European Commission Green Paper on Audit Policy: Lessons from the Crisis. Opinion of the Chamber of Auditors of the Czech Republic

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1 (1) Do you have general remarks on the approach and purposes of this Green Paper? We have no general remarks on the approach of this Green Paper and on its purpose, and we fully support the discussion on the issues presented. However, should it happen that the audit development processes are wrongly understood, certain parts of this important document might lead to the reverse of what is required. We therefore recommend thorough evaluation of all the suggestions put forward by us for each issue. We welcome the opportunity to contribute our views to the debate. (2) Do you believe that there is a need to better set out the societal role of the audit with regard to the veracity of financial statements? We appreciate that the Green Paper emphasises the importance of the audit of financial statements for the stability of financial markets and financial systems. In this context, we believe, that more could be done by both the entity, those charged with governance and the auditor to better set out the societal role of the audit. However, in further determining and/or enhancing the societal role of the audit, it is necessary to ensure that the primary role of the auditor as provider of services to company owners is not weakened or compromised. At the same time, it must be clearly declared that however important an audit is, it is far from being the only element underlying the veracity of financial statements and the stability of financial markets. Any activity of business entities requires the ability to assess risks and willingness to accept risks. An auditor cannot be expected to fully eliminate or take on such (business) risks. We also believe that it is advisable to avoid using the term audit to refer to services (provided by both auditors and non-auditors) other than the audit of financial information and which provide lower level of assurance than an audit. (3) Do you believe that the general level of "audit quality" could be further enhanced? Although it is generally impossible to define what audit quality is, we believe that it is always possible to improve the quality of audit and we believe that it is in fact being improved (e.g., with the current development of ISAs and the IESBA Code of Ethics). It is a continuous process. Auditors are clearly motivated for it and support it. On the other hand, it must be born in mind that audit is a subjective service, relying on people s reason and judgment. There is no system (however sophisticated it may be) that eliminates any possibility of human failure. It is not advisable to push the system beyond a certain limit where it would be too complicated, time consuming and too costly. The costs of specific solutions must always be weighed against the reasonably expectable benefits. (4) Do you believe that audits should provide comfort on the financial health of companies? Are audits fit for such a purpose? An auditor judges the quality of the financial information provided by the accounting entity, he/she cannot judge the quality of the accounting entity s financial results. Nevertheless, an auditor shall always assess whether the accounting entity used adequate accounting methods with respect to the assumption that it is able to continue as a going concern.

2 In our opinion, an auditor could only give direct assurance of a good financial health of a company if he/she assesses the information about the company s future prospects. We are afraid that such a shift in approach would confuse the understanding of the auditor s role and the auditor would thus also substitute for the typical activities of rating agencies. We also think that it would lead to the conflicts of interest and to the independence and objectivity threats. However, we are sure that high quality financial statements provide to its user basic information about the financial health of the audited company assuming that conditions existing at the balance sheet date are ongoing. Nevertheless, we believe that if adequate standards and criteria are in place, the appropriate role of an auditor may be to assess the credibility of certain specific information about the company s prospects as presented by the accounting entity. (5) To bridge the expectation gap and in order to clarify the role of audits, should the audit methodology employed be better explained to users? This is a very important point and we support it by cooperating with regulators and oversight bodies and through publicity and educational efforts. Certain stakeholders, especially investors, may be unaware of the limitations of an audit connected with the provision of reasonable, not absolute assurance. It is advisable to assess whether an auditor s report as a primary means of communication between the auditor and the users of his/her services can be used to ensure that the nature and role of audit is explained more transparently. We do not believe that going back to basics with a focus on substantive verification aiming at provision of higher level of assurance as suggested in the Green Paper is appropriate. In complex business an increase in substantive audit procedures at the expense of the test of controls and risks would lead to a decrease in an audit quality and, at the same time, to an increase in costs. We believe that the objectives of an audit can only be achieved through a meaningful combination of assessment of internal controls and substantive procedures. It is essential, at the same time, that adequate tools must be available to ensure that members of company bodies (audit committees, supervisory boards or statutory bodies) possess adequate knowledge about audit. Obligations related to education, specific criteria or even certain forms of certification underlying membership in such bodies deserve detailed examination and evaluation. (6) Should "professional scepticism" be reinforced? How could this be achieved? Professional scepticism is one of the basic prerequisites for auditors work and, in our opinion, auditors apply it to a sufficient extent particularly within the context of the existing and clarified ISAs. We believe that the professional scepticism concept should also be applied by management and by those charged with the governance of the accounting entity, as well as by the users of the financial statements. (7) Should the negative perception attached to qualifications in audit reports be reconsidered? If so, how? In our opinion, qualifications in audit reports need to be perceived negatively, because it refers to deficiencies in the accounting entities audited. Concerns about adverse perception of qualifications contribute to prevention of poor-quality financial reporting. Absence of the negative perception of qualifications would detract from the importance of audit.

3 (8) What additional information should be provided to external stakeholders and how? A framework should be defined (on the basis of wide consensus) for the reporting of such information and for determining the method of how an independent expert presents his/her opinion on such information. If the presumption of benefits exceeding costs of such requirements is valid, we are prepared to invest adequate resources to ensure that we are able to express our opinion on such information on an appropriate and timely basis. (9) Is there adequate and regular dialogue between the external auditors, internal auditors and the Audit Committee? If not, how can this communication be improved? There always is scope for improvement of communication, because it leads to a reduction of risks and to audit quality improvement. We believe that the importance of corporate governance should generally be increased and that the cooperation between the audit committee and the internal and external auditor co-operation in this area should be intensified. At the same time, there should be an adequate framework for the activities of the audit committee, i.e., a closer description of the tasks and of the methods of how the audit committees should fulfil them. (10) Do you think auditors should play a role in ensuring the reliability of the information companies are reporting in the field of CSR? Yes, auditors are able and ready to provide assurance services in respect of the information reported in the field of CSR. However, an adequate framework and clear criteria must be determined for such assurance. In addition, it may be necessary in certain cases that audit firms posses specialised professional knowledge in the field of CSR; nevertheless, this principle (accepting an engagement only if having sufficient professional knowledge) is sufficiently reflected in the IESBA Code of Ethics. (11) Should there be more regular communication by the auditor to stakeholders? Also, should the time gap between the year end and the date of the audit opinion be reduced? The frequency of submission of audit reports and similar information is not within auditors discretion. It is determined by the requirements of national legislation and the ISAs. ISAs contain the requirements for the timing of the communication between the auditor and those charged with the governance of accounting entities. Communication between the auditor and other entities depends on the financial information being audited. We think that for the public interest entities half-yearly submissions are an optimum frequency for interim audit reports. (12) What other measures could be envisaged to enhance the value of audits? The key measures we consider suitable are indicated in responses to questions (13) What are your views on the introduction of ISAs in the EU? Introduction of ISAs in the EU is essential for EU s competitiveness in the global economy and our perception of their introduction is clearly positive. Failure to introduce ISAs in the EU would lead to problems with the credibility of financial statements on capital markets outside the EU; in addition, it would result in two audit levels: European and ISA-based.

4 (14) Should ISAs be made legally binding throughout the EU? If so, should a similar endorsement approach be chosen to the one existing for the endorsement of International Financial Reporting Standards (IFRS)? Alternatively, and given the current widespread use of ISAs in the EU, should the use of ISAs be further encouraged through non-binding legal instruments (Recommendation, Code of Conduct)? Yes, we believe that ISAs should be made legally binding in the EU. Taking into account the legal system practices prevailing in the majority of EU Member States, it is advisable to incorporate ISAs into EU law through the endorsement process without undue delay. Also, it is appropriate that no exceptions (e.g. add ins and curve outs ) to ISAs are adopted by the EU. We also emphasise the importance of the quality of translations into the official languages of EU Member States. We believe that the member states should be involved in the translation process through the involvement of local experts. (15) Should ISAs be further adapted to meet the needs of SMEs and SMPs? In the application of ISAs, the key factor is the size of the accounting entity rather than the size of the audit firm. The clarified ISAs contain (in their application material) considerations specific to the audit of small and medium-sized enterprises and we believe that these aspects should be further refined. (16) Is there a conflict in the auditor being appointed and remunerated by the audited entity? What alternative arrangements would you recommend in this context? Auditors regard their independence as essential. We are of opinion that significant safeguards have already been put in place in response to the possible threat to the auditor s independence in relation to the appointment and remuneration. In the Czech Republic, the auditor is appointed by the accounting entity s supreme body. The statutory body is then authorised to sign an audit agreement only with the auditor appointed as described above. This has significantly strengthened auditors independence on the accounting entity whose financial statements are audited because it removed the opportunities for the members of accounting entity management and statutory bodies to freely influence the appointment of the auditor as well as the performance of the audit work. It should be noted in this context that members of statutory bodies are also appointed and removed by the accounting entity s supreme body. As a result, conflict of interest is significantly mitigated. The fact that the fee for the audit services is paid by the accounting entity whose financial statements are audited is not crucial in this context. With respect to the above, and on the basis of our generalised experience, we would like to recommend to strengthen significantly the independence of the members on the audit committee of the accounting entity s statutory body. Detailed definition of the rights and obligations of the audit committee would be a welcome and relevant measure that could lead to further reduction of potential conflicts of interests. It is also necessary to focus on supervisory boards, whose role is based, for the most part, on commercial law at present. The audit committee / supervisory board relationship remains to be defined in detail this situation may be a source of ambiguities or even discrepancies.

5 (17) Would the appointment by a third party be justified in certain cases? We express strong concern about the involvement of third parties in the process of appointment and remuneration of auditors, since it may create corruption environment. We are also concerned that a company s owner to whom the auditor s report is addressed might feel free not to respect the third party s choice of an auditor and would engage another auditor to perform the audit. This might result in various complications, which may lead to inadequate disputes, causing the parties to spend a lot of time and money. This might even negatively affect the reputation of audit, including its perception as a service provided in public interest. Thus the societal role of audit could paradoxically decline rather than get better. Such situations cannot occur where the auditor is selected by the company s owner as indicated in the response to the preceding question. We have very negative experience with the control performed without influence of main stakeholders based on own knowledge of planned economies where control of entities was performed by the central authority. (18) Should the continuous engagement of audit firms be limited in time? If so, what should be the maximum length of an audit firm engagement? First of all it must be noted that some experience has already been gained with the external rotation of auditors. Generalised experience has shown that mandatory rotation complicates the performance of audits. Available academic research highlights the risk of decrease in the audit quality in the first two years of the audit engagement. This is so because, first, each new auditor must gain knowledge of the activities and functioning of the company being audited and the risks related thereto and, second, such a measure would paradoxically encourage the development of informal networks among auditors, which might significantly negatively affect the quality of audit and detract from the initial intention of the measure. In addition, mandatory external rotation might lead to higher audit prices, including possible non-public pricing agreements. Audit is a service provided in public interest. We are therefore of the opinion that the appointment of an auditor by the supreme body of the accounting entity should be based on a transparent tender regardless of any pricing or other limits. We emphasise in this context that price should not be among the decisive criteria, because such a situation might lead to unfair competition and exert pressure to reduce audit quality connected with the negligence of some process steps, which may range from risk assessment to adequate mapping of the audit process in the audit file. We therefore believe that it would be appropriate to define objective criteria based on respect to the quality of audit activities, i.e., on the auditor s ability to perform the audit in compliance with the applicable laws and regulations (for more information refer to question 29) (19) Should there be a ban preventing audit firms from providing non-audit services? Should such a ban apply to all firms and their clients, or only to certain types of institutions, e.g. systemic financial institutions? Already today, there are number of activities whose performance is prohibited to auditors, and activities that must not be provided to the accounting entity in which the auditor performs the statutory audit. We believe, therefore, that it is not advisable further to tighten the ban on the provision of non-audit services.

6 We believe that a decision to prohibit even the currently permitted non-audit services could further increase the concentration on the audit services market with all the adverse effects referred to in the introduction to the Green Paper. Such consequences are certainly undesirable. In addition, we believe that for a number of additional services the auditor is able to provide the best value for money, with regard to his knowledge of the client. (20) Should the maximum level of fee an audit firm can receive from one client be regulated? We agree that an excessive dependence on the fees from one client represents independence threat. Auditors shall comply with the IESBA Code of Ethics that significantly reduces this threat. It is set out in the Code that When the total fees from an audit client represent a large proportion of the total fees of the firm expressing the audit opinion, the dependence on that client and concern about losing the client creates a self-interest or intimidation threat. The significance of the threat shall be evaluated and safeguards applied when necessary to eliminate the threat or reduce it to an acceptable level. All these circumstances must be precisely documented in the audit file. This can be verified during any inspection by the public oversight bodies. An excessive reduction in the limit of the fee could lead to a pressure on the decrease in the quality of audit and unfair competitive practices could be encouraged. It is questionable, then, to what extent such a limitation could be positively reflected in the structure of auditors and their social esteem. We are afraid that such a measure may result in the reverse of what was intended. In addition, it could represent a barrier to the entry into the profession. (21) Should new rules be introduced to govern the transparency of audit firms financial statements? In the Czech Republic, like in a number of other EU Member States, the financial statements of audit firms are prepared and disclosed in accordance with the same rules as those of other companies. The financial statements of an audit company are audited when the criteria specified in the Act on Accounting (which are set much lower than in Directive 78/660/EEC) are met. According to the records of the Chamber of Auditors, there has been no interest todate among external stakeholders to see additional financial data related to auditors and audit firms. We therefore believe that the current rules are sufficient. It should also be noted that additional requirements would increase the administrative burdens. The transparency of the activities of audit firms is supported by the requirement to publish a transparency report by the auditors and audit firms of public interest entities. This requirement is new in our environment: it was enacted in 2009 and we think it is too early to assess how effective it is. (22) What other measures could be taken in the area of governance and management of audit firms to strengthen auditors independence? In the mandatory transparency reports, audit firms must provide sufficient information about their governance and management. As already mentioned, the requirement to prepare transparency reports is new to our environment and it is too early now to assess how effective it is. We believe it is important that audit firms senior management insists on quality. Audit firms in the Czech Republic are obliged to comply with the ISQC 1 which significantly helps to the

7 quality of audit work. It must be emphasised that management must not intervene in how individual audits are performed. (23) Should it be verified if it is possible to use alternative structures that could enable audit firms to gain capital from external sources? We believe that such an approach would increase the threats to auditors independence. External investors interests would increase the pressure on short-term business results. Primary economic interests would increase the pressure on quality through cost cutting. We understand there are concerns that audit firms may be unable to fulfil their obligations based on auditors liability in certain situations. These concerns may limit smaller audit firms access to engagements and support market concentration. A good response to such threats may be to thoroughly apply European Commission Recommendation concerning the limitation of the civil liability of statutory auditors of 5 June 2008 and we recommend that EC should thoroughly asses its application and effects. (24) Do you support the suggestions regarding Group Auditors? Do you have any further ideas on the matter? We fully support the view of the European Commission that the group auditor should bear full responsibility for the audit report in the relation to the consolidated financial statements. Such a responsibility must be supported by access of the group auditor to the documentation of auditors reviewing/auditing sub-entities of the group and by timely and adequate communication with these auditors. The issues of group audits are addressed by the requirements of the Statutory Audit Directive, which strengthened the role of group auditors and their responsibility for the financial statements as a whole. Little experience has so far been gained with the Directive s practical implementation. On an international scale, the role of group auditors would be strengthened by global harmonisation based on the rules contained in the Statutory Audit Directive and availability of audit files of all auditors of the financial statements of consolidated entities to a group auditor. These issues are further addressed by the ISA 600 Special Considerations Audits of Group Financial Statements. This clarified standard poses significant requirements on group auditors, including in the field of communication with the auditors of the components. The application of the procedures specified in the standard ensures that the group auditor is able to express his/her opinion on the group financial statements, as required by the Statutory Audit Directive. (25) Which measures should be envisaged to improve further the integration and cooperation on audit firm supervision at EU level? We support cooperation between the public oversight bodies of EU Member States. As most of these authorities have been established recently, we consider it advisable to give them time to develop. We therefore believe that the current involvement of the EGAOB is sufficient. (26) How could increased consultation and communication between the auditor of large listed companies and the regulator be achieved? We are supportive of any form of dialogue that leads to improvement of the quality of audit. This can be achieved by organising seminars and through regulators participation in conferences on auditing. The regulator s participation in meetings of the audit committees of

8 listed companies may be a good method to involve the regulator in communication with the auditors of such companies. (27) Could the current balance of power on the audit market involve a system risk? In general, we understand that any concentration may represent possible risk. Therefore, we consider it necessary to create prerequisites for the growth of small and medium-sized audit firms. Means chosen for such prerequisites should allow for the organic growth of small and medium sized audit firms. We believe that possible system risk cannot be eliminated by administrative intervention to the market structure or by other administrative means. (28) Do you believe that the mandatory formation of an audit firm consortium with the inclusion of at least one smaller, non systemic audit firm could act as a catalyst for dynamising the audit market and allowing small and medium-sized firms to participate more substantially in the segment of larger audits? We do not believe that the mandatory formation of an audit consortium could lead to increase in the competitiveness on audit market. The membership of small and medium-sized practices in the consortium would be just formal and would lead to a loss of their independence. It would be an artificial regulatory measure for which the market would soon find an artificial response, which would make it ineffective. Another issue is a split liability for risks arisen in the consolidated group. (29) From the viewpoint of enhancing the structure of audit markets, do you agree to mandatory rotation and tendering after a fixed period? What should be the length of such a period? Tenders usually do take place, as a rule, in the Czech environment. We do not believe that the rotation frequency should be regulated. The experience hitherto gained with mandatory rotation of audit firms does not give a clearly positive answer. Rotation of the responsible persons (auditors) is obviously a sufficient measure. The risks associated with mandatory rotation of audit firms, the loss of continuity, the newly selected firm s lack of knowledge, the increased costs of audit none of these factors can be considered insignificant. The benefits of the mandatory rotation of audit firms are unclear. It is not advisable to rely on the mere fact that the new auditor has no relationship with the client and that this is the main advantage. (30) How to treat the assertion that the Big Four are the best? Such an assertion should be treated as prejudice. The market is what decides. It is important that the Big Four firms are represented all over the world and are able to provide services at a comparable level of quality. (31) Do you agree that crisis plans, including detailed wind-up and liquidation plans (living wills), could be a key to addressing system risks and the risk of failure of audit firms? We do not consider crisis plans and detailed plans to wind up audit firms to be a good solution. We believe that such plans are formal and may not be legally enforceable. (32) Are the wider reasons that led to the consolidation of large audit firms over the last two decades (global service offering and synergies) still valid? In what circumstances could things return to what they were before consolidation?

9 Yes, taking into account the continuing globalisation, the reasons that led to the consolidation of large audit firms are still valid. It is not probable that the huge supranational groups (manufacturing, commercial or financial) will atomise, inspiring large audit firms to do the same. (33) In your opinion: how to best improve the transborder mobility of audit professionals? Certain prerequisites are necessary to encourage transborder mobility, including, in particular, convergence of Member States commercial and fiscal law and the accounting and audit standards. It is impossible to perform high quality audit without knowledge of the local legislation. In our opinion it is not desirable at present to increase transborder mobility, as it could affect the quality of audits. (34) Do you agree with "maximum harmonisation" combined with a single European passport for auditors and audit firms? Do you believe this should also apply for smaller firms? We agree with maximum harmonisation. To achieve it, legislation related to audit and to the subject of audit (i.e., in particular, legislation in the commercial, accounting and fiscal field) must be unified. (35) Would you favour a lower level of service than an audit, a so called "limited audit" or "statutory review" for the financial statements of SMEs instead of a statutory audit? Should such a service be conditional depending on whether a suitably qualified (internal or external) accountant prepared the accounts? We consider it reasonable to introduce a lower level of review ( statutory review ) for companies not subject to statutory audit under the local legislation. Statutory review would enable them to prepare for moving to the category of companies which are subject to statutory audit. Our experience shows that many companies are not prepared for the requirements in this category. We do not think it would be reasonable to replace statutory audit with a statutory review. (36) In the context of the possible future ban on the provision of non-audit services, should a safe environment be created to enable the provision of such services to clients among the small and medium-sized enterprises? As stated in our response to question 19, we believe that it is not advisable to prohibit the provision of non-audit services. Distinguishing between large enterprises and small and medium-sized enterprises would be discriminatory and would only lead to confusion. The rules of independence must be generally applicable, not discriminatory and on behalf of market functioning. (37) Should a "limited audit" or "statutory review" be accompanied by less burdensome internal quality control rules and oversight by supervisors? Could you suggest examples of how this could be done in practice? We believe that all audit engagements, including statutory review, must be subject to equal internal quality control rules and oversight. This is the only way to ensure that outcomes of such engagements are reliable and that users will accept them.

10 (38) What measures could in your view enhance the quality of the oversight of global audit players through international co-operation? Cooperation between public oversight bodies should be focused on the quality of supervision of global audit firms. Within the EU, exchange of information and coordination of activities should be intensified. As to relationships with oversight bodies outside the EU, further bilateral agreements on mutual provision of information would contribute to quality improvement. Requested information: Name of the organization: Country: Registered in IRP: Contact person: Contact Objections to publication of the personal data: Chamber of Auditors of the Czech Republic Czech Republic No Markéta Jindřišková No