The provisions of the European Statutory Audit Directive have ruffled some feathers in the UK. Neil Hodge explains.

The European Union's plans to harmonise statutory audit has kicked up a real hornet's nest among the Big Four accounting firms, accounting regulators, and the UK's most influential business lobby groups, despite the fact that they have all said that the new rules will make little difference to UK corporate governance.

The EU's Statutory Audit Directive, agreed in October last year and approved in April this year, is a thorough revision of the 8th Company Law Directive adopted in 1984. Described by Internal Market and Services Commissioner, Charlie McCreevy as 'a crucial directive which will bring EU financial reporting into the 21st century by introducing a much more rigorous and ethical audit process for company accounts', the directive aims to largely catch up with corporate governance standards that are already in place in the UK.

In fact, according to Big Four accountant Ernst & Young, the directive only introduces three issues that are new to the UK: the requirement for audit firms to publish an annual transparency report; the option of allowing EU member states to introduce audit partner rotation up to a maximum of every five years and audit firm rotation up to a maximum of seven years (inserted because Italy is the only EU member to practice mandatory firm rotation); and quality assurance reporting for audit committees and management. It is this latter requirement which is the source of tension.

Article 39 of the directive states that companies 'shall have an audit committee' and that EU member states shall determine whether the audit committee is to be composed of non-executive members of the administrative body and/or members of the supervisory body. The bone of contention is the fact that the directive goes on to say that 'at least one member of the audit committee shall be independent and shall have competence in accounting and/or auditing', though such competency is not defined. The fuss is because business groups oppose further duties on directors - especially non-executive directors - and fear that the burden of regulation will dissuade suitable people from taking boardroom roles.

Chris Hodge, head of corporate governance at the Financial Reporting Council (FRC), the UK's independent regulator for corporate reporting and governance, says that the 8th directive mixes aspects of the UK's Combined Code of Corporate Governance and the US Sarbanes-Oxley Act. "The Combined Code says that audit committees should be entirely staffed by non-executive directors, and Sarbanes-Oxley says that at least one member should be financially competent. The 8th directive is a mixture of both: it says that at least one member should be independent and that that person should also be financially competent."

Under the guidelines, the audit committee is responsible for monitoring the financial reporting process, as well as monitoring 'the effectiveness of the company's internal control, internal audit where applicable, and risk management systems'. The audit committee must also monitor the statutory audit of the annual and consolidated accounts, review and monitor the independence of the statutory auditor or audit firm, and 'in particular (monitor) the provision of additional (non audit) services to the audited entity'. The directive also states that 'the statutory auditor or audit firm must report to the audit committee on key matters arising from the statutory audit, in particular on material weaknesses in internal control in relation to the financial reporting process'. However, the responsibility for the internal control system, the internal audit and the risk management system remain with the audited entity's management.

Room for confusion

Despite the prescriptive nature of the directive, there is some room for confusion. While the directive spells out that all EU companies must have an audit committee or an equivalent body, paragraph 5 of Article 39 states that 'member states may allow or decide that the provisions laid down in paragraphs 1 to 4 of this Article shall not apply to public interest entities (ie companies) that have a body performing equivalent functions to an audit committee, established and functioning according to provisions in place in the member state where the entity to be audited is registered'. It goes on to say that 'in such a case the entity shall disclose which body carries out these functions and how it is composed'. This last point seems to imply that member states do not need to follow the provisions of the directive too closely, perhaps even ignoring the European Commission's intention that at least one member of the audit committee is independent and competent in accounting or auditing, since companies only need to disclose information regarding composition and function, rather than amend the process.

A spokesperson for the European Commission declined to clarify, saying that "implementing the directive is now in the hands of the governments of the member states." The UK's Department of Trade & Industry, which is responsible for drafting the provisions of the directive into UK company law, did not reply to a request for comment.

The conditions regarding audit committees have all been in place in the UK - albeit on a voluntary basis - since the Combined Code on Corporate Governance was revised and the Higgs and Smith reports into the role of non-executive directors and corporate governance were published in 2003.

However, the bone of contention lies in the possibility that corporate governance in the UK may move away from being voluntary to being required by statute. The real impact of such a turn around is not yet fully known but some interest groups do not like any talk of a move away from the Combined Code's 'comply or explain' regime of following principles rather than rules.

Peter Wyman, head of professional affairs at auditors PricewaterhouseCoopers, says that much of the UK's antipathy to the directive stems from a concern over how strictly the UK government will implement its contents into company law. "UK companies are very concerned that the directive will result in a 'one size fits all' approach rather than keeping the UK's current light touch regulation that allows a degree of flexibility," says Wyman.

Wyman echoes the concerns of business bodies such as the Confederation of British Industry (CBI) and the Institute of Directors (IoD) regarding the directive's specification that the independent member of the audit committee should be competent in auditing or accounting. "Non-executives have enormous responsibility and are now becoming almost full-time because of the increasing duties they need to fulfil to satisfy corporate governance demands. By requiring them to have competence in auditing and accounting, there is a very serious risk that UK companies will be unable to attract such talent to the boardroom, which would be a terrible unintended consequence of the directive," he says.

The FRC's Hodge agrees that the directive - if strictly implemented - could have catastrophic implications for the future of non-executives in the UK. "The need for an independent director to be competent in accounting or auditing might preclude a lot of existing non-executives in UK companies from taking on such roles, which would be very counter productive," warns Hodge. "Furthermore, because the directive effectively nominates the independent director as the person responsible for financial competency, that person could be held personally liable for any failures relating to either external or internal audit. This is unacceptable. There should be collective responsibility."

Who wants to be a non-exec?

Recent surveys appear to show that the job of non-executive director is becoming increasingly unappealing. According to Ernst & Young's fifth annual corporate governance survey of 124 board members among the UK's leading 500 companies, over 40% of respondents were sceptical about taking on a non-executive position and one in three are less likely to take on the role. As one respondent put it, "The responsibilities that a non-executive has are huge, but reward for taking on that responsibility is tiny, so it seems to me a pointless exercise."

The reluctance of people to take on a non-executive role is also having a detrimental effect on corporate governance. According to a survey released last autumn by Deloitte, FTSE 350 companies would need to appoint at least 145 new non-executive directors this year in order to be fully compliant with the 2003 revised Combined Code, which requires that non-executives should comprise not less than half the board in listed companies. According to Deloitte's Board Structure and Non-executive Director Fees, 16% of FTSE 100 and 39% of FTSE 250 companies have boards where the proportion of independent non-executives fails to meet that 50% target. A report published last October by UK training and development specialist Roffey Park found that there was simply an inadequate number of non-executives to meet demand.

Clive Edrupt, company affairs spokesman at the CBI, says that "whether we support the 8th directive depends on how the Government puts it into practice and intends to use it". He adds that as a result of the directive's insistence that an independent director be required to have accounting and auditing competency, "there may need to be a review of what an 'independent' or 'non-executive' director means in UK law. Currently, there is no distinction between an executive and a non-executive director. This directive - if implemented strictly in the UK - may lead to calls for the Government to make such a distinction."

Neil Hodge is a freelance writer.