Role modelling

The European Commission is attempting to standardise statutory audits, writes Tony Upson
The role of auditors comes under the microscope tomorrow when the European Commission holds a conference on the subject. This will cover the issues raised in its Green Paper, "The Role, the Position and the Liability of the Statutory Auditor Within the European Union", issued in July.

The ostensible purpose of the paper is to make progress towards a common understanding of audit across the EU and, in the process, to try to reduce expectation gaps between providers and users of audits in each member state.

Not all of the matters covered by the paper are contentious. A common understanding of audit, clear communication of audit reports and auditor competence and independence are examples of those which are not. The threat of litigation and its constraint on auditors' effectiveness is certainly contentious, though not among auditors! And there are several other areas that will need further debate.

First, the assumption in the paper is that a public interest in the audit of large, publicly traded companies does not exist in respect of the audit of smaller, private companies. I believe this misses the real point. Listed companies are clearly different from owner-managed companies. For a start, there are far fewer listed companies. In the UK, there are more than one million companies, of which about 2,100 are listed and another 200 are on the Alternative Investment Market (AIM). Moreover, they tend to be much larger. Neither of these reasons calls for a different approach to audit.

I believe the public interest arises from the availability of limited liability. This is why limited liability companies are required to file accounts on the public record. It is this requirement for accountability which drives the requirement for audit. If accounts are to be on the public record they should be authenticated and reliable. The shareholders of a company have it within their power to control the directors they appoint and, if they see fit, to call for an audit. They are privileged users of accounts, as are certain other users such as the Inland Revenue and the bank manager. It is the non-privileged users who benefit from the statutory requirement to have an audit.

Already, member states may exempt small companies from audit under EU directives. The Green Paper questions whether this should be extended to medium-sized companies. In fact, there is little government enthusiasm in the UK for raising the limit. We have so far only taken advantage of the exemption in respect of very small companies, with turnover below pounds 350,000. The real question is: should small companies have to file accounts on the public record? If so, then it is reasonable to expect that those accounts should be audited.

The second contentious issue is the extent to which good corporate governance should be imposed on companies by law rather than being demanded from them by their shareholders. While it is clear that many listed companies have unproved their corporate governance in response to changes in the Listing Rules reflecting recommendations of the Cadbury committee, these recommendations have also led to an explosion of verbiage in annual reports, some of which hardly counts as "disclosure" as it is designed to create an impression rather than saying anything substantive. The EU paper opens up the way for exporting this tendency to other countries.

The paper also considers the desirability of auditors reporting that companies have put in place internal control systems to minimise the chance of fraud or of illegal acts being committed in the name of the company. But is it in fact desirable? The law is a blunt and ineffective weapon to protect shareholders. The law should merely provide adequate mechanisms for shareholders to exercise control over the directors they appoint. If the rationale of legislation is to respond to a wider public policy that is commendable but I doubt whether the cost to companies and their shareholders of achieving this public policy can be justified by the benefit. The cost is likely to be prohibitive to establish, maintain and monitor the effectiveness of such systems of control. To raise public expectations which cannot be met other than at a prohibitive cost is likely to create fresh problems and disappointment in the future.

In fact, that exemplifies one of the problems with the Green Paper: much of it is written in very general terms. Many of the assertions in the paper seem innocuous at first sight. Yet agreement to these general statements may in future years be taken as a mandate to pass measures that have serious adverse consequences for the users of accounts, the primary "consumers" of audit. There is a danger the European Commission and its conference will avoid difficult decisions and end up causing prohibitive costs to companies throughout Europe, rather than confronting fundamental questions about the accountability of companies to their shareholders and to the wider public

Tony Upson is director of Audit and Accounting Services at Pannell Kerr Forster.