The impact of Brexit on UK business is unclear and is likely to vary from entity to entity. While some entities will face difficulties, others may benefit commercially. Until 31 December 2020, the UK is in a period of transition to allow for a period of UK-EU negotiations. During this period, the UK continues to apply EU Law.
When the transition period ends, the UK’s trade agreements will end, not just with the EU, but with non-EU countries with which the EU has trading agreements. The UK government is currently working to negotiate replacement trade agreements (further information is available here on current agreements). However, in the absence of a new agreement, trade with other World Trade Organization (WTO) members will take place on WTO terms when EU trade agreements cease to apply to the UK.
The UK government has published a transition hub providing guidance to businesses during and after the transition period. This includes a letter to auditors and audit firms, as well as an interactive questionnaire for businesses and citizens to understand how they might be impacted.
Management will need to identify, assess, and respond to these uncertainties. Auditors will also need to identify, assess, and respond to Brexit-related uncertainties to the extent that they have the potential to have a material effect on the financial statements. Entities and auditors will need to analyse the key risks arising from a variety of possible Brexit scenarios.
Understanding Brexit risk factors is now particularly important considering the additional risk of the global COVID-19 pandemic. Entities and auditors will need to analyse and understand the combined impact of these two significant economic events.
ISA 315 Understanding the entity and its environment requires auditors to undertake a risk assessment, which will be key to understanding the risks posed by Brexit and COVID-19. While undertaking risk assessments, audit teams should consider:
- What are the potential areas of risk from Brexit?
- How significant is the threat of material misstatement associated with these risks?
- Are there any risks exacerbated by the dual impact of Brexit and COVID-19?
- What audit procedures need to be performed to respond to the levels of risk assessed?
We explore the following potential risk areas: industry specific risks, entity specific risks, uncertainties in estimates and forecasts, and other practical risks.
Industry specific risk factors
Brexit will not impact businesses in a uniform manner. Certain industries are more likely to be impacted than others, for example, due to business models which rely on supply chains and customers located in the EU. Others may see indirect impacts, from knock-on delays in other industries and general economic impacts. These will not necessarily be negative impacts – some industries are likely to benefit from Brexit.
Audit teams may find it useful to consider whether there are industry or sector specific risks applicable to the entity. Questions to consider include (but are not limited to):
- Does the industry rely on fast turnaround imports or exports, for example, those trading in perishable goods such as food or pharmaceuticals, or ‘trend’ items with rapid obsolescence, like clothing? Increased delays at ports could result in unsellable goods.
- Does the industry rely solely on EU supply chains, or are alternative suppliers available domestically or internationally? Supply chains can impact many aspects of a business model, from bottlenecks in production to increased cost of sales should tariffs apply. This could particularly impact business operating on a just-in-time basis.
- Does the industry rely on access agreements or licenses from the EU to operate or sell within the EU, for example, passporting arrangements for banks or rights to operate airlines between the UK/EU? Entities may be required to establish local operations to continue to operate, or face closing local divisions, regardless of any future agreements.
- Is the industry impacted by EU quotas, for example, fishing rights and aquaculture? Uncertainty arising from Brexit deal negotiations may make future planning difficult in these businesses.
- How reliant on EU labour is the sector? Will replacement labour be able to access the necessary immigration rights or will the business need to recruit UK labour? The agriculture and health care services are particularly reliant on EU labour. The dual impact of Brexit and COVID-19 will need to be considered for health care businesses.
- How reliant is the sector on tax, grant funding or other incentives from the EU? Some sectors, for example, biomedical research, rely significantly on EU tax incentives for research and development.
- Is the industry dependent on general economic well-being? Industries such as hospitality, travel, entertainment and leisure tend to be impacted significantly by the general economy. Soft cultural influence may also factor into these industries, for example, if the UK is seen as an undesirable holiday destination for EU travellers. Combined with restrictions due to COVID-19, these types of businesses may face more significant risks.
- Does the industry typically depend on tight cash flow management? Restaurants, food and general retailers typically operate on narrow cash margins. Significant economic shocks may present major challenges.
- Does the industry tend to have significant market-linked portfolios? Pension funds typically have significant property and corporate investments, which can fluctuate significantly with market volatility.
- How dependent is the industry on wider supply chains based in countries with EU trade agreements? Where the industry is largely reliant on supply chains from countries without EU trade agreements, for example, China and Australia, these may be less affected by Brexit-related risk factors. However, the wider supply chain should be considered, both for positive and negative impacts.
Entity specific risk factors
ISA 315 requires auditors to understand the entity and its environment, including industry, regulatory and other external factors. Understanding changes in the economic and business environment arising from Brexit will form a key part of this understanding. Among many other things, auditors will need to consider the potential impact on the financial statements of potential Brexit-related risk factors such as the following:
- Will the business be able to continue to operate in the EU, without changes to operations? Some businesses have relied on ‘passporting’ rights under EU law to provide services in the EU, such as broadcasting, financial services, airlines and hauliers. A no-deal Brexit could mean that these businesses either need to establish a local entity to continue to operate or wind-up any activities in EU states. Even if a deal is agreed, the details for individual industries may vary considerably. This could fundamentally reshape the business or result in significant segments ceasing operations.
- Does the entity rely on UK staff regularly working in the EU or vice versa? If staff either work regularly, or for extended time periods across UK/EU borders, they may need work visas. Depending on availability and cost, this could impact business operations.
- Are products and services subject to EU regulatory and compliance law? Where businesses sell products and services into the EU, in addition to the UK law they will need to be aware of risks in areas governed by EU law, such as licensing, product compliance, technical restrictions, trademarks and intellectual property, insolvency proceedings and competition law.
- Does the entity rely on EU labour, in particular to fill business critical roles? Some sectors rely heavily on EU labour, for example, in agriculture and in health care. The loss of EU labour may make it difficult to fill critical operational roles. There may be as a consequence be increased labour costs, particularly if competition for that labour becomes intense. There may be additional administration costs, due for example, to changes in employment contracts and the cost of EU worker Settled Status applications and visas.
- What legal and compliance issues impact the entity’s operations? Are there any risks of non-compliance with laws and regulations? For example, changes in laws and regulations may impact trading. Any business restructuring to move operations or administration functions in or out of the EU could be impacted by these changes. Compliance may result in additional administrative costs. Non-compliance with laws and regulation could result in penalties and fines.
- Will the entity face increased administration costs relating to importing EU goods? These costs could arise from a variety of sources. For example, there is likely to be additional administration required at ports and bonded warehouses for collection, declaration and customs – these costs may be passed onto the entity. Delays could also result in direct and indirect costs from operating. Other costs could arise from a need to obtain Authorised Economic Operator (AEO) status or costs relating to proof of origin requirements if the common rule book and facilitated customs arrangements are agreed on.
- Will the entity face increased tariffs and duties on goods exported to the EU? There may be risks such as double duties, paying duty on selling price rather than cost price, and the potential loss of Generalised System of Preferences (GSP) relief on UK exports to GSP partners. Guidance on VAT and other taxes is available in our Brexit hub.
- Will the entity face increased tariffs and duties on goods imported from the EU and elsewhere? When the transition period ends, the UK’s trade agreements will end, not just with the EU, but non-EU countries that the EU has trading agreements with. The UK government is currently working to negotiate replacement trade agreements. Further information is available here on what agreements exist. However, in the absence of a new agreement, trade with other World Trade Organization (WTO) members will take place on WTO terms when EU trade agreements cease to apply to the UK. Entities may be particularly impacted if they import goods, for example, from countries benefiting from the EU GSP rules for developing countries, countries benefitting from EU Free Trade Agreements, non-EU countries not benefitting from EU GSP or Free Trade Agreements, EU countries and Turkey, and EFTA countries.
- Will increased administration, tariffs and duties, potentially result in additional risk to the entity being able to purchase supplies, produce goods and services, and or deliver? For example, delays due to administration at ports could result in goods being received too late. A need to find new suppliers could result in lower quality products, resulting in a risk of increased returns.
- How exposed to macro-economic changes, such as currency fluctuations, unemployment, interest rates and inflation rates, is the entity? Consider as well whether COVID-19 exacerbates any impact. Entities with different functional and presentational currencies may see significant impacts on reporting, as well as on margins. If the entity has significant third party financing, interest rates may present additional operational challenges.
- How has the control environment been impacted by Brexit? Consider as well the impact on control over subsidiary operations. Control environments may be strained in entities needing to change suppliers, diversifying their operations or benefiting from Brexit due to increased demand. This could be exacerbated by challenges from remote working due to COVID-19.
- Has the risk of fraud increased in the entity? Consider whether factors of the fraud triangle, pressure, opportunity, and rationalization, exist and may influence management. If Brexit has a negative impact on a business, this may increase pressure on management. Changes to the control environment, for example, from remote working, may provide individuals with the opportunity to commit fraud. There may be additional rationalizations of saving jobs or protecting the business due to the dual pressures of Brexit and COVID-19.
Financial statement uncertainties – estimates, forecasts and other financial statement risks
Estimates and forecasts are inherently uncertain at the best of times. Combined with the impact of Brexit and COVID-19, there is likely to be increased risk in estimates and forecast accuracy. In particular, risks may arise from uncertainty in management estimates and forecasts relating to, for example: asset impairments; going concern; fair value calculations; loss provisions in contract accounting; and the recovery of deferred tax assets.
Assessment of financial statement level risks (such as going concern) may be higher than usual when clients have undertaken no or limited analysis. It may also be higher even where analysis has been undertaken if management has not considered or addressed relevant risks or material uncertainties.
Other financial statement risks could include:
- Covenant breaches – consider whether the entity is at a higher risk for covenant breaches. This could impact the classification of liabilities and the going concern assessment.
- Complex financial instruments – complexities may arise when auditing entities which use interest rate swaps or forward exchange contracts to mitigate risks, or instruments issued to obtain third party finance.
- Subsequent events – the timing of Brexit may result in adjusting events.
- Other accounting issues – consider whether Brexit may impact revenue recognition and existence, returns provisions, contingent liabilities and discontinued operations.
Auditors also need to consider the risk of inconsistent approaches to Brexit-related risks by different management teams within a single organisation, such as the identification of different risks, and different assessments of, or assumptions about, the same risk. Analytical reviews may be more difficult to undertake, given the significant uncertainty and unpredictability of Brexit and COVID-19.
Management and auditors may find it helpful to undertake reverse stress testing when considering estimates and forecasts.
Other practical risk factors
Brexit may result in more practical audit risks. While the FRC noted in their letter to auditors and audit firms that they do not anticipate that any significant issues will arise for group audits involving a UK parent company and EEA subsidiaries, they encourage auditors to take steps to ensure access to files and working papers is maintained.
It may also be helpful for group audits involving the consolidation of subsidiaries located in the EU for the group auditor to communicate at an early stage any Brexit-related risk factors identified and any additional work required. Additional reporting considerations seem likely to apply to UK groups listed on EEA exchanges. Audit teams may need to consider the need for work permits and issues such as data sharing.
Finally, auditors working in the EU may be impacted by registration requirements following the end of the transition period. Guidance on auditor registration is available here.