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Structural deficiencies at largest audit firms, fundamental reform and cultural change necessary

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The quality of statutory audits performed by the four largest audit firms has insufficiently improved in recent years. The number of statutory audits deemed ‘inadequate’ by the AFM is too high. The auditing sector will have to implement concrete measures as soon as possible to ensure the quality of the statutory audits and focus more on the public interest.

In the meantime, the sector too seems self-aware of the urgency to increase the quality, so that among others, investors, pension participants, consumers and others can rely on the auditors’ opinions.
The Netherlands Authority for the Financial Markets (AFM) states this following its inspections of the quality of statutory audits and the quality control and monitoring by the four largest audit firms, the so-called Big 4 (Deloitte, EY, KPMG and PwC).

Urgency

“The essential product of an auditor is to provide a high quality audit. After our first round of inspections in 2010, the audit firms formulated plans to increase that quality, but unfortunately the effects of those plans are insufficiently observable in the most recent inspection results. This is a gloomy conclusion. Today, the sector subscribes to the urgency to take real, more fundamental steps to increase audit quality. The AFM appreciates this.

The Big 4 announced far-reaching measures in response to our inspections. Moreover, the professional body NBA proposes improvements for the entire auditing sector in its report 'In the public interest'. The AFM hopes that today the foundation has been laid for the necessary strengthening of this important sector and the cultural change that is needed for that,” says Gerben Everts, Board Member of the AFM.
It still remains to be seen whether these measures will be effective. "It is crucial that all audit firms in the sector proceed expeditiously and decisively. The sense of urgency should not be lost,” says Everts.

Inspections of statutory audits

For each of the four audit firms, the AFM reviewed ten statutory audits from the period 2012/2013. The number of ‘inadequate’ statutory audits is four at Deloitte, three at EY, seven at KPMG, and four at PwC. Overall, the AFM qualified the quality of 18 of the 40 (45 percent) reviewed statutory audits as ‘inadequate’.
According to the AFM, the external auditors failed to obtain sufficient and appropriate audit evidence in order to support the auditor’s reports issued. The audits are therefore not up to standard. Although the results are not necessarily representative of the quality of all statutory audits carried out, the results are a clear indication of whether the quality of the statutory audits is sufficiently ensured by the audit firms.

This is the second round of regular inspections on statutory audits performed by the Big 4. In the first round of regular inspections, published in 2010, the AFM concluded in the final inspection reports that on average in 52 per cent of the reviewed statutory audits the external auditors failed to obtain sufficient and appropriate audit evidence.

The most common deficiencies relate to the tests of controls, the substantive procedures and the external auditor’s critical assessment of obtained audit evidence. In most cases, it concerns a combination of several deficiencies. For instance, external auditors performed insufficient audit work to determine the operating effectiveness of the audit client’s internal controls, and they performed little or no tests of details, substantive analytical procedures or analytical procedures concerning relationships. Also, when the occasion arose, external auditors reviewed insufficiently critically the audit evidence that they obtained directly from the management of the audit client or from an auditor’s expert.

Recommendations

The quality of the statutory audit is primarily dependent on good professional practice by the auditor. He should adopt an attitude of professional skepticism and act in the public interest. Statutory audits are conducted, however, in a system where incentives are present to prioritize other interests (such as commercial interests or self-interest) over the public interest. Measures are needed to remove these incentives.

A consistently good quality of audits is what one may expect from the auditing profession by virtue of its entrusted statutory audit mandate. To meet this trust, a more thorough analysis of all causes (root causes) that interfere with good quality will be required.

Therefore, the AFM calls on the Big 4 audit firms to implement the announced measures expeditiously and decisively, including measures arising from the sector-wide NBA proposals.

The AFM believes it is important that the Big 4 pay attention and give priority in particular to the following topics:  

  • Strengthening governance. Consideration is being given to the composition of the board (supplemented with members from outside the organization) and an internal supervisory body, the Supervisory Board, consisting of mainly external members. 
  • Creating a quality-oriented culture, focusing on the public interest with room for critical voices. 
  • Ensuring the legal level of quality. The legally required level of quality should be known by everyone within an audit firm and everyone should act accordingly. Auditors have the responsibility to keep their knowledge up to date; audit firms should support their auditors in doing so. 
  • Increasing the transparency of quality. More clarity on the performance of statutory audits contributes to improving the quality. Audit firms could be transparent about the way they work, the quality they provide, and in particular the way they implement the announced measures for improvement.

Additional legislation

The inspection results are reason for the AFM to ask for additions to current legislation. The AFM advises the legislature to make a supervisory board mandatory for audit firms that audit public interest entities (PIEs) on the highest level. Furthermore, the AFM wants to be able to test the suitability of individual members of the boards of directors and supervisory boards as well as the collective boards of directors and supervisory boards of audit firms.

To increase the transparency of quality, the AFM advocates the possibility to be allowed to provide its findings and conclusions directly to, for example supervisory boards and audit committees. Finally, the regulator wants to extend the PIE definition with socially relevant institutions that qualify as large, such as housing corporations, municipalities, pension funds, educational institutions, healthcare institutions, and energy companies.

Role of the AFM

The AFM will closely monitor the implementation and effectiveness of the remedial actions and improvement measures. The AFM remains in discussions with the audit firms and the sector. If the measures turn out to be too little effective, the AFM can take formal enforcement measures to enforce expeditious and decisive implementation. Moreover, the AFM is considering enforcement actions against individual audit firms based on the results of its inspections.

The AFM is committed to promoting fair and transparent financial markets.

As an independent market conduct authority, we contribute to a sustainable financial system and prosperity in the Netherlands.

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