New regulations should ensure auditor independence and better financial reporting

It is usually emphasized that independent external auditing or auditing of financial statements aims to provide reasonable assurance that the financial statements present a ‘true and fair’ or ‘realistic and objective’ view of the financial position, performance, and cash flows of the company.

In this sense, the public, primarily investors, has great trust, but also high expectations of auditors. However, auditing has its limitations, which are commonly highlighted as inherent risks of auditing. First and foremost, auditing can provide only reasonable, but not absolute assurance that the financial statements are realistic and objective. In this sense, auditors cannot be expected to detect all errors in the financial statements. Auditing is based on samples, not on examining the entire population. In other words, it is the auditor’s task to investigate whether the financial statements contain significant material misstatements.

The Big Four’s Dictate The issue of the organization and operation of auditors and the entire auditing profession has come under public scrutiny, especially after the outbreak of the economic crisis. To prevent such disruptions in the future, regulations have changed. After analyzing the auditing market in the European Union, many weaknesses in the organization and operation of the auditing profession were identified. Among other things, the identified weaknesses of the auditing market relate to the high market concentration dominated by the Big Four and the lack of choice of auditors.
It has been shown that due to the strong connection between auditors and clients, which is based, among other things, on the provision of non-audit services and due to long-term audit engagements, there are serious threats to auditor independence. Furthermore, such situations create conflicts of interest and reduce the auditor’s ability to exercise professional skepticism, which significantly diminishes the quality of audits performed. As a result, changes to regulations at the European Union level were initiated, based on general and specific measures. General measures should be applied by all auditors conducting statutory audits, and they are provided in the form of the European Union Directive on statutory audits of annual and consolidated financial statements (2014/56/EU). A novelty is the introduction of the Regulation on specific requirements regarding the statutory audit of public interest entities (No. 537/2014). This regulation separately addresses the issue of specific audit requirements for public interest entities for the first time.

Against Pressures One of the most important provisions of the Directive is the introduction of additional requirements to ensure independence. Namely, an auditor should not conduct a statutory audit if there is a threat of self-review, self-interest, advocacy, familiarity, or intimidation arising from financial, personal, and business relationships between the auditor and the entity being audited. In addition, auditors should not accept a management position, become members of the management or supervisory body, or members of the audit committee in the entity they audited for at least one year, or in the case of audits of public interest entities, for at least two years after they have ceased to perform the duties of a certified auditor or the main audit partner. These provisions aim to strengthen auditor independence.
The auditor’s report is considered the main source of information for investors. However, its content is relatively standardized. Therefore, efforts have been made to enhance the informational usefulness of auditor reports by requiring the inclusion of additional elements regarding the audit of financial statements, in addition to the basic elements.

Audit of Audits There is also a move to strengthen the competencies and responsibilities of bodies responsible for public oversight of the auditing profession. Namely, after corporate scandals in which auditing firms were directly and indirectly involved, regulators concluded that self-regulation of the auditing profession is insufficient and that it is necessary to introduce an ‘audit of audits’. Thus, public oversight of the auditing profession has been introduced. Now, the competent bodies for public oversight of the auditing profession can impose warnings for violations of requirements and monetary fines, as well as introduce a temporary ban on conducting statutory audits and/or signing audit reports for up to three years for the certified auditor, audit firm, or main audit partner.

Application of Sanctions The new regulations also establish criteria (factors) that competent public oversight bodies must consider when imposing and applying sanctions. To ensure effective application of sanctions, competent bodies must take into account factors that include, among other things, the financial strength of the responsible person (for example, total turnover, annual income, net profit), the seriousness and duration of the violation, as well as the degree of cooperation of the responsible person with the competent body. In addition to the established minimum standards for determining appropriate sanctions against responsible persons, public disclosure of administrative sanctions is encouraged after all rights to appeal have expired or been exhausted. Public disclosure of sanctions imposed against responsible persons should improve the application of regulations and contribute to the transparency of the system.

Deadline: Two Years The financial crisis has revealed weaknesses in conducting statutory audits, especially in public interest entities, which, due to their significance, size, and number of employees, have a wide range of interested stakeholder groups. The identified weaknesses in conducting statutory audits were the motivation for changing regulations and introducing specific regulations for audits of public interest entities. The new regulations on statutory audits should encourage the mobility of audit firms across the borders of the European Union and strengthen the auditing market.
Given that these are significant changes to auditing regulations, member states have been given a deadline of two years to align and adopt the new regulatory rules of the Directive and Regulation. Considering the date of adoption of the Directive and Regulation, all member states are obliged to apply these rules from June 17, 2016. In the Republic of Croatia, the process of aligning the Audit Act with the provisions of the Directive and Regulation is underway. This is a challenging and demanding area of operation, and therefore numerous discussions on this topic are expected until the adoption and enactment of the new Audit Act.