US embassy cable - 04FRANKFURT3169

UNCLAS SECTION 01 OF 04 FRANKFURT 003169 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS RIES, EB BAY, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR ICN COX, STUART 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, EUN 
SUBJECT: Commission proposes directive on auditor regulation 
and oversight 
 
 
T-IA-F-03-0004 
 
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 
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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 
governments. 
 
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. 
 
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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. 
 
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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. 
 
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Regulatory and oversight arrangements between EU member 
states 
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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. 
 
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Third countries 
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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. 
 
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Reactions 
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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 
countries. 
 
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 
requirements. 
 
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- 
2238. 
 
BODDE