Mr. Pat Houlihan:

I thank the Chairman for the kind welcome and I thank the committee for the invitation to appear before it to discuss these EU Commission proposals on audit. The EU Commission proposals on audit arise from the financial crisis. There are two draft instruments, a directive on statutory audits of annual consolidated accounts and a regulation on statutory audit of public interest entities. The overall objective is to restore confidence in EU audits through enhanced audit quality.

I may give a short preamble before we get to the slides. In some sense, this summarises the first three bullet points. Credit institutions were the institutions worst affected by the financial crisis and in the aftermath of the crisis, the EU and other jurisdictions addressed the situation as it pertained to the intrinsic activities of these institutions - liquidity, solvency and, in many cases, recapitalisation. In the case of the European Union, the second wave of the activity in the wake of the crisis relates to audit. Hence the proposals we are examining here today.

It was a source of surprise to many that many entities, particularly credit institutions, began to send out major distress signals a short time after receiving clean audit reports at the time of the financial crisis. While I do not apologise for auditors, certain factors, such as the so-called expectation gap contributed to this. An expectation gap is where there is an expectation of something from the audit process that the process itself does not deliver. There are those who would argue that the expectation exceeds the legal expectations of the audit. Therefore, there is a gap. These proposals intend to address this in part by closing or eliminating the gap. Impairment of loans may also have been a factor, arising from the strict application of international financial reporting standards, IFRS.

Another set of factors run parallel to the crisis as much as being intrinsic to it. These are issues that have been on the European Commission's radar for some time, such as features of the audit market, where at the upper end the so-called "big four" have a vast global monopoly. The sense that this impacts on competition is manifest. The Commission has also expressed a concern on many occasions with regard to what will happen if one of the "big four" fails, as we will be in a situation where there is practically no competition in the market place, not to mention dealing with the fall-out from such a situation. These considerations are of abiding concern to the Commission. Another concern is the length of tenure of many audit contracts, some of which span generations. It is almost like having a sitting tenant in one's house. This is a concern with regard to true independence. Unsurprisingly, these kinds of considerations crop up in the proposals the Commission brought forward late last year to address the audit system and those entities and elements which comprise it.

It might be helpful here to go over the various players involved in the audit system. I have already referred to the "big four", which are a key element of the auditor part of the equation and which have global reach. They are constituted as networks. To the man in the street, this is a bit like McDonald's or a car dealership, which has a presence in all member states or globally. This is not an attempt to denigrate any of the entities mentioned, the audit firms or the others. Down the line from the top echelon, there is a clear second tier set of audit firms. These would be distinguished in terms of size and capabilities from those under them, but their reach does not extend up to the level of the "big four". The third tier would be audit firms and individual auditors.

There are an estimated 3,500 practising auditors in Ireland and public interest entities are audited by nine of the cohort of audit firms. Therefore, only a small number of audit firms audit public interest entities. The entitlement to audit comes from membership of a recognised accountancy body. There are six of these bodies in Ireland and they derive their recognised status from the public oversight authority. In Ireland, this authority is known as the Irish Auditing and Accounting Supervisory Authority, IAASA. Together, IAASA and the layers I have mentioned constitute a kind of pyramid with IAASA at the top. This is the kind of structure with which we are dealing and some of the proposals address the totality or various strands of that structure.

The proposal for the draft directive is to amend Directive 2006/43 on statutory audits of annual accounts and consolidated accounts. The particular focus of the proposal is on the audit of non-publicly accountable entities. This is distinct from the regulation, which expressly addresses that cohort. One of the key areas covered is independence. This concerns independence of the auditor from the firm. Other forms of independence are concerned also. The oversight body is not, as of the present draft, permitted to have audit practitioners. Also - we will come to this point later - the public oversight body is being asked to assume certain functions which up to now have been carried out by the recognised bodies themselves, in terms of regulating audit firms and auditors.

We will discuss the issue of liberalisation of ownership rules of audit firms later, as it is an issue that is the subject of criticism from certain quarters. One of the effects of liberalisation is, for example, to enable firms to have an inflow of capital. Up to now, a majority of members in an audit firm were required to be auditors, but now it is proposed to change this. Other proposals are proportionate audit for medium sized companies and where member states require an audit for entities, small companies can conduct the audit as well. This is of interest to the lower end of the audit market. There will be enhancement of cross-border activity, thereby allowing audit firms to perform audits in other member states either on a temporary or permanent basis. I already touched on the issue of the reallocation of functions currently carried out by auditor bodies to the public oversight system. As of now, only two of those functions are deemed as appropriate to be retained by these recognised bodies, namely, approval and registration.

The final and key proposal of the directive is the extension of the definition of public interest entities. In the directive this one purports to amend, there is a relatively clear and concise definition of public interest entities. The core of these would be listed and systemic entities, such as credit institutions, insurance undertakings and the like. Now there is a proposal to extend significantly the coverage of public interest entities. This means that those in the category of public interest entities are subject to the rigours of the regulation, which is obviously more demanding than the directive. This is an area about which Ireland has some "hesitations", a mild way of expressing its position.

The regulation sets out specific requirements with regard to the statutory audit of public interest entities. As I mentioned, the core element of these would be credit institutions, insurance undertakings and listed companies. However, there is a long list of other categories. I will list these later in the presentation when we get to the point of the issues arising from this. There are new requirements with regard to the appointment of the auditor and there is a significant role for the audit committee. The regulation deals with the performance of the audit and audit reporting, including to prudential regulators. Articles Nos. 14 to 18 and so on include various provisions and requirements with regard to the performance of audit and reporting to prudential regulators. In Ireland's case, this would be the Central Bank for companies that are credit institutions or under the regulatory remit of the Central Bank.

The next key area in the regulation is the new EU co-operation framework. Article 45 provides for investigations and so on. If something goes awry with a company that has a number of operations in various member states, there will be a need for co-operation and collaboration among the relevant authorities in those member states to investigate what exactly has gone on. Significant elements of such a system are already in place under the 2006 directive. This will enhance them. The European Securities and Markets Authority, ESMA, has a kind of co-ordinating role in this regard. I will deal with that agency later in this presentation.

The next key area is transparency reporting by auditors of public interest entities. If one is auditing a public interest entity, considerable disclosures are required. One has to put a great deal of information on one's website about one's audit firm and about what one is auditing. That facilitates the oversight of how those who audit these entities are constituted and provides details on other relevant matters such as the incomes of audit firms. There would be a public interest in having this information.

One of the core elements of the proposed new structure is the enhanced role of the audit committee, which is involved in the appointment of auditors, as I have said, and in many other areas relating to audits. This is one of the strengths of the proposals. At least it directs itself at the process. Arguably, some of the others could not get to the core of the thing, whereas this one does.

The next key area is the prohibition on the provision of non-audit services. Essentially, these proposals are seeking to restrict the provision by auditors of audit-related services, and in certain cases to prohibit the provision of non-audit services, with a view to ensuring the independence of those auditors. There are three categories of service - audit services, audit-related services and non-audit services. The last of those categories is being placed pretty well on the black list. Audit services are fine and a percentage stipulation of 10% applies in the case of audit-related services. This provision is being introduced to ensure auditors are independent. The Commission seems to share the feeling some people have, which is that auditors that have been supplying audit-related services and non-audit services in addition to audit services are being unduly influenced by the non-audit aspect of the revenues they are obtaining. That is why the Commission is seeking to curtail these activities. It is an interesting attempt to ensure there is independence. It is difficult to be absolutely certain that these ancillary activities are having an influence in the manner that has been suggested. That is the proposal the Commission has made.

I have summarised the two measures - the directive and the draft regulation - so I will move on to the discussions of these matters at European Council working group level in Brussels. At a later stage, I will set out where those discussions are and where the Parliament is on the issue. As I usually represent the Department at the European Council working group discussions, I will comment on the matters that have arisen at that forum. The question of whether there is a proper legal basis for the proposed regulation is being examined by the Council and Commission legal services. Many of the bigger member states, in particular, have hesitations and doubts about the proportionality of the use of a directive in this instance. They claim the criteria that normally apply when the Commission introduces a regulation might not be present on this occasion. It is an interesting debate. At one of the recent meetings of the committee in Brussels, the Council legal services issued an informal adjudication to the effect that the criteria are probably met. That is not the end of the matter; I think it will be considered again at some future time.

The second matter that has arisen in this context - the question of the subsidiarity and proportionality of these measures - borders on the matter I have just set out. Many people would prefer if some of the measures in the proposed regulation could be relocated to the directive. Some of the bigger member states get a bit jittery when something is included in a regulation because that means it has direct application, as the committee is aware. They feel it might be a heavy instrument to bring to bear in these cases. They have not been awfully happy with it for that reason. The other thing is that there are 72 draft articles in the regulation, whereas the directive is a much more sparse document. Perhaps some member states want to balance the two documents. I am not too sure.

Ireland shares the misgivings of many member states about the proposed expansion of the scope of the definition of "public interest entities". Article 1.2(d) of the draft directive, which is where the proposed expansion is provided for, would expand the definition to include investment firms, payment institutions, undertakings for collective investment in transferable securities, electronic money institutions and alternative investment funds. We have expressed concerns about this rather expanded definition of "public interest entities" compared with the original directive. We believe the clarity needed to pinpoint exactly what entities will be covered by the definition is missing from the directive. The Department has established a contact group of relevant interested parties, and we keep them abreast of developments.