The Proposed Concept of the Hungarian Public Oversight System

The proposed concept of the Hungarian public oversight system (Slide 1)

Ladies and Gentlemen,

The speaker before me, Mr. Devlin, the President of FEE, drew a clear picture of the European public oversight mechanism, the need for a public oversight on an EU level, and the institutional aspect of the coordination of EU public oversight, in connection with the implementation of the Directive No. 8.

Before discussing the plans to establish public oversight in Hungary and the ideas behind, let me give you a brief overview about the conditions of auditing in Hungary.

The present Hungarian regulations and the current supervision system (Slide 2)

The auditing profession woke up from its approximately 40-year “Sleeping Beauty” period - which was forced upon it by the mechanism of state socialism - a bit earlier than the big changes in the political and economic system occurred in 1989. The Hungarian Parliament passed the Act on Business Associations (or Company Act) including the statutory audit requirement in 1988.

After the political changes in the early 90-ies there was rapid increase in the number of people obtaining auditing qualifications. First the professional organization was formed as an associationand after ten years in 1997 as a chamber.

The Hungarian Chamber is now the member of FEE and IFAC. It means that our organization meets the requirements of these international bodies.

The Company Act, modified several times in the last few years, defines auditors as the guarantee for the lawful operation of the business associations. In addition, the act on accounting and the act on capital market also assign an important role to auditors. The relevant acts stipulate auditing obligations in a wide range of cases, but compared to other countries, the audit threshold is low (cca EUR 200 000 in sales revenue). In addition to companies, local governments also have to be audited. The approx. 3.6 thousand registered active auditors (50 % are sole practitioners, 50 % work in audit companies) provide audit and assurance services and many of them offer accounting and tax advisory services, too. (To be honest, the number of auditors seems to be too high for the size of the market.) Those professionals who work for companies or state organizations can be so-called “suspended” members of the chamber.

In 1997, a law came out on auditing and the Chamber of Hungarian Auditors. (Slide 3) This act acknowledged the right of the auditing profession to self regulation (as it is usual in most European countries). The law says that in Hungary only auditors who are registered with the Chamber can conduct statutory audit. (Just a comment: according to Hungarian law only natural persons could be the members of the chamber but audit firms are also registered.) Self regulation means that the chamber has licenses in the registration, professional qualification and disciplinary procedures. Auditing is performed on the basis of the International Standards on Auditing. The Chamber has continuously implemented the ISA’s. The implementation means some “+” in accordance with the Hungarian special legal requirements. The Chamber is entitled to issue auditing standards and carrying out quality assurance program. From 2002 external quality control system has been introduced, too.

Supervision(Slide 4) over the chamber exists in Hungary, this means legal supervision by the Minister of Finance. The minister checks whether the self-regulation rules of the chamber meet the legal requirements, whether the steps taken by the chamber violate the legal regulations or self-regulation rules. Therefore each relevant resolution and the rules of the chamber have to be sent immediately to the minister. When any irregularity is detected, the minister calls on the president of the chamber to restore legality, or he takes the case to a court, if necessary. The court is entitled to suspend the operation of the bodies and elected new officials of the chamber (president, vice presidents), and to appoint a supervisor. These are the rules that the law defines but no such step has been taken since the foundation of the chamber. This legal supervision covers only the work of the professional organization (chamber), there is no direct responsibility for the quality of audit or inspection of the audit firms.

The Hungarian capital market (Slide 5) is relatively underdeveloped; the number of listed companies is limited. (Therefore, the number of those companies who prepare IFRS Financial Statements is also limited.) Similarly to the continental European trends, loan financing plays the leading role in our economy. The ratio of small businesses, and within them, the micro companies, is over the EU average. This might be one of the reasons why bigger accounting scandals have avoided us so far. Although it is mandatory for the auditors to have insurance, the number of lawsuits initiated against them so far has been negligible, and with a few exceptions they have passed almost unnoticed. Statutory audit is rather a legal obligation than enhancing the confidence of users of financial information, even in the eyes of the owners and the management. Naturally, in the course of the privatization, during the inflow of the foreign capital in the 90-ies, and even after that, the authentic financial statements are of high importance for foreign investors. On the capital market the international investors are in majority. The capital market primarily requires IFRS financial statements.

With this historical background, we are aware that - being a member of the European Union - we have to make sure that the new directives are adopted, just like in the past. This includes the adoption of the concept of oversight, in Hungarian practice, as part of Company Law Directive No. 8.

External quality control (Slide 6)

Before discussing the ideas regarding public oversight, let me tell you some words about our quality control, as the assurance of quality is an essential (or perhaps the most important) element of the oversight concept. In Hungary, since 2002, the law has required the external quality control of auditing on the basis of the EU quality control recommendations. Quality reviewers check the statutory audits carried out after 1 January 2001. So far, approx. 1500 auditors have been undergone quality control procedures.

The objective is the same as everywhere: improve quality, strengthen the recognition of auditors, and increase the authenticity of auditing.

The subjects of the review are active auditors and registered audit firms.

Principles: secrecy, independence, incompatibility and professional behavior.

The system is a combination of monitoring and peer-review. (Slide 7) The Chamber has a Quality Control Committee operating with 7 people. This committee produces an annual plan, processes the data supplied by the auditors, organizes the work of quality reviewers, then records and evaluates the results of quality reviews. The Committee produces an annual report on the results of the investigations (the general findings).

Quality reviewers are selected in tenders, from chamber members that have an experience of at least 6 years, who received a “meets the requirements” result in quality review, went through special training, and are not under a disciplinary or ethical procedure.

The review is usually carried out in every 6th year. In the case of companies where 5 or more auditors are employed, the frequency is 4 years, and for auditors auditing public interest companies, it is 3 years. If somebody does not meet the requirements, the review is repeated next year.

The companies and the members supply data to the quality control committee on the companies audited by them (the number of their clients, working hours, and the type of the report issued).

The quality reviewers selects samples, in which each registered auditor is affected at the companies. The sample selection is based on the working hours input. Public interest clients should represent 40% in the sample, and qualified reports should represent 20 %.

The results of the review are: (Slide 8) „meets the requirements”, „meets, but needs further development” and „failed”. The auditors are subject to disciplinary sanctions in the case of negative outcome of quality reviews. Sanctions are: written warning, obligation to attend training, and after a repeated unsuccessful investigation, a disciplinary or ethical procedure (which includes in worst cases, the removal from the register).

The work started in 2003, and the so-called introduction phase will finish in 2006. The primary objective of this period is rather to give assistance in the application of the Hungarian auditing standards, not so much reprimanding.

In the introduction of the external quality control, we anticipated that a public oversight committee would be set up and oversight of quality control would have been only task of the oversight committee. In the meantime, taking into account the preparations of 8th Directive, it has become clear that the competence of modern oversight is much wider than our original idea (it means that oversight arrangements should cover not only the supervision of quality assurance but cover the standards on education, auditing principles and procedures and ethics), therefore the setting up of this body has been postponed until the finalization of the EU Directive and the passing of the new act in Hungary.

The implementation of the Directive

How to proceed now, after the formulation of the new directive? (Slide 9)

Although the Directive allows 2 years for the implementation for the member states, Hungary has made a relatively good progress with the adaptation process. This has mainly internal political reasons. In addition to the fact that presently 33 acts deal with auditing from various aspects, the act on Company Act is of vital importance among them for the profession. The recodification of this is on the agenda currently. This act refers to auditing activities at several points, identifies the rules of electing the auditors, withdrawing the auditors, and even refers to independence and the corporate governance system. It seems logical that the legal harmony has to be created, and it is not advantageous to separate the approval process of the act on auditors and the act on economic associations in time. In 2006, parliamentary elections will be held in Hungary. The experiences of our young democracy show that after the parliamentary elections, a few months are required for legislation to get back to normal, and to include an act on auditing and the chamber of auditors – which is not the most essential from political aspect – into the legislation program. For this reason, the government would like to submit the new bill on auditing this year or early next year. The Chamber of Hungarian Auditors has been requested to prepare the act – as a token of trust in this professional organization. After a comprehensive reconciliation, the bill has been presented to the government, which will manage it further, and present it for approval.

The concept of Hungarian public oversight

What will the Hungarian public oversight be like? (Slide 10)

We are aware, that according to the new Directive 8 of the EEC, the member states have to operate an efficient public oversight system over the statutory audit. Public oversight is an essential condition of the maintenance of the self-regulation system accepted and practiced in the union. The operation of oversight plays an important role in the international reputation of the profession, including the equivalence with other oversight systems. Together with the other EU countries we would like to demonstrate that our oversight system is equivalent in quality to the other (e.g.US) systems.

According to the directive, the oversight system has a final responsibility over

• the registration of auditors and audit firms,
• adoption of standards on ethics, internal quality control of audit firms and auditing
• continuous education, quality assurance and investigative and disciplinary systems.

(Slide 11)As to the tools to implement this final responsibility, the directive does not give a detailed guidance. The directive stipulates that the oversight should be entitled to perform an investigation itself if necessary, and should be able to take proper steps. This is the most difficult and sensitive issue of the oversight concept. We think that it could be done on exceptional basis in practice; therefore the Committee can hire experts in these cases to perform its investigations.

The cultural differences that jeopardize the federal dreams of the European Union from time to time (see the failure of the referendum about the constitution in France and in Holland) inevitably divide the European nations in certain subjects. Obviously, this cultural division is present in every attempt to unify. It is not any different in the regulations of oversight. The European picture will probably be colorful, but hopefully diversity will not jeopardize the completion of the task.

The Hungarian regulations generally do not wish to be stricter than the directive itself, they wish to follow it; fitting the oversight concept into the Hungarian legislation and culture (The points I am making are based on the bill drafted and presented to the Government.)

The Hungarian public oversight will be established by the new act on auditing and chamber of auditors.

(Slide 12)

In the establishment of the oversight system, we wish to avoid bureaucratic, costly solutions that set up a separate organization, and that would be strange to the Hungarian regulatory culture, i.e. solutions of American type. In order to do that, our idea is to set up oversight in the form of a committee. (Please note, that in the establishment of the system, we studied the German regulations regarding the oversight committee, in force since 1 January 2005. For historical reasons, the Hungarian legal culture shows a lot of similarity with the German system, so their experiences are important to us.)

The key question is the independence of the persons performing the oversight. We are planning to guarantee it in a way that oversight would be carried out by persons who are independent of the profession (specialists who have never belonged to the profession, but have some qualifications in certain skills required for auditing or persons acting as auditors before, but not any more). We are happy to note the possibility - and wish to utilize it - that practicing auditors can also be involved in public oversight, even if in minority.

According to the proposal, the Committeewould consist of 7 members, the majority of whom (four persons) are independent, i.e. they have not done the following activities for at least three years before the act comes into force

• perform auditing activities, be a member of the chamber,
• be an owner, senior official or supervisory board member at an audit firm,
• be an employee of a chamber member or audit firm,
• be a member of an audit committee.

However, as I have already mentioned, the independent members should also have some skills that are required for the auditor qualification.

The rules of independence apply to close relatives, too.

One of the weapons against possible illegal influence by the auditing profession or the organization of auditors is financial independence. (Slide 13) It is a delicate question, as the professional organization and the chamber of auditors financed by the membership fees and the registered companies’ contribution (and, naturally from the income earned with professional publications and events) in Hungary. The possibility of increasing the income is limited. We suggested that the minister of finance (state budget) should look after the conditions of operation. This satisfies the stipulation in the directive that the oversight is financed in a way that the profession could not have an influence on it through financing.

The members of the committee can also be a guarantee for independence and unbiased behavior. As to the selection of the committee members, (Slide 14) it is proposed that the members of the committee would be selected from persons of public respect and acknowledged experts of accounting, finance, law, auditing or financial reporting in the area of state authorities, administration, big companies and science, or still work in such an area or responsible position. This is the reason why - according to the domestic culture - we prefer direct invitation than inviting bids for selection. In the composition of the committee, it is advantageous to create a proper balance between science and practice. The president of the chamber makes recommendations for the minority active auditor members of the committee (maximum 3 persons).

The president, the vice president and the members of the Oversight Committee would be appointed by the Minister of Finance. The appointment is for 5 years, and can be extended on one occasion. On the establishment of the committee and the selection of the president, the Minister of Finance will inform the European Committee.

The Minister of Finance is entitled to call back the members in case of extraordinary circumstances. An extraordinary circumstance is when an independent member of the committee loses his independence because of joining a professional organization. The members of the committee may resign from their posts any time.