On December 15th, 2003 the German Ministry of Justice has presented the draft version of a Balancing Law Reform Act (Bilanzrechtsreformgesetz) amending the German Commercial Law. The reform is i.a. regarding auditing, i.e. the independence (of mind and in appearance) of annual auditors (Abschlussprüfer). The draft is influenced by the Sarbanes-Oxley Act as well as by a recommendation by the European Commission of May 16th, 2002. It is intended to reestablish public confidence in the annual auditing after the well known cases of Enron, Mobilcom, Parmalat and others. The modifications of the German Commercial Code (Handelsgesetzbuch, HGB) with respect to the annual auditor will be presented in this article.

I. Present law:

The eligibility of chartered accountants or audit firms under the German Law is currently regulated in section 319 German Commercial Code (Handelsgesetzbuch, HGB), which is subdivided in 4 paragraphs:

1. Paragraph 1 stipulates the personal requirements. Principally, the annual auditor has to be a chartered accountant or an audit firm. Only if the audited firm is of a medium size and either a German (private) limited (liability) company (Gesellschaft mit beschränkter Haftung, GmbH), a general partnership (offene Handelsgesellschaft, OHG) or a limited partnership (Kommanditgesellschaft, KG), a certified accountant can be chosen as annual auditor.

iQ: An exemption makes article 25 paragraph 1 Introductory Act on the Commercial Code (Einführungsgesetz zum HGB, EGHGB), according to which certain companies which are owned by cooperatives or auditing associations which are authorized to audit cooperatives, can be audited by the auditing association they are a member of, if, again, the members of the executive board of the auditing association are by more than 50 % chartered accountants (for further detail see here).

2. Paragraph 2 clause 1 in 8 numbers governs situations, in which the chartered or certified accountant is not eligible as auditor, in detail

no. 1: if he is holding shares of the to be audited company,

no. 2: if he is - or was during the last three years prior to the audit - legal proxy, employee or member of the supervisory board of the to be audited company,

no. 3: if he is legal proxy or member of the supervisory board or owner of a company holding more than 20 % of the shares of, or being affiliated with the to be audited company,

no. 4: if he is an employee of a company holding more than 20 % of the shares of, or being affiliated with the to be audited company,

no. 5: if he has been engaged in the bookkeeping of the to be audited company, except for activities connected with and necessary for the audit itself,

no. 6: if he is legal proxy, employee, member of the supervisory board or partner of a legal or natural person being excluded from auditing under the just mentioned no. 5,

no. 7: if he is employing a person who falls under nos. 1 - 6,

no. 8: if he has received more than 30 % of his annual income from the to be audited client or the client's affiliated companies in each of the past 5 years and will probably receive the same percentage of income in the year of the audit.

3. Paragraph 2 clause 2 governs that a chartered or certified accountant is not eligible as auditor, too, in case

no. 1: he is employing a chartered accountant who has signed more than 6 audit certificates during the past 10 years for the to be audited stock company which, again, is accredited to the official stock market, or

no. 2: he has not obtained the certificate for participation in a quality control and has not been granted an exceptional permission.

4. Paragraph 3 governs that an audit firm is not eligible as auditor, too,

no. 1: if it or a company it is affiliated with is holding shares of, or is being affiliated with, or is holding more than 20 % of the shares of the to be audited company,

no. 2: if it is as a partner of a legal person or of a partnership in the sense of paragraph 2 clause 2, no. 6 or under paragraph 2 clause 2, nos. 5, 7 or 8 not permitted to become auditor,

no. 3: if it is a legal person and at least one of its organs or its 50+%-partner is not eligible as auditor under paragraph 2 clause 2, nos. 1 - 4, or, if it is no legal person, one partner can not become auditor under paragraph 2 clause 2, nos. 1 - 4.

no. 4: if a legal proxy or a partner of it is not eligible as auditor under paragraph 2 clause 2, nos. 5 or 6,

no. 5: if one of the members of its supervisory board can not be auditor under paragraph 2 clause 2, nos. 2 or 5.

no. 6: if it is employing a chartered accountant who has signed more than 6 audit certificates during 10 years preceding the accounting year for the to be audited stock company which is accredited to the official stock market,

no. 7: if it has not obtained the certificate for participation in a quality control and has not been granted an exceptional permission.

5. Paragraph 4 stipulates that paragraphs 2 and 3 are applicable to a group’s annual auditor, too.

II. The alterations of section 319 HGB:

1. Paragraph 1 will be left far reachingly unchanged. Only in order to clarify the importance of the personal qualification of the chosen accountant or firm, the hitherto regulated in paragraph 2 clause 2 stipulation, that the auditor must have taken part in a quality control under section 57a of the Certified Accountants Regulation (Wirtschaftsprüferordnung, WPO), will be put "on top of the agenda", i.e. as clause 3 into paragraph 1.

The alteration has no material consequence.

iQ: Currently, there is a differentiation between paragraph 1 on the one, and paragraphs 2 and 3 on the other hand. Only a violation of paragraph 1 makes void the audit certificate, while a behaviour contrary to paragraphs 2 or 3 leaves valid the certificate, so that only the auditor's right to compensation is anulled. The insertion of clause 3 will, however, bears no material consequences, which is being clarified by paragraph 5.

2. Paragraph 2 will be reshaped. In its 1st clause it will simply refer to paragraphs 3 and 4. The 2nd clause will comprise the general rule of independence of mind and in appearance:

"A person must not be annual auditor, if there are further reasons [i.e. besides those regulated in paragraphs 3 and 4], especially business dealings, financial or personal dealings [with the to be audited undertaking], which cause concern with respect to impartiality.“

3. Paragraph 3 will then, referring to paragraph 2 clause 1, describe cases of ineligibility in detail - as today’s paragraphs 2 and 3.

No. 1 and 2 will integrate today's paragraph 2 clause 1, nos. 1 - 4. One alteration is that all participations, not only shares (the only participation today's paragraph 2 clause 1, no. 1 does mention), i.e. bonds, promissory notes, options and (all) other securities, will be mentioned. As a result every investment in the to be audited company will lead to the ineligibility as auditor.

iQ: That takes into account that every participation in a company is likely to influence the accountant and thus to jeopardize his (necessary) impartiality and independence.

"No. 1: [A chartered or certified accountant is not eligible as auditor, if he or a person he is working with] is holding shares of or has any participation in the to be audited company or another company which is holding more than 20 % of the shares of or is affiliated with the to be audited company;

no. 2: [A chartered or certified accountant is not eligible as auditor, if he or a person he is working with] is legal proxy or member of the supervisory board or owner or employee of a company holding more than 20 % of the shares of, or is affiliated with the to be audited company;"

The measures taken in no. 3 are comparable to those in section 201 of the Sarbanes-Oxley Act.

"No. 3: [A chartered or certified accountant is not eligible as auditor, if he or a person he is working with]

a) has provided bookkeeping to the client or services related to the accounting records,

b) has taken part in the administrative audit of the client,

c) has provided management services or financial services to the client,

d) has provided actuarial or assessment services to the client,

provided that these activities are of no minor nature; no. 3 also applies to cases in which the aforesaid services are provided by an undertaking the chartered or certified accountant is legal proxy for, employee or member of the supervisory board of, or partner to;“

iQ: The provision deals with „self-auditing“. If someone audited his own work, confidence would not be possible (and reasonable). The new regulation, however, does not in general prohibit the auditor from every non-audit activity or from auditing as a result of such activity, respectively. The legislator does only govern 4 cases (a - d). Other situations are left open to judicial descretion in the particular case (paragraph 2 clause 2), so that in the not explicitly mentioned cases the auditor - with a grain of salt - has to ask himself whether he would accept another person as auditor, if that person was involved in the way he actually is.

No. 4 will resemble today's paragraph 2 clause 1, no. 7.

"No. 4: [A chartered or certified accountant is not eligible as auditor, if he or a person he is working with] is employing a person who falls under nos. 1 - 3;"

No. 5 will conform today's paragraph 2 clause 1, no. 8 and will state that "[a chartered or certified accountant is not eligible as auditor, if he or a person he is working with] has received more than 30 % of his annual income from the client or the client's affiliated companies in each of the last 5 years and will probably receive the same percentage of income in the year of the audit.“

4. Paragraph 4, alike today's paragraph 3, will govern that an audit firm is not eligible as auditor, too, if

(clause 1:)

the firm itself,

one of its legal proxies,

a partner who is controlling more than 50 % of the voting power,

a partner who is responsibly engaged in the auditing process,

any other person who is able to influence the result of the audit or

(clause 2:)

a member of the supervisory board

is excluded from becoming annual auditor under paragraphs 2 and 3.

5. Paragraph 5 governs that, in case the auditor does know or does gross negligently not know that he shall not be auditor under section 319 paragraph 1 clause 3; paragraphs 2 - 4 HGB,

iQ: In case the auditor has only negligently violated the mentioned provisions, he will remain entitled to payment. He will, however, have to hand over a part of his payment, because under the new section 334 paragraph 2 HGB he can be fined up to 25.000 Euros for every culpable violation of the new sections 319 paragraphs 2 and 3; 319a paragraphs 1, 2 and 4 HGB.

(implicitly:) the audit certificate will be valid, but

(explicitly:) the annual auditor’s entitlement to payment will be annulled, while

(implicitly:) the underlying contract and the thereby founded obligations will remain valid.

6. Paragraph 6, as well as today's paragraph 4, will govern that paragraph 1 clause 3; paragraphs 2 - 5 are applicable to a group’s annual auditor, too.

III. The new section 319a HGB

After section 319 an entirely new section 319a, dealing with further prohibited activities, will be inserted into the HGB. The section aims at a higher quality of audit certificates for credit institutions, financial services institutions, insurance undertakings, pension funds and undertakings which are listed on the official stock market. It tightens up section 319 HGB.

1. Paragraph 1 clause 1 states, that a chartered accountant is not eligible as auditor, too, if he or a person he is working with

iQ: A certified accountant can audit medium size firms only, so that section 319a HGB does not apply to him.

no. 1: has received more than 15 % of the annual income from the to be audited client or his affiliated companies in each of the last 5 years and will probably receive the same percentage of income in the year of the audit,

no. 2: has provided legal or tax services which affect finances, assets or proceeds and thus the annual account more than unessentially,

iQ: Advice affecting the annual account will be admissible, if it is part of the audit, e.g. if the auditor points out mistakes or gaps, while tax shelter will always be incompatible.

no. 3: has taken part in the development, installation and introduction of accounting information systems, unless the activity was of a minor nature,

no. 4: has represented the to be audited firm in court,

iQ: That takes into account that a person representing another person in court regularly has a bias towards the represented person and is thus not impartial anymore.

no. 5: a chartered accountant who is responsibly engaged in the auditing process has taken part in auditing the client during 7 years preceding the accounting year.

iQ: The internal rotation is not new, vide today's section 319 paragraph 2 clause 1, no. 6 HGB. It will, however, be tightened up, especially with respect to the stipulated period and the covered activities, so that all chartered accountants who have taken part in the audit will be excluded for seven years from further auditing. The ministry did, on the other hand, not decide on implementing external rotation. The latter is deemed producing unduly high costs and problems with respect to the quality of the audit, since the auditor as a result of a long lasting business relation will know the client and will be able to use his experience. Against „blindness by habit“, the internal rotation is considered being sufficient.

It is being stated here that the draft does mean „during 7 years preceding the accounting year“, not only „in each of the prior 7 years“. Firstly, the draft's rationale refers to today's section 319 paragraph 3, no. 6 HGB, which stipulates the period of ten years during which at least 6 audit certificates were signed, so that one has to understand the period itself as an absolute figure. In the rationale of the draft it is said that the law will be tightened up. This, however, was not the case, if one would understand the passage in another sense than as „during 7 years“. Otherwise it would be possible to take part in the auditing for 6 years, pause one year, and audit again, so that under the new law one could take part in 9 instead of only 6 audits during 10 years. Secondly, the new sections 319 paragraph 3, no. 5; 319a paragraph 1 clause 1, no. 1 HGB explicitly refer to „each ... year“ („jeweils“), while section 319a paragraph 1 clause 1, no. 5 HGB merely says „during“ („in den ... vorhergehenden sieben Jahren“). As a result section 319a paragraph 1 clause 1, no. 5 HGB means „(at least) once in 7 years“.

2. Paragraph 1 clause 2 refers to section 319 paragraph 3, no. 3, last subparagraph; paragraphs 4 and 5, so that

 paragraph 1 clause 1 also applies to cases

- in which the aforesaid services are provided by an undertaking the chartered accountant is legal proxy for, employee of, member of the supervisory board of, or partner to (319 paragraph 3, no. 3, last subparagraph), or

- in which the audit firm itself, one of its legal proxies, a partner who is controlling more than 50 % of the voting power, a partner who is responsibly engaged in the auditing process, any other person who is able to influence the result of the audit, or a member of the supervisory board is excluded from being annual auditor under section 319 paragraph 2 or 3 (section 319 paragraph 4).

 in case the auditor does - negligently or gross negligently - not know that he shall not be auditor under section 319 paragraph 1 clause 3; paragraphs 2 - 4 HGB, the audit certificate will be valid, but the auditor’s entitlement to payment will be annulled, while the underlying contract and the thereby founded obligations will remain valid.

3. Paragraph 2, alike section 319 paragraph 6 HGB, will stipulate that section 319a paragraph 1 HGB is applicable to a group’s annual auditor, too.

IV. Not goverened

Two questions remain open, a cooling-off period and a tightend up liability of the auditor.

1. The draft does not govern a cooling-off period, so that - at first glance - there are no restrictions for an auditor or an employee of an auditing firm to become (wording of article 206 of the Sarbanes-Oxley Act:) chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position.

As a consequence the new section 319 paragraph 2 clause 2 HGB will have to be applied in such cases, i.e. a possible conflict of interest has to be determined in the particular case. Thus, e.g. thought has to be given to the background and date of the change and the particular new position of the former auditor. It is, however, to be expected that the German jurisdiction will come close to what the Sarbanes-Oxley Act says.

iQ: Article 206 of the Sarbanes-Oxley Act: „It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service required by this title, if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit.“

2. The draft does not tighten up the liability of the auditor. This is in line with the position of the European Commission, which is planning to at first explore the consequences of an increased liability, i.e. the question whether an increased liability is actually leading towards a better quality of the audit certificates.

iQ: Apart from the difficulties connected with answering that question (clear of bias and clear of shaping the facts), a higher quality of the certificates as the result of a tightened up liability is to be doubted. Experience shows that information the issuer can be held liable for, are either (very) expensive or indifferent in content, so that such liability often proves to be counterproductive. Additionally, bearing in mind that most the auditors are being insured, the increased liability is not likely to considerably contribute to a better quality of the certificates.

CLM