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How changes to public interest entity audits are impacting small firms

Changes in the definition of, and rules governing, public interest entity audits are keeping smaller audit firms on their toes, as Caroline Biebuyck finds out

Last summer’s EU audit reforms led to front-page headlines as big-name companies changed auditors. Less well publicised was the impact on other entities – not just FTSE-listed companies, but other organisations that fall under the broader public interest entity (PIE) net.

Under previous audit regulation, most PIEs were listed companies or other large entities. Since 17 June 2016, the PIE definition has expanded to include all companies listed on an EU-regulated market as well as unlisted banking and insurance companies. This is having a big impact on smaller audit practices. In the past only a handful of firms had PIE clients. Now, this figure is thought to be many dozens, says Tom McMorrow, audit partner at RSM UK. “This means these firms need to consider the regulatory cost versus the benefit of keeping those clients on,” he says.

Audit firms need to establish whether any of their clients fall into the PIE definition – and to continue reviewing the situation year on year. For example, a client not currently a PIE might decide to issue debt listed elsewhere in the EU. That one action would bring it into the PIE net.

While some companies realise they are PIEs because they have debt listed on a UK market, others are caught out because they do not consider debt they have listed on a regulated market elsewhere in the EU. “They might just think that debt listed in the UK is relevant,” says Mark Shennan, policy and planning director at the Financial Reporting Council (FRC).

Then there’s the issue of who the PIE rules apply to, says Mark Babington, director of audit policy at the FRC. “Requirements apply to PIEs, any associated undertakings in the EU and to the parent undertaking of the PIE if this is in the EU. We have heard anecdotally that some entities have realised quite late in the day that an action they might have taken some years ago means that they now have a PIE in their group.”

Checking to see if a client is a PIE is not always as simple as it sounds. For example Steve Robinson, partner at Mercer & Hole, believes there is a potential issue around industrial and provident societies. After checking with ICAEW the firm is confident that some clients are not PIEs as they do not provide credit services, he says. “But these societies include entities like working men’s clubs, football clubs and credit unions. Many of them are able to offer credit but most don’t. However, it is critical that as an audit firm you check this is the case. The onus is on firms to check their own client base and take advice where necessary. We went to ICAEW to seek guidance on some of our clients. They were very supportive.”

PIE audits will soon be inspected by FRC’s Audit Quality Review Team, extending their scope from 10 to some 50 firms in all. But McMorrow adds that firms can engage with the FRC. “It’s not a case of us and them. The FRC is an avowed self-improvement regulator. They are interested in improving audit quality, not just for the biggest firms but the smallest firms too. So talk to them. And invoke their help early, before the inspections.”

Firms need to put procedures in place to make sure they comply with the various rules when they are working on an existing engagement or taking new work on. This includes having firm-wide processes in place as well as other processes specific to the audit assignment. These processes and procedures have to focus on independence. “The requirements of the EU audit reform are about removing any risk that a conflict of interest might pose to the auditor’s independence,” says Shennan. “These prohibitions are now set out in law.”

One of the two biggest changes from the EU audit reforms was the introduction of mandatory audit firm rotation for all PIEs. The other is prohibitions and limits on non-audit services, which an audit firm can provide to a PIE client.

There is a list of proscribed services an auditor cannot take on for the PIE, its parent company or any company controlled by the PIE in the EU. A few non-audit services are allowed, but these are subject to a fee cap. Broadly speaking, the total fees for these allowed services must be less than 70% of the average of the past three years’ audit fee.

The devil is in the detail of establishing exactly which kinds of services are allowed. The new reforms have tripled the size of the glossary of defined terms. Also the new terms have come straight from EU rules and are not always clear. “Not all the definitions can be easily understood and applied to your clients,” says McMorrow.

Tax is a particular issue – not least because many smaller entities that fall under the PIE regime used to bundle their audit and tax tenders together. “Taxation is generally a prohibited service,” says Andy Sayers, partner and head of public sector audit at KPMG. “But the rules refer to a derogation in certain circumstances. There’s discussion with the regulators about when and how the derogation might apply.”

One of the practical consequences of the new rules is that organisations need to think very carefully about which professional services firms they want to work with on what. For instance, companies need to assess who they want to do their tax and their statutory audit, all while complying with their own supply and procurement rules.

Another area that needs careful thought is what Sayers refers to as “grandfathering”. “A firm, which was not the auditor, may have given advice in the past about, say, a pensions valuation. Now the firm is the auditor. Circumstances have changed and the organisation wants to get an updated valuation. In an ideal world they would go back to the original adviser for an update to reflect the changes. But now they can’t.”

Larger firms have generally had the capacity to take on board the extra work involved. The question is: can smaller firms cope – and do they even want to? McMorrow has heard of firms that have decided to get rid of their PIE client because they simply can’t manage the regulatory burden of keeping them: “That’s counterintuitive in competition terms. The FRC and the Competition and Markets Authority are encouraging more firms to take on PIE clients as they want this to promote innovation. If instead firms are retreating from the PIE regime, how is that objective to be satisfied?”

Henry Irving, head of the Audit & Assurance Faculty returns: “A PIE by its nature needs to have and be perceived to have a good quality audit under the law, and this is the primary focus of regulation and legislation. A PIE audit is therefore something an auditor should probably not just do one of to meet the standards required cost-effectively – this will likely mean that over time fewer auditors audit PIEs than at present.”

Housing debt

One of the main types of non-listed organisation to become a PIE because of its funding choice is housing associations. Their decision to list their debt has often been taken not just because of cost, but from an intention to simplify their funding (traditionally grants and bank loans).

Some loans are very complicated, says Jenny Brown, head of housing at Grant Thornton. “FRS 102 has shown just how complex loans can be. Housing associations face the risk that the bank may vary the interest rate, plus they have all sorts of complex covenants to deal with.”

Bonds are a sensible way to raise finance in the current market. One large bond can be less risky than a number of different loans with different rates and maturities, and different covenants, all of which have to be tracked.

But the risk of becoming a PIE is making some housing associations pose serious questions about the potential benefits of going down the bond route.

Brown says she would be really concerned to hear about a housing association writing off the option of bond finance, if that were the best option for them, on the grounds that they did not like what it would do to their status.

“In a cost benefit analysis you would probably still get to the point where the benefits would outweigh the costs. But being a PIE does add more cost and regulatory scrutiny than is warranted,” she says.

Originally published in Economia on 6 January 2017.