  13/12/1976  which  states  that  in  case  of  a  serious  loss  of  the  subscribed 
capital,  a general  meeting  of  shareholders  must  be called  to  consider  whether the  company  should  be 
wound up or any other measures taken. 

See Bibliography  annexed. 

12 

3.21 Although  neither  the  directors  nor  the  statutory  auditors  can  guarantee  the 
continuing  financial  soundness  of  a  company,  it  seems  reasonable  to  expect  the 
directors to state publicly whether in their judgement,  given the trading  environment 
in  which  the  company  is  operating  and  expects  to  operate,  adequate  financial 
resources  are  available  to  enable  it  to  remain  a  going  concern  for  at  least  twelve 
months  from  the  day  the  directors  adopt  the  financial  statements.  It  seems  equally 
reasonable  to  expect  the  auditors  to  carry  out  procedures  aimed  at  testing  the 
directors' stated judgement and to report publicly on the result of such tests. 

The existence of fraud 

3.22 Audits  have  traditionally  been  associated  with  the  detection  of  fraud.  A  survey 
carried  out  in the  UK  in  1989 found  that  75% of  the  general  public,  including  the 
majority  of financially knowledgeable  people, think  that  it  is the  statutory  auditor's 
responsibility  to  detect  fraud  of  all  kinds.  The  same  survey  found  that  61% of  the 
general  public think  that  it is the responsibility  of the  auditor  actively  to  search  for 
fraud. 

3.23 Until  recently  the  standard  auditor response was to  say that the auditors' prime  role 
is not to prevent  or detect  fraud  and that this  is in any  event  impossible.  It was  not 
until  the  1980s  that  in  some  Member  States,  legislation  sought  to  make  explicit 
reference  to  fraud  reporting  /  detection  as  an  audit  objective.  Since  that  period, 
governments  have  become  particularly  concerned  with  issues  of  law  and  order, 
white  collar  crime  and  investor  protection  following  well-publicised  affairs  that 
made press headlines in several Member States. 

to  the  statutory  auditor's  responsibility 

3.24 Regulatory  bodies  in  a  number  of  Member  States  have  issued  auditing  guidelines 
to  fraud,  other 
related 
irregularities  and  errors.  The  guidelines  specify  the  respective  responsibilities  of 
management  and  of  the  auditor.  Management  has  primary  responsibility  for  the 
detection  of fraud,  other  irregularities  and errors. This responsibility  is  seen  as  part 
of  management's  stewardship  role.  The  auditor's  responsibility  is  to  plan,  perform 
and  evaluate  his  audit  work  so  as  to  have  a  reasonable  expectation  of  detecting 
material  misstatements  in  the  accounts,  whether  they  are  caused  by  fraud,  other 
irregularities or errors. 

in  relation 

3.25 The  guidelines  recommend  that  if,  during  the  course  of  the  audit,  the  statutory 
auditor  begins  to  suspect  fraudulent  activity,  he  has  a  responsibility  to  investigate 
until  his  suspicions  are  either  allayed  or  confirmed.  In  some  Member  States  it  is 
recommended  that  the  auditor  promptly  report  to  senior  management  all  fraud 
detected during the audit, even if the effect  of the fraud  is not material  in the context 
of  the  company's  financial  statements.  The  only  circumstances  in  which  auditors 
should  not  so  report  is  when  they  suspect  senior  management  is  involved  in  the 
fraud.  In these  circumstances  the auditor  should  report  the  matter  to  an  appropriate 
authority.  In  some  Member  States,  statutory  auditors  are  required  to  report  to  the 
Ministry of Justice. 

13 

3.26 Auditing  guidelines  suggest  that  the  auditor  may  need  to  take  legal  advice  before 
making a decision on whether the matter should be reported to a proper authority  in 
the  public  interest.  The  difficulty  for  auditors  is  that  normally  they  will  have  to 
make  a  decision  based  on  their  suspicions  of  fraud  rather  than  on  proven  facts.  If 
they report their  suspicions to a third party  and are subsequently  unable to  establish 
firm evidence of fraud they may be liable to legal action. 

3.27 In the financial  sector, auditors' responsibilities  in this regard have been clarified,  in 
most Member  States, by legislation which releases auditors from  their obligations of 
confidentiality  to  their  client  organisations  and  give  them  the  right  but  not  the 
obligation to report to a regulatory body. 

It  is  now  specifically  provided  for  in  Article  5.1  of  a  Council  Directive  95/26/EC 
adopted in June  1995 that the statutory auditor of a financial undertaking" shall have 
a  duty  to  report  promptly  to  the  competent  authorities  any  fact  or  decision 
concerning  that  undertaking  of which he has become  aware  while  carrying  out  that 
task which is liable to : 

-  constitute  a  material  breach  of  the  laws,  regulations  or  administrative  provisions 
which lay down the conditions governing authorisation or which specifically  govern 
pursuit of the activities of financial  undertakings, or 

- affect  the continuous functioning  of the financial undertaking, or 

- lead to refusal  to certify  the accounts or to the expression of reservations  ;..." 

This Directive also provides in its Article 5.2 that  : " The disclosure in good faith  to 
the  competent  authorities,  by  persons  authorised  within  the  meaning  of  Directive 
84/253/EEC (the statutory auditor), of any factor or decision referred  to in paragraph 
1  shall  not  constitute  a  breach  of  any  restriction  on  disclosure  of  information 
imposed by contract or by any legislative, regulatory or administrative provision and 
shall not involve such persons in liability of any kind". 

This Directive is to be implemented in all Member States by July  1996 

3.28 If the fraud  is material, statutory auditors need to ensure that the financial statements 
reflect  the  effect  of the  fraud  and  that  all  necessary  details  are  disclosed.  Provided 
the  auditors  are  then  convinced  that  the  financial  statements  give  a  true  and  fair 
view, it is not necessary to qualify  the audit report. If the fraud  is not material in the 
context  of the  financial  statements, it  is the responsibility  of the directors to  decide 
whether  disclosure  is  necessary.  However,  since  undetected  material  fraud  will 
result  in  financial  statements  which  do  not  present  a  true  and  fair  view  of  the 
company's  affairs,  it  would  seem  that  auditors  have  a  duty  to  employ  the  means 
which they think are necessary to detect material fraud  if their opinion is to be valid. 

14 

3.29 The public expects the opportunities  for  fraud  to be minimised.  It seems  reasonable 
to expect the Board of Directors to take responsibility for setting up and maintaining 
systems  of internal  control that,  inter  alia, minimise  the opportunities  for  fraud  and 
maximise the likelihood  that any  such fraud will be quickly  detected.  It  seems  also 
reasonable  to  expect  statutory  auditors  to  confirm  in  the  audit  report  that  such 
systems of internal control exist and to say whether or not they appear well designed 
to  serve  their  purpose.  In  the  same  way,  it  would  appear  reasonable  to  expect 
auditors  to  support  the  directors  in  their  attempts  to  prevent  and  detect  fraud  by 
reporting to the directors any weaknesses they may have identified  in these  systems 
of internal control and any suspicions they may have in regard to  fraud. 

The respect by the company of its legal obligations 

3.30 It appears to be the general view that it is the auditor's duty to detect  contravention 
of  company  law  or  of  statutory  regulations  which  specifically  relate  to  company 
law.  The  auditor  cannot  however  be  reasonably  expected  to  report  on  matters 
beyond  his  competence  or  expertise,  especially 
legal 
environment. 

today's  complex 

in 

3.31 The  directors  should  take  responsibility  for  setting  up  and  maintaining  systems  of 
internal  control  that,  inter  alia,  minimise  the  opportunities  for  committing  illegal 
acts  in  the  name  of  the  company  and  that  maximise  the  likelihood  that  any  such 
illegal acts will be quickly detected. It would seem reasonable to expect the  statutory 
auditor to confirm  in his audit report that such  systems  of internal  control  exist  and 
to say whether or not they appear well-designed to serve their purpose. 

3.32 In addition, as part of their responsibility to prepare financial  statements which show 
a  true  and  fair  view,  directors  must  ensure  that  the  statements  reflect  the  financial 
implications  of illegal  acts detected,  if these implications  are judged  to be material. 
The statutory  auditor, as part of his responsibility  to express an opinion  on whether 
the  financial  statements  give a true and fair  view, must  confirm  that the  statements 
reflect the financial  implications of any such illegal acts. 

Responsible  behaviour  by  the  company  with  regard  to  environmental  and 
societal matters 

3.33 There have been demands over recent years for  companies to be  subject  to an  audit 
of  their  social  behaviour,  most  notably  in  respect  of  the  physical  environment  but 
also in terms of employment practices, safety  of operations, trade sanctions, product 
development  policies  and  other  issues  of  concern  to  the  general  public  and  to 
particular interest groups. 

15 

3.34 Without  entering  into  the  merits  of  such  an  audit  or  audits,  it  might  be  asked 
whether  the  statutory  auditor has  appropriate  qualifications  and  experience  to  carry 
out  this  work,  or  whether  it  should  be  a  separate  exercise  from  the  statutory  audit 
and be carried out by qualified  experts in the area(s). 

3.35 Although  it  is unreasonable  to  expect  the  statutory  auditor  to  make judgements  on 
matters  outside  his competence  and  expertise, it can be  argued  that  auditors  should 
accept  that  their  responsibilities  will  tend  to  increase  in  line  with  public 
expectations. The auditor can, given time and a sufficiently  clear consensus on what 
is expected,  avail himself  of the necessary  expertise in areas which go beyond  strict 
financial  audit. 

Priorities for action and possible methods 

3.36 The  absence  of  a  common  definition  of  the  statutory  audit  in  the  EU  creates  a 
damaging  expectation  gap.  A  common  approach  to  the  statutory  audit,  taking 
account  of  the  latest  developments  at  international  level,  seems  desirable.  If  the 
audit  is  to  add  confidence  to  published  financial  statements,  users  need  to  know 
what  the  audit  certificate  means  in  terms  of  assurance.  In  this  regard,  particular 
attention should go to the role of the auditor in respect of the going concern status of 
the  company  and  the  action  to  be  undertaken  by  the  auditor  in  case  of  fraud  and 
other illegal acts. 

3.37 Consideration  should  be  given  to  what  extent  existing  International  Standards  on 
Auditing  could  be  the  starting  point  of  a common  definition  of the  statutory  audit. 
Full  account  would  also  need  to  be  taken,  however  of  any  particularities  which 
distinguish the European from the international  environment. 

3.38 To be effective,  the common definition  would need to become part of the  regulatory 
framework  in  all  Member  States.  It  is  for  consideration  whether  an  EU  Directive 
would be needed to achieve this result or whether a Recommendation  would  suffice. 
In  either  case,  due  attention  would  need  to  be  paid  to  flexibility,  so  that  any  legal 
requirement  can easily be adapted to the rapidly changing environment  in which the 
auditor operates. 

16 

The audit report 

Contents of the audit report 

3.39 The  audit  report  is  the  medium  through  which  the  statutory  auditor  communicates 
with  shareholders,  creditors, employees  and with the public  at  large.  It  is the  result 
of  the  audit  process.  Usually,  a  distinction  is  made  between  a  "long  form"  audit 
report  and  a  "short  form"  audit  report.  The  "long  form"  report  is  addressed  to 
management and is not normally made available to the public. 

3.40 Although  the  content  of  the  audit  report  is  not  prescribed  under  the  Accounting 
Directives,  company  law  in  most  Member  States  has  specified  the  matters  which 
have to be included  in the published  audit report. Professional  bodies in all Member 
States  have  established  standard  forms  of  published  audit  reports.  However,  only 
three Member States have made it a binding rule that those standard forms be used. 

3.41 In general, the audit report concerning the annual accounts  in Member  States would 

normally contain the following  information  : 

whether  the auditor  has  obtained  all the  information  and  explanations  which, 
to the best  of his knowledge  and belief, are necessary  for  the purposes  of his 
audit ; 

whether,  in  his  opinion,  proper  books  and  records  have  been  kept  by  the 
company ; 

whether the annual report is consistent with the annual accounts ; 

whether the annual accounts give a true and fair view of the company's assets, 
liabilities, financial position and profit  or loss ; 

whether the annual accounts comply with the requirements of company law ; 

whether the audit was carried out in accordance with auditing standards. 

3.42 Looking  at the  audit  reports  of the  largest  listed  companies  in  Member  States,  one 
could say that, in their present form, users can derive comfort  only from  the absence 
to  the  financial  statements.  They  give  users  no  help  in 
of  a  qualification 
understanding  what  the  auditors,  who  are  appointed  by  shareholders  and  report  to 
them, actually  do in return for  the audit  fee paid to them.  Without this  information, 
it  is difficult  to  see  how  investors  and  other  users  can  form  a  conclusion  with  any 
degree of confidence  on the weight they can place on the auditors' opinion. 

17 

3.43 There seems to be a general consensus that more information  should be given  about 
the scope and nature of the work on which the audit report is based. Users very  often 
consider the audit report as an assurance or a certificate  for their decision making. It 
is  necessary  that  the  audit  report  clearly  states  the  auditor's  responsibilities  for 
reporting on the financial statements. 

3.44 The  results  of  recent  surveys  have  shown  that  harmonisation  of  the  form  and  the 
wording of the audit report has increased in the EU over the last ten years. This is to 
a large extent the consequence  of a more widespread  and consistent  adoption  of the 
relevant International  Standard on Auditing. Differences  still exist however between 
Member  States  with  regard  to  the  wording  and  the  coverage  of  the  standard  short 
form  statutory  audit  report.  These  differences  have  a  single  market  impact  to  the 
extent  that  they  reduce  the  utility  of  reports  issued  in  other  Member  States.  In 
principle,  where  similar  statutory  audit  work  has  been  performed,  this  should  be 
clearly communicated by way of similar wording in the audit report. 

Priorities for action and possible methods 

3.45 Once  an  agreement  has  been  reached  on  the  definition  of  the  statutory  audit,  it 
should  be  easier  to  agree  on the  minimum  content  of the  audit  report.  Because  the 
audit  report  is the medium  through  which  the  statutory  auditor  communicates  with 
shareholders,  creditors,  employees  and  with  the  public  at  large,  it  seems  desirable 
that a similar wording in the audit report is used throughout the EU. 

3.46 In  several  Member  States  the  wording  of the  audit  report  has  been  adapted  to  that 
developed  by the International  Federation  of Accountants.  It is for  consideration  to 
what extent this could also be the starting basis for a common definition  at EU level. 
Proper  attention  would  however  need  to  be  given  to  any  particularities  which 
distinguish  the European  from  the international  environment.  In order to reduce  the 
expectation  gap,  it  would  be  necessary  for  the  audit  report  to  provide  more 
information  on what the auditor  has actually  done, which professional  standards  he 
has  applied  in carrying  out his task  and  whether  the  financial  information  prepared 
by  the  company  conforms  with  legal  and  other  regulatory  requirements.  It  would 
also  be  necessary  for  any  reservations  which  the  auditor  might  have  to  be  clearly 
spelled out in his report. 

18 

3.47 As  for  the  definition  of  the  statutory  audit,  it  seems  necessary  for  the  common 
definition  of the audit report  to have legislative  backing  in the Member  States. It  is 
for  consideration  whether  this points  to  binding  legislation  ( i.e.  a Directive)  at  the 
EU  level,  or  whether  a  Commission  Recommendation  would  be  enough.  Due 
attention must  in any case be paid to flexibility, so that any  legal requirement  could 
be easily adapted to the rapidly changing environment in which the auditor operates, 
information 
to  the 
in  particular  developments  related 
technologies. 

introduction  of  new 

19 

4  THE POSITION OF THE STATUTORY  AUDITOR 

The competence of the statutory  auditor 

Competence in the Eighth Directive 

4.1  There  can  be  no  doubt  that  the  demands  put  on  the  statutory  auditor  require  this 
auditor  to  be  a  highly  qualified  professional.  This  is  the  reason  why  the  Eighth 
Directive  of  10 April  1984 on the  approval  of persons  responsible  for  carrying  out 
the statutory audits of accounting documents has put the competence of the statutory 
auditor at a very high level indeed. 

4.2  However,  differences  in  the  educational  systems  of  the  Member  States  cannot  be 
ignored. These were a source of difficulties  when attempts were made at the time of 
implementation  of  the  Directive  to  compare  national  educational  levels  in  the 
Member  States.  As  a  result,  the  accounting  profession  in  Europe  has  stressed  the 
need  for  professionals  who  want  to  offer  cross-border  services  to  acquire  the  host 
country professional  title. 

4.3  Although the Eighth Directive has led to some harmonisation  in this field, there  are 
still  important  differences.  There  is at present  no  common  understanding  about  the 
contents of the different  courses which are listed in Article 6 of the Eighth  Directive 
and  which  are  part  of  the  test  of  theoretical  knowledge.  The  lack  of  a  common 
understanding became clearly apparent when new Member  States joined the EU and 
when  Central  and Eastern  European  countries  asked  for  technical  assistance  for  the 
establishment of training programmes for auditors. 

4.4  The  development  of 

is 

likely 

to  have 

technology 

information 

important 
consequences  for  the  audit  function.  It  is  sometimes  seen  as  a  threat  to  auditors, 
because of the diminishing importance of published financial statements to investors 
who  may  be  able  to  obtain  financial  information  on  a  permanent  basis  through 
different  means. It can however  also offer  new opportunities, in terms of new  attest 
functions  associated  with  the  new  information  flows,  systems  and  types  of 
information  that reporting entities will provide to users as the information  era moves 
forward.  This is bound to have implications  for the educational  requirements  which 
are  presently  included  in  the  Eighth  Directive  and  which  were  established  taking 
account  of the audit  function  in a different  technological  environment.  For this  and 
other  reasons,  it  may  be  necessary  to  adapt  or  clarify  Article  6  of  the  Eighth 
Directive. 

20 

Priorities for action and possible methods 

4.5  It is regrettable that neither the accounting profession,  nor the academic  community 
have  taken  any  concrete  steps  to  clarify  the  competence  requirements  listed  in  the 
Eighth  Directive.  It  would  appear  that  the  definition  of  a  curriculum  for  the 
education  of auditors  should be primarily  a task for  those who are directly  involved 
in  the  educational  process.  More  harmonisation  in  this  field  would  certainly 
facilitate  the application  of the Mutual Recognition  Directives ( see also section  8 ). 
In  this  context,  it  should  be  evident  that  the  training  process  must  prepare  the 
auditors to operate in a Single Market. Such an initiative at European level could be 
undertaken  for  instance  in  the  framework  of  the  new  Community  programme 
SOCRATES and in particular Chapter I - ERASMUS, Action  1 .D on University  co 
operation  projects  on  subjects  of  mutual  interest  ("Thematic  Networks"),  which 
provide  a  reflection  forum  involving  representatives  of  the  socio-economic  and 
professional  world in specific  subject  study areas, including those of other  countries 
participating in these programmes. 

4.6  Updating the list of courses included in Article 6 of the Eighth Directive will require 
an  amendment  to  the  Directive.  If  and  when  that  is  considered  opportune, 
consideration  should  be given to the introduction  of a procedure which will allow it 
to  be  further  amended  in  future  without  passing  through  the  full  legislative 
procedure. 

The independence of the statutory auditor 

Definition  of independence 

4.7  In accordance  with the Eighth Directive, the  statutory  auditor  must  be  independent. 
At  the  time  of  adoption  of the  Directive,  it  was  impossible  to  agree  on  a  common 
definition  of  independence.  As a result,  this  subject  has  been  dealt  with  differently 
by Member States. 

4.8  As  pointed  out  by  FEE4,  independence  is  the  main  means  by  which  the  statutory 
auditor demonstrates that he can perform  his task in an objective manner. In dealing 
with  independence,  it  is  necessary  to  address  both  independence  of  mind,  i.e.  the 
state of mind which has regard to all considerations relevant to the task in hand and 
independence  in appearance, i.e. the avoidance of facts  and circumstances  which are 
so  significant  that  an  informed  third  party  would  question  the  statutory  auditor's 
objectivity. 

See bibliography 

21 

4.9  In recent years, concern has been expressed  about the threats which have  developed 
to auditors' independence.  Several  surveys reported on the fact  that companies  were 
increasingly  prepared  to  challenge  auditors,  to  shop  for  opinions,  to  seek  legal 
advice  on  auditors'  views  and  to  change  auditors.  Some  reports  concluded  that, 
given the competitive pressures, it would be idealistic to assume that all auditors are 
at all times unmindful  of the risk of losing business. Criticism  has been voiced  that 
the  professionalism  of  the  audit  function  has  diminished  in  favour  of  a  more 
"businesslike" attitude. 

4.10 Moreover,  it  has  become,  more  common  for  the  audit  to  be put  out  to  tender.  The 
principal  objective  in  seeking  competitive  tenders  is  to  obtain  the  services  of  the 
auditors as cheaply as possible. It is sometimes suggested that management resort to 
tendering  in  order  to  put  pressure  on  the  incumbent  auditors,  particularly  when 
disputes have arisen. 

4.11 The  growing  intensity  of  competition  for  audit  "business",  and  especially  for  the 
audit  of  large  "prestige"  companies,  is  also  a  cause  of  concern.  There  is  no  doubt 
that competition sometimes results in low-cost and perhaps even below-cost tenders. 
The  procedure  of  calls  for  tenders  which  ensures  transparency  and  competition, 
should  not  have  as  a  consequence  that  auditors  quote  an  audit  fee  which  does  not 
allow them to carry out their work in accordance with professional  standards5. Some 
observers  infer  that the successful  tenderers expect to recoup the balance  of the  full 
cost of the audit from  non-audit consultancy  services. This points to another concern 
which relates to the provision of non audit services. 

4.12 The  question  whether  the  auditor  should  provide  other  services  to  his  audit  client 
has  been  the  subject  of  much  debate.  It  has  been  advocated  that  the  provision  of 
other  services  to  an  audit  client  is  likely  to  increase  the  auditor's  understanding  of 
the client's business and operations and therefore  results in a better audit. Is has also 
been argued that there is no evidence that the volume of non-audit fees in relation to 
the  level  of  audit  fees  is  a  threat  to  objectivity.  Nevertheless,  there  is  an  equally 
strong belief that the provision of a broad range of non-audit  services to an  existing 
audit  client  can  impair  audit  objectivity.  Safeguards  are  necessary  to  respond  to 
these concerns. 

In  the  case  of  public  procurement,  the  Council  has  adopted  a  set  of  rules  assuring  transparency  in 
competition  for  the  award  of  public  entities  contracts.  These  rules  also  apply  to  audit  services.  See 
Directives 92/50/EEC and 93/38/EEC - Annex  1A - Category 9. 

22 

4.13  Such  safeguards  could  consist  in  confining  the provision  of  other  services  to  those 
whose  nature  and  quality  are  consistent  with  the  auditor's  professional  image  and 
which are unlikely to impair his objectivity, or in requiring the fee for both audit and 
non-audit services to be disclosed. A solution which would consist in preventing the 
auditor  from  providing  any  other  service to his  audit  client  would  clearly  solve  the 
appearance  problem.  However, practice  has  shown that this  solution  is not  a  viable 
alternative,  as  it  is  too  easy  to  circumvent  by  having  the  service  provided  by  an 
affiliated  or associated firm. 

4.14 In  all  cases  the  auditor  should  ensure  that  he  and  his  firm  are  not  involved  in  the 
management  or decision making  of his client. The auditor  should not be engaged  in 
the preparation  of the financial  statements of his client, be involved  in the valuation 
of assets or liabilities for purposes of recording them in the financial  statements, act 
for the client in the resolution of litigation which may have a material  impact on the 
financial  statements,  or  perform  services  having  a  direct  impact  upon  senior 
management such as their recruitment. 

4.15 Some  commentators  find  cause  for  concern  where  a  company  retains  the  same 
auditors  for  a  long  period.  It  is  argued  that  this  can  lead  to  too  close  and  cosy  a 
relationship  with  management,  with  the  auditors  becoming  too  responsive  to 
management's  wishes.  The  question  whether  the  statutory  audit  should  be  made 
subject  to  a  system  of  mandatory  rotation  has  been  the  subject  of  considerable 
debate. The arguments in favour  of such a system are not conclusive. In this context, 
it  is  important  to  note  that  one  of  the  two  Member  States  which  had  a  system  of 
mandatory  rotation  has  recently  abolished  it.  A  solution  which  could  enhance  the 
perception  of  the  auditor's  objectivity,  without  causing  the  efficiency  and  quality 
drawbacks  of  firm  rotation,  could  consist  in  setting  up  a  rotation  of  audit  partners 
within the same firm. 

Priorities for action and possible methods 

4.16 Independence  is  an  important  issue.  Based  on  different  traditions  and  experiences, 
this  issue  is  dealt  with  differently  in  Member  States.  It  is  unlikely  that  it  will  be 
possible  in the short term to agree at EU level on a common definition  covering  the 
various issues raised  in relation with auditor independence. The adoption of a set of 
rules  which  regulate  independence  does  not  by  itself  bring  about  independence  in 
practice.  However,  agreement  on  a  common  core  of  essential  principles  in  all 
Member  States would  constitute  an important  step towards the  establishment  of  an 
internal  market  for  audit  services.  These  principles  could  be  developed  by  the 
profession  at EU level. 

4.17 It  is  for  consideration  which  instrument  is  most  appropriate  to  ensure  that  an 

agreement reached at EU level is likely to be adhered to in practice. 

23 

The position of the statutory auditor within the company 

The statutory audit and corporate  governance 

4.18 The statutory  audit is an essential element of the system of corporate governance. In 
order to put the statutory  audit  in the right perspective, it is necessary  to  distinguish 
the  role  of  the  various  organs  of  the  company  in  the  field  of  financial  reporting. 
While  the  directors  are  responsible  for  the  preparation  of  the  financial  statements, 
the  role  of  the  statutory  auditor  is  to  report  to  the  shareholders  on  the  financial 
statements  presented  to him  by the  directors.  In doing  so, the  statutory  auditor  acts 
in  the  interests  of  the  shareholders  who  have  a  financial  stake  in  the  company.  In 
addition,  his  report  lends  credibility  to  the  financial  information  used  by  third 
parties. 

4.19 Because  the  shareholders  have  the  most  direct  interest  in  the  outcome  of  the 
statutory  audit, all Member  States have given the right to appoint and to dismiss the 
auditor to the shareholders  in the general meeting. However,  for the shareholders  of 
most  listed  companies, as a result  of their  large numbers  and transient  nature, there 
is  no  effective  mechanism  for  them  to  do  so.  It  is  usually  the  directors  who 
effectively  appoint and dismiss the statutory  auditor, with the decision merely  being 
ratified  by the  shareholders  at the annual  general  meeting. A consequence  of this  is 
that  statutory  auditors  are  criticised  for  not  being  independent  of the  directors.  It  is 
argued  that,  in  disputes  between  the  directors  and  the  statutory  auditor  on  issues 
such as accounting  policy  choices, the  statutory  auditor has an incentive to  concede 
to  the  wishes  of  the  directors.  The  statutory  auditor  may  be  put  in  a  particularly 
difficult  position  in  such  disputes  if  the  directors  have  gathered  opinions  from 
competing firms of auditors. 

4.20 It  is  argued  that  another  result  of  the  auditors  being  effectively  appointed  by  the 
directors  is  that,  due  to  cost  pressures,  both  parties  have  reduced  the  role  of  the 
statutory  audit  to  the  minimum  necessary  to  fulfil  the  legal  requirements  of 
company  law  as  interpreted  by  the  auditing  firms  themselves.  It  is  argued  that  this 
has  led  to  less  attention  being  given  by  the  statutory  auditors  to  the  assessment  of 
the efficiency  and effectiveness  of companies' internal control  systems, which  could 
lead to an increased incidence of fraud  and other illegal acts. 

4.21 The  agreement  of  the  statutory  auditors'  remuneration  with  the  directors  creates  a 
further  problem.  The  audit  fee  is  normally  agreed  in  advance  and  is  based  on  the 
usually valid assumption that the auditors will not find any evidence of malpractice. 
However  if,  in the  course  of  their  work,  the  auditors  become  suspicious  that  there 
has been fraudulent  activity that they  feel  should be  subject  to further  investigation, 
they  will  have  to  agree  with  the  directors  a  fee  for  this  additional  work.  If  the 
directors are involved in the malpractice, the statutory auditor finds himself in a very 
difficult  situation. 

24 

4.22 In  order  to  preserve  the  independence  and  objectivity  of  the  statutory  auditor, 
procedures  giving  greater  assurance  that  the  shareholders  are  able  to  make  a  real 
choice,  for  instance  through  a  greater  use  of  audit  committees  and/or  reforms  of 
board  procedures  or  through  the  association  of  other  parties,  such  as  the  workers 
council  in the appointment  and dismissal  of the auditor, have been developed  or are 
currently been examined  in certain Member States. 

4.23 Both  the  Cadbury  report  in  the  United  Kingdom  and  the  Vienot  report  in  France 
recommend  that the board  of directors in listed  companies  should  establish  an audit 
committee  of  at  least  three  non-executive  directors,  chaired  by  one  of  their 
members.  Since  1978,  the  New  York  Stock  Exchange  has  required  all  listed 
companies  to have  audit  committees  composed  solely  of  independent  directors  and 
the  1987  report  of  the  American  Treadway  Commission6  concluded  that  audit 
committees  had  a  critical  role  to  play  in  ensuring  the  integrity  of  US  companies 
financial  reports. Experience  in the United  States has  shown that,  even where  audit 
committees  might  have been  set up mainly  to  meet  listing  requirements,  they  have 
proved  their  worth  and  developed  into  essential  committees  of  the  board  of 
directors. 

4.24 However,  it is likely that companies without  a strong  internal  audit function  will  be 
unable  to  provide  an  audit  committee  with  sufficient  information  to  fulfil  its 
responsibilities.  The scope of the work of the statutory  auditor and the timing  of the 
statutory  audit  are  unlikely  to  be  adequate  and  appropriate  for  this  purpose. 
Furthermore, the statutory  audit is essentially  a snapshot at a particular point in time 
whereas  assessment  of  the  effectiveness  of  a  company's  management  information 
systems and systems of internal control  should be undertaken  on a continuous basis. 
Consequently,  recommendations  have  been  made  for  the  appointment  in  major 
companies  of  a  chief  internal  auditor  to  lead  a  strong  internal  audit  team  that  is 
capable  of  providing  the  audit  committee  with  sufficient  information  to  fulfil  its 
responsibilities  on behalf  of the board. As stated  by the European  Confederation  of 
Institutes  of  Internal  Auditing  in  their  position  paper  on  Internal  Auditing  in 
Europe7,  the  furnishing  of  objective  and  timely  appraisals  of  the  quality  of  an 
organisation's  internal  control  and  systems  for  managing  business  risk,  would 
contribute  significantly  to  strengthening  management's  control  of  the  operations, 
thus  contributing  to  sound  corporate  governance.  In  their  view,  it  is  necessary  for 
the  EU  to  introduce  binding  legislation  for  significant  enterprises  and  sectors 
requiring  the  establishment  of  a  professional 
internal  auditing  function  and 
regulating  qualifications  and experience  required, as well as the duties  of the  Board 
and Chief Executive in relation to internal audit conclusions and recommendations. 

6 

7 

See bibliography 

See bibliography 

25 

4.25 In Member  States, the length of the  statutory  audit  appointment  varies  from  a fixed 
period  of  1 year  to  6 years  to  an  indefinite  period.  In the  Amended  Proposal  for  a 
Fifth  Council  Directive  it is proposed that the  statutory  auditor  should  be  appointed 
for  a  specified  period  of  not  less than  three  financial  years,  and  not  more  than  six 
financial years. 

4.26 The  1996  study  carried  out  for  the  Commission  shows  that  the  position  of  the 
statutory  auditor  within  the  company  is  not  the  same  in  all  Member  States. 
Differences  range  from  an  external  adviser  to  an  organ  of  the  company.  In  some 
cases there even exists a dual audit requirement, which means that in addition to the 
statutory  audit  requirement  following  from  the  Accounting  Directives,  there  is 
another  audit  imposed  by  the  Stock  Exchange  Regulatory  Authority.  It  is not  clear 
that such a system offers  any advantages in terms of improved  control. On the  other 
hand, it can lead to confusion  concerning the relative status of the different  auditors, 
especially if they come to different  conclusions concerning the same company. 

Priorities for action and possible methods 

4.27 Recent  debates  about  corporate  governance  have  stressed  the  need  to  define  more 
clearly  the  role  of the  board  of  directors  in preparing  the  financial  statements.  The 
issue  is  however  much  more  complicated  and  extends  to  defining  the  role  of  all 
parties  involved  in  the  financial  reporting  process  (board  of  directors,  supervisory 
board,  general  meeting  of  shareholders,  auditor). In order to  improve  the  system  of 
checks  and  balances  within  the  company,  more  attention  should  be  paid  to  issues 
such  as  the  creation  of  an  audit  committee  and  the  establishment  of  a  proper 
functioning  system of internal control. 

4.28 It is difficult  to deal at EU level with matters  of corporate  governance  : past  efforts 
to  harmonise  law  on the  structure  of the  company  have  not  succeeded.  In  order  to 
contribute  to  the  debate  at  national  level,  it  might  be  useful  to  consider  a 
Recommendation  at  EU  level  on  possible  ways  to  improve  the  present  system  of 
corporate governance, especially in as far as it relates to financial reporting. It would 
then  be  up to  Member  States to  initiate  any  necessary  legislative  action  at  national 
level. 

The role of governmental and professional  bodies 

Quality  control 

4.29 In accordance  with the Eighth Directive, auditors must be approved  by an  authority 
designated  by  Member  States.  This  authority  must  see  to  it  that  the  persons 
approved  as statutory  auditors  satisfy  all the requirements  imposed  by the  Directive 
and  that  they  carry  out  audits  in  accordance  with  the  principles  of  professional 
integrity and independence. 

26 

4.30 Most Member  States have delegated the authority to approve the statutory auditor to 
one  or  more  professional  associations.  In  such  cases,  it  is  important  that  these 
associations also supervise the way in which their members conduct the audit.  Most 
of these associations have developed professional  rules describing the way in which 
the  audit  has  to  be  carried  out.  These  auditing  standards  are  often  inspired  by  the 
standards  developed  by  IF AC.  This  is not,  however,  the  case  in  all  Member  States 
and  these  auditing  standards,  where  they  are  applied,  are  in  most  cases  only  a 
recommendation  and  not  a  legal  requirement.  There  is  at  this  stage  therefore  no 
guarantee that the statutory audits carried out by professionals  approved  on the basis 
of the Eighth Directive are of equivalent quality. 

4.31 Similarly, the way in which professional  associations supervise their members is not 
the same. While some associations have organised peer review systems, whereby the 
work  of  an  auditor  is  at  regular  intervals  reviewed  by  another  auditor,  other 
associations  have  set  up  a  special  unit  responsible  for  reviewing  the  way  in  which 
members  carry  out  statutory  audits.  Here  again,  there  is  no  guarantee  that  quality 
review systems in the various Member States are equivalent, or even adequate. 

4.32  Some Member  States have decided not to delegate the authority to approve  auditors 
to  a  professional  association  but  have  this  task  carried  out  by  a  Ministry  or  by 
another  body,  such  as  a  Chamber  of  Commerce.  In  this  case  too,  appropriate 
arrangements need to be made to ensure that there is quality control  and that  actions 
are undertaken in cases where the auditors do not carry out their tasks in accordance 
with the principles of professional  integrity and independence. 

4.33 In  most  Member  States,  special  audit  requirements  apply  to  companies  in  the 
financial  sector  which  are  subject  to  prudential  control  by  a  competent  authority. 
These additional requirements have been set up to ensure the protection of  investors 
and  policyholders.  In  addition,  Member  States  may  authorise  exchanges  of 
information  under  strict  conditions  and  between  the  competent  authorities  of  the 
.financial  sector  and  the  professional  body  of  the  statutory  auditor,  according  to 
paragraphs  1  and 2 of Article 4 of Directive 95/26/EC. 

Priorities for action and possible methods 

4.34 The absence of a legal requirement at EU level that all statutory audits conducted  on 
the  basis  of  Community  law  must  be  carried  out  on  the  basis  of  an  agreed  set  of 
auditing  standards  is  a  handicap  for  the  Single  Market  and  in  the  international 
context.  It  should  be examined  whether the  standards  on auditing  developed  by  the 
International  Auditing  Practices  Committee  of  the  International  Federation  of 
Accountants  and  already  applied  to  a  certain  extent  in  most  Member  States  could 
provide  a  possible  basis  for  agreed  standards  at  EU  level.  As  with  international 
accounting  standards, it would  seem necessary  to devise  a mechanism  to  determine 
whether  existing  IF AC  standards  meet  European  requirements  and  to  ensure 
increased European influence  in the development of international auditing standards. 

27 

4.35  Such  a mechanism  at EU  level  could  bring  together  all parties  involved  at  national 
level  in the  definition  of  auditing  standards  and  could  discuss  all  relevant  auditing 
matters.  It  would  be  important  that  an  assurance  be  obtained  that  any  auditing 
standards  agreed  upon  at  EU  level  were  actually  being  followed  in  practice  at 
national  level.  This  might  be  difficult  to  achieve  without  giving  those  standards 
some kind of legal backing. 

4.36 Even  if  a  code  of  principles  on  auditor  independence  and  a  core  set  of  auditing 
standards can  be agreed  upon, the  system  will  only be effective  if the  standards  are 
enforced  and  if  there  is  appropriate  quality  control.  If  a mechanism  were  set  up  at 
EU  level,  as  suggested  above,  one  of  its  tasks  could  also  consist  in  examining  the 
way  in  which  quality  control  in  the  audit  field  is  assured  in  the  various  Member 
States.  Within  the  context  of  the  Single  Market,  it  is  also  important  that  the 
regulatory  authorities  in Member  States communicate  with  each  other.  The  rules  of 
professional  secrecy should not present any obstacle to this. 

28 

5.  AUDITOR'S CIVIL LIABILITY 

Towards a limited liability  ? 

5.1  Professional  liability  is  an  important  issue  for  auditors.  In  some  Member  States, 
audit  firms  have  been  made  responsible  in  a  number  of  cases  for  amounts  which 
were  disproportionate  with the  audit  fee  and with  the  auditor's  direct  responsibility 
for  the  financial  failure.  The  auditor  usually  disposes  of  professional  indemnity 
insurance  and there  is a tendency  to  sue by preference  the party  whose  professional 
liability has been insured. 

5.2  There  are major  differences  as to the liability  regime of the  statutory  auditor  within 
the  EU.  In  some Member  States, there  exists  a legal  civil  liability  cap, limiting  the 
amount  of  damages  that  the  statutory  auditor  might  have  to  pay  in  the  case  of 
litigation.  In  other  Member  States,  auditors  can  limit  their  liability  by  contract. 
Differences  also exist regarding  the possibility  for  the courts to  limit the amount  of 
damages in the case of litigation. 

5.3  Various  suggestions  have  been  made  in  order to  arrive  at  a regime  which  could  be 
regarded  as  more  equitable  to  the  auditor.  These  suggestions 
the 
generalisation  of  a  legal  liability  cap,  the  possibility  for  the  auditor  to  limit  his 
liability  by  contract,  the  incorporation  of  the  audit  firm  into  a  limited  liability 
company,  the  introduction  of  proportional 
liability  and  the  introduction  of 
mandatory professional  insurance for auditors and for directors. 

include 

5.4  The  original  proposal  for  a  Fifth  Company  Law  Directive  provided  for  unlimited 
liability  of the  statutory  auditor to third parties. The  amended  proposal  contains  no 
provision  directly  imposing upon the statutory auditor a liability to third parties, but 
provides  for  liability  of the  auditor  only  to the  audited  company,  stating  that  these 
provisions do not in any way exclude an auditor's liability to shareholders and third 
parties  under  the  general  private  law  of the  Member  States. During  the  negotiation 
of  this  proposal  in  the  Council  of  Ministers  working  group,  the  text  was  further 
clarified  by stating that it is up to the Member  States to regulate the civil  liability  of 
the  persons  responsible  for  the  statutory  audit  so  as to  ensure  that  compensation  is 
made for  any damage  sustained  by the company, any  shareholder or third party  as a 
result  of  wrongful  acts  committed  by  the  auditors  in  carrying  out  their  duties. 
Member  States could however allow the limitation by law or by contract of the civil 
liability to the audited  company  on the basis of negligence. Discussions on the  Fifth 
Directive were however discontinued  in  1991. 

29 

5.5  Meanwhile,  it  cannot  be  denied  that  the  existence  of  different  liability  regimes  in 
Member  States  has  internal  market  consequences.  As  a  result  of  an  extensive 
liability  regime,  audit  firms  may  avoid  high-risk  clients  or  even  entire  industries, 
calling  into  question  the  very  rationale  for  a  compulsory  statutory  audit.  Costs  of 
statutory  audits  to  clients  in  highly  litigious  Member  States  may  be  higher  than 
elsewhere. Insurance premiums throughout the EU might become more expensive as 
a  result  of  litigation  in  some  Member  States.  This  might  lead  to  a  further 
concentration of the audit market in the hands of a limited number of audit firms. To 
the extent that there exists a legal  or contractual  liability  cap only  in  some  Member 
States,  there  might  be  a  tendency  to  sue  the  auditor  preferably  in  those  Member 
States where there is no such liability cap. 

Priorities for action and possible methods 

5.6  There  can  be  no  doubt  that  the  clarification  of  the  role  and  the  position  of  the 
statutory auditor would have a positive effect  on the assessment of his liability  in the 
case  of  an  audit  failure.  Whilst  there  does  not  seem  to  be  a  reason  to  confine  the 
liability  of  the  auditor  to  the  audited  company  -  as  the  statutory  audit  has  been 
required  in  the  public  interest  -  it  would  seem  reasonable  that  the  liability  of  the 
auditor should be limited to amounts which reflect  his degree of negligence. 

5.7  Action  at EU  level  in this  field  is likely  to be  difficult.  The  audit  profession  is  not 
the  only profession  which  is struggling  with problems  of liability.  Furthermore,  the 
legal traditions in Member  States in the area of civil liability  are quite different.  It is 
for  consideration  whether the negative effects  of a continuation  of differences  in the 
regulation  of audit  liability  are  significant  enough  to justify  EU  action,  considering 
the  difficulties  which  such  action  is  likely  to  face  and  the  possible  discrimination 
which  action  specific  to  the  audit  profession  might  entail  as  regards  other 
professions. 

30 

6.  THE STATUTORY AUDIT IN SMALL  COMPANIES 

The small company audit 

6.1  In accordance with Article 51 (2) of the Fourth Directive, Member  States may relieve 
small  companies,  as  defined  in  Article  ll8,  from  the  requirement  to  have  their 
annual  accounts  audited  by  a  qualified  professional.  Important  reasons  for  this 
exemption were the wish not to create an additional  burden for  small companies  but 
also  the  risks  involved  in  a small  company  audit,  where  the  auditor  can  rarely  rely 
on appropriate internal  control mechanisms. Where the exemption has been  granted, 
Member  States  must  introduce  appropriate  sanctions  in  order  to  ensure  that  the 
annual  accounts  and  the  annual  report  are  prepared  in  conformity  with  the 
requirements of the Directive. 

6.2  On the basis of Article  51 (2), most Member  States have exempted  small  companies 
from  the  audit  requirement,  although  the  criteria  for  defining  a  small  company  do 
not  necessarily  correspond  with  the  thresholds  included  in  the  Directive.  In  1989, 
the  Commission  proposed  to  require  all  Member  States  to  abolish  the  audit 
requirement  for  small  companies. This proposal  was  strongly  resisted  by  a  number 
of Member  States. It was argued that published accounts which had not been  subject 
to  an  audit  by  a qualified  professional  could  be misleading.  It was  also  argued  that 
the  audit  is  in  the  interest  of  the  company  itself  because  it  provides  the  company 
with the expertise of a qualified  professional. 

6.3  Considerations  of  independence  play  a  lesser  role  in  a  small  company  where  the 
auditor  fulfils  the  role  both  of  an  adviser  and  of  an  external  controller.  It  is  not 
uncommon for the auditor in a small company to keep the books and records and to 
audit the financial  statements. This certainly raises questions as to the  independence 
of this professional  and the usefulness  of such an audit. This is the reason why  some 
Member  States  forbid  the  auditor  to  be  involved  in the  preparation  of the  financial 
statements  of the  company  which  he  audits.  In practical  terms, this  means  that  the 
company  will  have to pay  for  the  services  of two  different  experts, one expert  who 
keeps  the  books  and  records  and  prepares  the  financial  statements  and  another 
expert who carries out the statutory audit. 

According to article 53(2) of the Fourth Directive, the thresholds  in Article  11 are reviewed  every  five 
years  by  the  Council  on  a proposal  of the  Commission.  The  next  revision  of the  thresholds  is due  to 
take  place  in  1999  and  will  take  account  of  the  Commission's  Recommendation  of  3  April  1996 
concerning the definition  of small and medium size enterprises 96/280/EC. 

31 

6.4  Some Member  States have recognised  the different  reality  of a small company  audit 
and have created different  professions,  one profession  which is primarily engaged  in 
advising  and  auditing  small  companies  and  another  profession  which  concentrates 
on  large  companies.  Other  Member  States  have made  a distinction  between  micro-
companies  and  small  companies,  whereby  micro-companies  are exempted  from  the 
audit  requirement,  while  small  companies  are  made  subject  to  a  so-called 
compilation  report,  which  does  not  give the  same  assurance  of  a full  audit  but  still 
gives some reassurance to users that the accounts have been properly kept. 

6.5  Medium-sized  companies  fall  somewhere  in  between  the  two  categories.  The 
general  feeling  seems  to  be  that  these  companies  should  still  be  required  to  have 
their  accounts  audited  by  a  qualified  professional.  In  that  case,  the  same  criteria 
should  apply  as in the  case  of  large  companies  in terms  of  independence  and  audit 
quality. 

6.6  If one considers the question whether a statutory  audit is useful  in the case of  small 
and  medium-sized  companies,  it  is  important  to  keep  in  mind  that  there  is  a 
tendency to use the vehicle of limited liability companies which are not subject to an 
audit  requirement  as  a  means  for  money  laundering.  The  question  whether  a 
company  should  be  subject  to  an  audit  requirement  can  therefore  not  be  seen 
exclusively  in terms  of deregulation.  Arguments  relating  to public policy  also  need 
to be taken into account. 

Priorities for action and possible methods 

6.7  It is for consideration whether any change in the regulatory environment  at EU level 
is desirable  or necessary  concerning  the  statutory  audit  in  small  and  medium  sized 
companies.  At  this  stage,  the  Commission  does  not  consider  that  convincing 
arguments  have  yet  been  advanced  for  changing  the  approach  in  the  Fourth 
Directive  whereby  Member  States  can  exempt  small  companies  from  the  statutory 
audit.  Moreover,  it  seems  unlikely  that  Member  States  which  require  a  statutory 
audit  would  be  prepared  to  do  away  with  it.  Similarly  the  case  has  not  been 
convincingly  made  for  allowing  or  requiring  the  exemption  of  medium-sized 
companies from the audit requirement. 

32 

7.  GROUP AUDIT  ARRANGEMENTS 

The statutory  audit in groups of companies 

7.1  Consolidated  financial  statements  portray  the  financial  position  and  results  of  a 
group  as  if  it  were  a  single  entity.  The  statutory  audit  of  consolidated  financial 
statements  should  be  carried  out  with  no  impediments  and  obstacles  greater  than 
those  encountered  in the  statutory  audit  of the financial statements  of  a single  legal 
entity.  With  the  increasing  complexity  of  international  business  and  the  ease  with 
which  funds  can  be  transferred  from  country  to  country,  it  is  of  increasing 
importance that the statutory  auditor  of a group has a total picture of the  significant 
activities  within  a  group.  This  can  be  difficult  in  the  case  of  groups  having 
operations in more than one jurisdiction. 

7.2  In practice, difficulties  arise because there are no specific  rules which offer  guidance 
in the case of  group  audits. It is  sometimes  difficult  for  the  group  auditor  to  obtain 
information  from  the management and the auditors of the group companies which he 
does  not  audit.  He  may  receive  audited  financial  statements  for  the  individual 
subsidiary  undertakings,  but  he  is  not  in  a  position  to  question  the  underlying 
rationale  for  the  accounting  treatment  of  transactions  reflected  in  the  financial 
statements.  The  group  auditor  may  not  have  a  total  picture  of  the  significant 
activities  within  the  group.  Difficulties  may  also  arise  due  to  the  rules  of 
professional  secrecy. 

7.3  Possible  solutions to these problems have been advanced  : joint  audit  appointments, 
the  development  of  a  comprehensive  and  integrated  standard  on  group  audits,  the 
granting of full  access to all information  necessary for the group auditor to carry out 
his tasks and the appointment of a single statutory auditor to all group companies. 

Priorities for action and possible methods 

7.4  The  conduct  of  a  statutory  audit  of  consolidated  financial  statements  could  be 
further  examined  to  see  to  what  extent  the  issues  can  be  dealt  with  without 
legislative  action.  The  mechanism  which  might  be  set  up  at  EU  level  in  order  to 
examine  the  question  of  auditing  standards  (see  paragraph  4.35  above)  might 
usefully  look  at this  subject.  In the  absence  of clear  guidance  at  international  level, 
an  attempt  might  be  made  to  develop  at  EU  level  a  set  of  principles  which  could 
guide the group auditor in this matter. 

33 

8.  THE  FREEDOM  OF  ESTABLISHMENT  AND  THE  FREEDOM  TO 

PROVIDE SERVICES 

8.1  The  Commission  studies previously  mentioned,  have  shown that there  is  at present 
no  European  market  for  audit  services.  National  audit  markets  in  the  EU  mainly 
function  as  separate  markets,  notwithstanding  the  fact  that  some  forms  of  intra-
Union trade in audit services exist. Although  the different  laws and regulations  may 
not constitute an absolute barrier to intra-Union trade in audit services, they do make 
establishment  or  services  offered  across  borders  more  costly  and  /  or  less  effective 
and therefore  less likely. 

8.2  To the  extent  that  an  equivalent  level  of  audit  quality  is established  in  all  Member 
States and to the extent that proper arrangements can be found  which ensure that the 
audit  carried  out  in  a  particular  Member  State  by  a  foreign  individual  or  firm  is 
surrounded with guarantees which are at least equivalent to those which surround an 
audit carried out by a local professional  it should be possible to make progress in the 
direction of an internal market for audit services. 

Freedom of establishment and freedom to provide services for  individuals 

8.3  The freedom  of establishment  of an individual  statutory  auditor  in another  Member 
State has been achieved, to a substantial extent, through Directive  89/48/EEC on the 
mutual  recognition  of professional  qualifications.  Auditors  who  wish  to  practice  in 
another  Member  State, must  acquire the  qualification  of this  Member  State  but  are 
exempted  from  following  the  complete  educational  programme.  They  can  obtain 
this  qualification,  provided  they  pass  an  aptitude  test.  A  possible  alternative  to 
establishment  in most  Member  States  is to  delegate  audit  work  in  another  Member 
State to  an  auditor  established  in that  Member  State.  As this  auditor  would  remain 
liable  for the  statutory  audit, this  solution  is not  in fact  often  practised.  The  Mutual 
Recognition Directive has only had a limited impact in the case of statutory  auditors 
in that only a small number of auditors have been approved under this regime. 

8.4  Impediments to freedom  of establishment  come from  the regulatory  bodies of  some 
Member  States which stipulate that their auditing  laws and regulations also apply to 
their  auditors  working  in  another  Member  State,  even  though  these  persons  have 
been approved to perform  audit work under the  law of the host  country.  In order  to 
be  able  to  work  simultaneously  in  each  of  the  two  countries,  such  persons  must 
respect, at the same time, the rules of the regulatory bodies of both countries, which 
can  sometimes  be  impossible.  A  possible  solution  would  be  the  adoption  by  the 
profession  and  the  authorities,  of  a  code  of  conduct  proposing  rules  in  cases  of 
conflict between the home Member State and the host Member State. 

34 

8.5  As  far  as  the  freedom  to  provide  cross-border  audit  services  is  concerned,  most 
Member  States require individual professionals  to have a professional  establishment 
on  their  territory.  This  requirement  results  from  the  need  to  maintain  an  active 
monitoring  of  the  professionals  concerned  so  as  to  guarantee  the  quality  of  the 
services they provide. It has been argued that where a professional  auditor  possesses 
the title of the host Member  State and respects the regulations  of that  country  when 
practising  there, the obligation  to have  a professional  establishment  on the  territory 
of  the  country  is  an  unnecessary  burden.  In  this  respect,  the jurisprudence  of  the 
European Court of Justice in the Ramrath case supports the argument that a Member 
State  can  require  a  mere  infrastructure  and  a  certain  effective  presence  of  the 
statutory  auditor. As the study carried out for the Commission  in  1996 points out, in 
those  Member  States  where  there  is no  restriction  on the  delegation  of  audit  work, 
the foreign  auditor can work under the responsibility of a national auditor in the host 
country. 

Freedom of establishment and freedom to provide services for audit  firms 

8.6  Freedom  of  establishment  can  first  of  all  be  exercised  through  the  creation  of  a 
subsidiary  in another  Member  State. The creation of a subsidiary  by  a foreign  audit 
firm or for that matter the creation  of an audit firm by foreign  professionals  is made 
difficult  by  the  fact  that  national  laws  and  regulations  directly  restrict  the 
opportunities  for  foreign  auditors to establish an audit firm. As the study carried  out 
for the Commission  in  1996 points out, almost all Member  States require that  (more 
than) the majority  ownership and/ or (more than) the majority  of management  needs 
to  be  in  the  hands  of  national  statutory  auditors.  In  addition,  in  some  Member 
States, other  legal  forms  than partnerships  and  sole proprietorships  are not  allowed. 
This  limits the possibility  of the  separation  of  ownership  and  management  of  audit 
firms. 

8.7  Compared  to  the  provisions  of  the  Eighth  Directive,  most  Member  States  have 
established  stricter  laws and regulations  on the ownership, management  and  control 
of  audit  firms.  First,  according  to  the  Eighth  Directive,  audits  may  be  carried  out 
both  by  natural  persons  and  firms  of  auditors  which  may  be  legal  persons  or  other 
types  of  company,  firms  or  partnership.  Second,  regarding  ownership  and 
management,  the  Eighth  Directive  only  requires  a  majority  to  be  in  the  hands  of 
statutory  auditors.  In  the  case  of  management,  the  majority  needs  to  be  national 
auditors  or  auditors  who  have  furnished  proof  of  the  legal  knowledge  required  for 
purposes of the statutory  auditing (Article 2(l)(b)(iii)). In the case of ownership, the 
majority  may  consist  of  statutory  auditors  from  other  Member  States  (Article 
2(l)(b)(ii)).  A  number  of  Member  States  require  that  the  capital  of  an  audit  firm 
should  be held  entirely  by natural  or legal persons  (individuals  or firms) having  the 
local  statutory  auditor title. In the  same way, many Member  States have  interpreted 
Article 2 (l)(b)(ii) of the Eighth Directive in such a way that a majority  of the voting 
rights  in an audit firm must  be held by natural persons or firms  of  auditors  who  are 
approved under the law of the host country. 

35 

8.8  Similar  problems  arise  when  an  audit  firm  wants  to  create  a  branch  in  a  host 
Member  State. An additional problem in this context results from  the fact  that  some 
Member  States have limited the number of legal forms which an audit firm can take. 
This  may  have  as  a  consequence  that  a  foreign  audit  firm  which  has  a  legal  form 
which  is  not  allowed  by  the  law  of the  host  country  cannot  create  a branch  in  that 
country. 

8.9  As far  as the freedom  to provide  cross-border  audit  services  is concerned,  the  same 
problems described  above may arise when a foreign  audit firm wishes to carry out a 
statutory audit in a host country where it does not possess an establishment. 

Priorities for action and possible methods 

8.10 Despite the public  interest considerations  involved  in the statutory  audit, there  is no 
convincing  reason  why  the  Treaty  provisions  on  freedom  of  establishment  and 
freedom  to provide services should not fully  apply to the trade in audit services. 

8.11 Freedom  of establishment  (and  to provide  services)  of  individual  statutory  auditors 
is  already  dealt  with  through  Directive  89/48/EEC.  Some  problems  remain.  For 
example,  retaining  the  home  country  title  after  having  obtained  the  host  country 
title,  and possible  differences  in the  scope  of  activity  between  the  Member  State  of 
origin and the host Member  State. These problems could be further  examined  within 
the  co-ordinators  group  set  up  by  Directive  89/48/EEC,  possibly  in  combination 
with the Contact  Committee  on the Accounting  Directives, which  is responsible  for 
the  Eighth  Directive  and 
in  close  co-operation  with  national  professional 
associations of auditors. 

8.12 Freedom of establishment  for professional firms through the creation of a subsidiary 
remains  problematic  because  many  Member  States  have  established  laws  and 
regulations  which  are  more  restrictive  than  those  in  the  Eighth  Directive.  Member 
States should be asked to remove those national requirements exceeding those of the 
Eighth  Directive. In this context, there  is a need to clarify  the meaning  of  Article  2 
of  the  Eighth  Directive  in  order  to  prevent  it  from  being  interpreted  too  narrowly. 
Such  clarification  should take place after  consultation  of the  Contact  Committee  on 
the Accounting  Directives. To the extent that Member  States have  adopted  national 
dispositions  which  contain  a  discrimination  on  the  grounds  of  nationality  or  non-
justified  restrictions  to  the  right  of  establishment,  action  will  be  promptly 
undertaken in order to ensure respect for the provisions of the Treaty. 

8.13  Without  prejudice  to the  direct  application  of the relevant  provisions  of the  Treaty, 
for  the  freedom  of  establishment  for  professional  firms  through  the  creation  of  a 
branch  as  well  as  for  the  freedom  to  provide  cross-border  audit  services  further 
initiatives  may  be  needed.  These  could  take the  form  of  a  specific  Directive  which 
complements  Directive  89/48/EEC,  as  in  discussion  between  the  Commission  and 
the  profession. 

36 

9.  CONCLUSION 

9.1  This  paper  cannot  deal  exhaustively  with  the  many  sometimes  very  complicated 
issues which surround the audit function.  The matters dealt with are those which are 
considered particularly relevant in the context of the Single Market. 

9.2  In suggesting possible priorities for future  action, particular  attention has been given 
to  the principles  of  subsidiarity  and proportionality,  as  enshrined  in the  Maastricht 
Treaty.  In conformity  with the  Communication  on  "Accounting  Harmonisation  : A 
new  strategy  vis-à-vis  international  harmonisation",  preference  is  given  to  an 
approach  which  will  allow  a  more  coherent  European  view  to  be  effectively 
expressed in the international debate. 

9.3  The underlying goal of this initiative is to contribute to a general raising of the level 
of auditing in the EU, which will ultimately benefit  to all parties concerned with the 
life of companies. 

9.4  Please  send  comments  to  European  Commission  -  DG  XV  -  D/3  -  Financial 
Information  and  Accounting  Standards  -  200,  rue  de  la  Loi  -  1049  Brussels  -
Belgium - ( Internet address d3@dgl5.cec.be) - before 20 December  1996. 

9.5  Comments  received  before  18  October  1996  will  be  taken  into  account  in  the 
preparation  of the Conference  to be held  on 5/6  December  1996 in Brussels  on this 
subject. 

37 

Bibliography 

Beijing,  W., Maijoor,  St., Meuwissen,  R. and Van  Witteloostuijn,  A., The  role,  position 
and  liability  of the  statutory  auditor within  the  European  Union,  final  report  of  the 
study, MARC, March  1996, Maastricht. 

Fédération des Experts Comptables  Européens, The Role, Position  and  Liability  of the 
Statutory  Auditor  in  the  European  Union  /  Rôle,  Statut  et  Responsabilité  du 
Contrôleur  Légal  des  Comptes  dans  LïUnion  Européenne,  Fédération  des  Experts 
Comptables Européens, January-Janvier  1996, Bruxelles. 

Fédération  des Experts Comptables Européens, The Role, Position  and Liability  of the 
Statutory  Auditor 
/  Rôle,  Statut  et 
in  the  European  Union.  Appendices 
Responsabilité  du  Contrôleur  Légal  des  Comptes  dans  L'Union  Européenne. 
Annexes,  Fédération  des  Experts  Comptables  Européens,  January-Janvier  1996, 
Bruxelles. 

European  Confederation  of  Institutes  of  Internal  Auditing,  Position  Paper  on  Internal 
Auditing in Europe, April  1996. 

Common  Law  Team  of  the  Law  Commission,  Feasibility  Investigation  of  Joint  and 
Several Liability (published for consultation),  1996, London: HMSO . 

CNPF  AFEP,  Le  Conseil  d'Administration  des  Sociétés  Cotées  (Rapport  Vienot), 
Juillet  1995, Paris. 

Centre  for  European  Policy  Studies,  Corporate  Governance  in  Europe,  Report  of  a 
CEPS Working Party, June  1995, Brussels. 

International  Federation  of  Accountants, 
Pronouncements, International Federation of Accountants,  1995, New York. 

IFAC  Handbook  1995.  Technical 

Ebke,  W.  F.  and  Struckmeier,  D.,  The  Civil  Liability  of  Corporate  Auditors  :  an 
International  Perspective,  A  discussion  paper, 
International  Bar  Association, 
November  1994, London. 

The 
Institute  of  Chartered  Accountants  of  Scotland,  Auditor's  Liability, 
Recommendations  of  a  Working  Party  established  by  The  Institute  of  Chartered 
Accountants of Scotland, November  1994, Edinburgh. 

Mclnnes,  W.M..(ed.),  Auditing  Into  the  Twenty-first  Century,  A  Discussion 
Document  by  the  Research  Committee  of  The  Institute  of  Chartered  Accountants  of 
Scotland, The Institute of Chartered Accountants of Scotland,  1993, Edinburgh. 

38 

Report  of the  Committee  on The Financial  Aspects  of Corporate  Governance  a Code 
of Best Practice (Cadbury report), Burgess Science Press, December  1992, London. 

Derek  Ridyard,  Jean  de  Bolle,  Competition  in  European  Accounting,  National 
Economic Research Associates (NERA), Lafferty  Publications  1992. 

The  Financial  Reporting  Commission,  Report  of  the  Commission  of  Inquiry  into  the 
Expectations  of  Users  of  Published  Financial  Statements,  The  Institute  of  Chartered 
Accountants in Ireland, January  1992, Dublin. 

Archer,  S.,  McLeay,  St. and  Dufour,  J.B., Audit  Reports  on the Financial  Statements 
of  European  Multinational  Companies:  a  Comparative  Study,  The  Institute  of 
Chartered Accountants in England and Wales, June  1989, London. 

39 

FINANCIAL  STATEMENT 

1 TITLE OF OPERATION 

Green Paper on the Role, the Position and the Liability of the Statutory Auditor 
in the European Union. 

2 BUDGET HEADING  INVOLVED 

B5- 3000 : Actions relatives au fonctionnement du Marché Intérieur 

3 LEGAL BASIS 

4 DESCRIPTION  OF  OPERATION 

4.1 

General objective 

The general  objective of the Green Paper and the proposed  conference 
on the Role,  the Position,  the Liability  of  the  Statutory  Auditor  in the 
EU is to contribute to a wide-ranging  debate with all  interested parties 
on the  issues  surrounding the role,  the position and the liability  of the 
statutory  auditor,  which  is  sought  by  the  Member  States  and  bodies 
representing the profession. 

4.2 

Period covered and arrangements for renewal 

The Green Paper is scheduled for adoption in July.  The Conference  is 
planned for 5 and 6 December  1996.  The preparation work has already 
started and the follow-up  to the Conference  will  continue  into the first 
quarter of 1997. 

5CLASSIFICATION OF EXPENDITURE OR REVENUE 

5.1 

Non-compulsory expenditure 

5.2 

Non-differentiated  appropriations 

5.3 

Type of revenue involved 

Uo 

6TYPE OF EXPENDITURE OR REVENUE 

The expenditures  involved  concern the costs relating  to the organisation  of  the 
Conference  namely  small  utilities  for  the  conference,  printing  costs  for  the 
programme  of  the  conference  and  the  report  that  will  be  issued  after  the 
Conference. 

100% subsidy 

NO 

Subsidy  for  joint  financing  with  other  sources  in  the 
public and/or private sector 

NO 

Interest subsidy 

NO 

Other 

NO 

Should  the  operation  prove  an  economic  success,  is 
there  provision  for  all  or  part  of  the  Community 
contribution to be reimbursed? 

NO 

Will  the  proposed  operation  cause  any  change  in  the 
level  of  revenue?  If  so,  what  sort  of  change  and  what 
type of revenue is involved? 

NO 

7FINANCIAL IMPACT 

7.1 

Method  of  calculating  total  cost  of  operation  (relation  between 
individual and total costs) 

hi 

7.2 

Itemised breakdown of cost 

Breakdown 

yearn 

n  +  1 

n  +  2  n  +  3  n  +  4  n  +  5 

Total 

Commitment appropriations 
ECU million 
(at current prices) 

1 

0,024 

Total 

0,024 

and 
subs, 
yrs 

0,024 

0,024 

7.3  Schedule of commitment and payment appropriations 

yearn 

n  +  1 

n  +  2 

n  +  3 

n  +  4 

0,024 

0,024 

Commitment 
appropriations 
Payment 
appropriations 

yearn 
n  +  1 
n  +  2 
n  +  3 
n  +  4 
n  +  5 
and subs, yrs 

Total 

0,024 

ECU million 
Total 
n  +  5 
and 
subs, 
yrs 

0,024 

0,024 

0,024 

8  FRAUD PREVENTION MEASURES 

Given the nature of the action, no specific fraud prevention measures are 
necessary. 

hi-

ELEMENTS OF COST-EFFECTIVENESS  ANALYSIS 

9.1  Specific and quantified objectives; target population 

The objective  is in particular  to help the Commission to 
identify  any  areas  or  subjects  where  action  at  EU  level 
may be needed, especially with a view to bringing about 
a  single market for  audit  services  and to continuing  the 
improvement  in the quality  of  financial  reporting  in the 
EU. 

The groups targetted are government  departments  in the 
the  regulation  of 
Member  States  responsible  for 
companies, 
accounting 
representing 
bodies 
profession  and  more  specifically  statutory  auditors, 
organisations  representing  the  preparers  and  users  of 
accounts  and  those  involved  in  standard-setting  in  this 
field. 

the 

^ 

9.2  Grounds for the operation 

The  statutory  audit  and  the  liability  of  the  statutory 
auditor are already the subject  of considerable debate  in 
a number of Member States.  The Commission has been 
pressed to participate. 

In  1995, DG  XV  launched  an  important  study  contract 
relating  to  the  role,  the  position,  the  liability  of  the 
statutory  auditor  in  the  European  Union.  This  study 
provides, for  the first time, an overview of the  different 
ways  in which the profession  of the  statutory  auditor  is 
organised in the Member States. 

As  a  follow-up  to  this  study,  DG  XV  has  prepared  a 
draft  Green Paper on the role,  the position,  the liability 
of  the  statutory  auditor.  This  Green  Paper  raises  a 
number of questions arising from  the conclusions of the 
study. 
It  is  intended  that  the  Green  Paper  will  be 
adopted by the Commission in July 1996. 

The  proposed  Conference  will  mark  the  end  of  the 
consultation  period  on  the  Green  Paper  and  will  bring 
together  an  invited  audience  drawn  from  the  groups 
referred to in the second paragraph of 9.1. above. 

9.3  Monitoring and evaluation of the operation 

An evaluation of the action will be made in  1997, based 
on  a  report  prepared  by  the  Commission  on  the 
Conference. 

hh 

10 

ADMINISTRATIVE  EXPENDITURE  (SECTION m,  P A RT  A  OF  THE  BUDGET) 

10.1  Effect  on  the  number  of  posts 

Type of post 

Staff to be assigned to 
managing the operation 
Temporary 
posts 

posts 

Source 

Duration 

Additional 
resources 

Existing 
resources in 
the DG or 
department 
concerned 

A 
Officials  or 
B 
temporary 
C 
staff 
Other resources 
Total 

1 
1 

2 

1 
1 
1 
3 

1(END) 
1 

March 97 
March 97 
March 97 

10.2  Overall  financial  impact  of  additional  human  resources 

Amounts 

ECU 
Method  of  calculation 

Officials 
Temporary staff 
O t h er  r e s o u r c es  (indicate budget heading) 

Total 

10.3 Increase  in  other  administrative  expenditure  as  a  result  of  the 

operation 

Budget heading 

Amounts 

ECU 
Method of calculation 

Total  "~ 

^ 

ISSN 0254-1475 

COM(96) 338 final 

DOCUMENTS 

EN 

06 

Catalogue number  :  CB-CO-96-414-EN-C 

ISBN 92-78-07854-9 

Office  for Official  Publications of the European  Communities 

L-2985 Luxembourg