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Cablegate: Commission Proposes Directive On Auditor Regulation

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A
SUBJECT: Commission proposes directive on auditor regulation
and oversight


This cable is sensitive but unclassified. Not/not for
Internet distribution.

1. (SBU) Summary: The European Commission has proposed a
directive to clarify the duties of statutory auditors in the
European Union and to set out clear principles to ensure
their objectivity and independence. The proposal mirrors
much of the Sarbanes-Oxley Act, and reflects close
consultation with the U.S. Public Company Accounting
Oversight Board. If adopted as currently drafted, auditors
from third countries will have to be approved and registered
in the EU if they audit companies listed in the EU.
However, on the condition of reciprocity and equivalence,
the proposed directive allows for exemptions for non-EU
auditors from registration, quality assurance,
investigations and sanctions. Moreover, under certain
conditions it would permit the transfer of audit documents
to third country authorities. The latter provision is
regarded with skepticism by some member states, including
Germany, as well as by many auditors. End summary

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Combating fraud and malpractice

2. (SBU) On March 16, the European Commission presented its
long-delayed proposal for a directive "on statutory audit of
annual accounts and consolidated accounts". The proposed
directive aims to clarify the duties of statutory auditors
and to set out clear principles to ensure their objectivity
and independence. It would introduce a requirement for
external quality assurance, new rules for robust public
oversight for auditors, and promote cooperation between EU
regulatory authorities. The proposal also calls for the
creation of an audit regulatory committee by member state
representatives to assist the Commission in the
implementation of the directive. Moreover, the Commission
proposes the use of International Standards on Auditing
(ISA) and establishes a basis for co-operation with third
countries. The proposal must be adopted by the Council of
Ministers and the European Parliament under the co-decision
procedure before it can be implemented by member state

3. (SBU) The initiative is the second in a pair of
initiatives announced in 2003 intended to improve corporate
governance in European Union countries. The Commission
stressed that while the recent corporate scandals in the
U.S. and the EU have emphasized the need for ensuring the
credibility and reliability of companies' financial
statements, its proposal for a directive is not "a knee-jerk
response" to these scandals, but rather reflects a long-
standing reorientation of EU policy on statutory audit
dating from 1996. Nevertheless, the actual Commission
proposal mirrors much of the Sarbanes-Oxley Act.

Ensuring independence and quality of auditing

4. (SBU) The proposal prescribes that each member state
designate competent authorities for the approval of auditors
and mandates that statutory audits be carried out only by
auditors or audit firms approved by the member state where
the audit is carried out. Those auditors would be put in a
public register.

5. (SBU) The text would require Member States to ensure that
auditors are subject to principles of professional ethics,
which at least cover the overall responsibility of the
auditors towards the public, their integrity and
objectivity, and their professional competence and due care.
National authorities would also have to make sure that
auditors are independent from the audited entity and are not
in any way involved in the latter's management decisions.
Auditors would be prohibited from carrying out a statutory
audit of a firm if they had any financial, business,
employment or other relationship, including the provision of
additional services, with the firm that might compromise the
auditors' independence. The Commission proposal would also
require member states to ensure that auditors be dismissed
only where there are proper grounds - divergence of opinions
on accounting treatments or audit procedures are not
considered proper grounds. Both the audited entity and the
auditor would have to inform the competent authorities about
the dismissal and the reasons for it.

6. (SBU) The Commission proposes that all statutory audits
prescribed by Community law be carried out in accordance
with International Standards on Auditing (ISA), as endorsed
by the Commission. Moreover, it also requires that member
states ensure a system of quality assurance for auditors
which meets a list of specified requirements. Among other
things, the quality assurance system must be organized in a
manner that is independent from the reviewed auditors. The
Commission proposal would also require member states to put
in place effective systems of investigations and sanctions
to detect, correct and prevent inadequate execution of
statutory audits. Where an auditor does not meet the
requirements of the directive, national authorities would
impose effective and proportionate civil, administrative or
criminal penalties.

7. (SBU) Reflecting the subsidiarity principle, the draft
leaves it to Member states rather than the Commission to
organize public oversight systems to which all auditors in
their respective jurisdictions would be subject. These
national systems would have to be governed by boards
comprising a majority of non-practitioners in auditing who
are, nevertheless, knowledgeable in the area.

Specific rules for "public interest entities"

8. (SBU) The draft directive also includes special
provisions for so-called public interest entities: companies
whose securities are traded on a regulated market as well as
banks and insurance companies. Such enterprises would be
required to publish annual financial reports and to
establish an audit committee composed of non-executive
members of its administrative body or members of the
supervisory board, including at least one independent member
with competence in accounting or auditing. The text calls
for this audit committee, inter alia, to monitor the
financial reporting process, the effectiveness of the
company's internal controls as well as the auditor's
independence, and to oversee the statutory audit of the
firm's annual and consolidated accounts. The appointment of
an auditor by the administrative body or supervisory board
must be based on a nomination by the audit committee. For
public interest entities, the proposal delegates oversight
of auditors exclusively to non-practitioners. More
controversially, it would require public interest entities
to rotate the statutory auditor or key audit partner within
a maximum of five years, and the audit firm within a maximum
of seven years. As many firms will end up being classified
as public interest entities this requirement will have far-
reaching implications for the audit industry.

--------------------------------------------- ----------
Regulatory and oversight arrangements between EU member
--------------------------------------------- ----------

9. (SBU) The Commission would require the national
authorities to establish procedures for the approval of
statutory auditors approved in other member states, thus
applying the principle of mutual recognition. The proposal
lays out how mutual recognition of regulatory arrangements
between member states would function: regulatory
arrangements of the member states would have to respect the
principle of home country regulation and oversight by the
member state where the auditor is approved and registered.
For example, regarding statutory audit of consolidated
accounts, the national authority requiring the audit of the
consolidated accounts could not impose additional
requirements concerning registration, quality assurance,
auditing standards, ethics or independence on an auditor
carrying out an audit of a subsidiary established in another
member state. In the case of a company whose securities are
traded in a member state different from where it has its
registered office, the national authority where the
securities are traded could not impose any additional
requirements in relation to the statutory audit.

10. (SBU) Moreover, the proposal requires the responsible
national authorities to cooperate with each other whenever
necessary for the purpose of carrying out their duties of
oversight of the auditors approved by them. This includes
assistance to the competent authorities of other member
states, in particular the exchange of information and
cooperation in investigation activities.

Third countries

11. (SBU) The Commission proposal would permit, "on the
condition of reciprocity," the competent authorities of an
EU country to approve auditors from a third country,
provided they can furnish proof of being approved as an
auditor, theoretical knowledge, practical skills, and
integrity "equivalent" to the provisions of the proposed
directive, as well as legal knowledge relevant in the member
state in question.

12. (SBU) Auditors and auditing firms from third countries
that issue audit reports of firms with securities traded in
the EU would have to be registered in an EU member state and
be subject to that member state's systems of oversight,
quality assurance, investigations and sanctions. Only
auditors meeting the "equivalent" quality criteria could be
registered. In order to prevent unnecessary international
regulatory overlap, the proposed directive allows for
exemptions from registration on the basis of reciprocity, if
audit firms from third countries are subject to equivalent
systems of registration and oversight. This equivalence
would be assessed by the Commission rather than, but in
cooperation with, member state authorities, and be decided
upon by the Commission as well.

13. (SBU) The Commission proposal notes that the complexity
of international group audits requires good cooperation
between the competent authorities of the member states and
those of third countries. Therefore, it proposes that
member state authorities may, under certain conditions,
allow the transfer to the competent authorities of a third
country of audit working papers or other documents held by
statutory auditors subject to their jurisdiction. The text
lays out preconditions including that "there are working
arrangements on the basis of reciprocity agreed between the
competent authorities concerned." Moreover, justification
would have to be provided by the third-country authority of
the purpose of the request for audit working papers and
other documents, which could only be used for the exercise
of the third countries' authorities' functions of public
oversight, quality assurance and investigations. The
authorities receiving the information would also need to
respect professional secrecy requirements.


14. (SBU) According to press reports, the German federal
government is, in principle, in favor of the Commission
proposal and supportive of closer cooperation with third
countries, in particular with the U.S. However, it is
skeptical of the proposal on transferring audit documents
outside EU territory. Many observers in Germany regard the
latter provisions as the Europeans going down on their knees
before the Americans. Reportedly, these provisions were
also controversial when discussed inside the Commission and
a number of member states are opposed to them. Experts
believe that it will take several years before the
conditions for the transfer of information to third
countries, such as approving reciprocity agreements, are
met. This may be due, not only to the length of time that
will be required for the EU to consider and implement the
legislation, but also to the fact that the Sarbanes-Oxley
Act does not contain any rules on cooperation with other

15. (SBU) The German auditors association (IDW), while in
principle welcoming the Commission's proposal, is vehemently
opposed to external rotation. It also criticized the
proposal for the provision of non-auditors exclusively to
the public oversight bodies for the public interest
entities, arguing that this even goes beyond the provisions
of the Sarbanes-Oxley Act. Moreover, the IDW is very
critical of the potential transfer of documents to third
countries, evoking professional secrecy and data protection

16. (SBU) The Federation of European Accountants (FEE)
welcomed the Commission's initiative to modernize
legislation on auditing, but also voiced concerns over the
provisions that foresee the transfer of information to third
countries and the mandatory rotation of auditors.
Furthermore, the FEE criticized the Commission for proposing
to exclude the audit profession from national oversight
systems for listed companies.

17. (SBU) According to the Financial Times, the big four
firms (Deloitte, Ernst & Young, KPMG and PwC) are strongly
opposed to rotation of audit firms, partly as it could
threaten their dominance of auditing multi-national
companies, thus providing new business opportunities for
their medium-sized competitors.

18. (SBU) Internal Market Commissioner Bolkestein briefed
member state finance ministers about the proposal at the
April 2-3 Informal Ecofin. However, with a new Parliament
and Commission not expected to be up and running until the
fall, this matter will fall to the incoming Dutch, UK and
Luxembourg presidencies to navigate through the EU
legislative process before action passes to member states.

19. (U) This cable has been coordinated with USEU.

20. (U) POC: C. Ohly, Economic Specialist, e-mail
ohlyc@state.gov; tel. 49-(69)-7535-2367, fax 49-(69)-7535-


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