Implementation of European Audit reforms

In April 2014 the European Union published its

• revised Audit Directive and
• Audit Regulation. A correction to the Regulation was published on 11 June.

The changes affect all areas of audit regulation, including market competition, auditor oversight, audit quality and standards application, audit reporting, corporate governance related to auditors, auditor selection and auditor independence. This briefing relates only to the latter aspect: auditor independence

In December 2014 discussion papers were issued by both the Department of Business, Innovation and Skills (BIS) and the Financial Reporting Council (FRC) on how to implement the requirements and member state options, in the UK. ICAEW has responded to the consultations from BIS and the FRC. Both BIS and FRC issued further consultation papers in late 2015 setting out precise proposals, taking into account responses to the earlier papers.

The BIS consultation paper set out proposals for an audit regulatory framework in which the FRC would be the ultimate competent authority responsible for audit regulation, but would be required to delegate all tasks to the Recognised Supervisory Bodies (including ICAEW) except those reserved to it by the EU Regulation (in essence, monitoring and certain disciplinary action in respect of audits of public interest entities (PIEs)). The paper also addressed the definition of a PIE, tendering of audit appointments and rotation of audit firms for PIE audits, auditor reporting to supervisory authorities and a number of other matters needing legislation, such as changes to the details of removing auditors, and restrictive clauses in contracts relating to audit appointments. ICAEW’s response on 11 December 2015 is available here.

FRC's consultation set out its precise proposals in respect of amendments to ISAs, the Ethical standards on auditor independence (ES), the UK Corporate Governance Code (CGC), and some other matters.  The consultation documents can be found here. ICAEW's response is available here.

The final Ethical Standard and Statutory Regulation were published on 17 June 2016 and take effect immediately for general requirements, or for audits of financial periods where those periods commenced on or after that date, in respect of individual audits.

As far as the ES (now combined into one) is concerned, the FRC has to a large extent listened to the responses to the December consultation and most of the changes are those required by the ADR. The additional requirements impact largely only on full market and ISDX main market listed and other PIE audits. The ES-PASE has been retained as section 6 of the new document. However, the proposals do go beyond the ARD in some areas. Key changes include:

• Changes to the wording on contingent fees and on advocacy in the provision of certain tax services on all audits (the only notable area of change for all audits), which could be read to be more restrictive, though are arguably clarifications of existing intent.
• Continuing to apply the previous listed company requirements to AIM audits, albeit with some significant reliefs compared to the previous position, for companies with a market cap of under €200m.
• Extension of extraterritorial requirements for network firms involved in a group audit that includes a PIE.
• Including new requirement for a 70% non-audit service fee cap on PIE audits.

The Regulation (which has direct application as if it were UK law) and the Directive (which amends the existing 2006 Directive and which has to be applied through UK law) apply from 17 June 2016 (subject to transitional arrangements for, primarily, mandatory audit firm rotation).

By and large, the Directive includes provisions applicable to all statutory company audits within the European Union. It includes a number of changes but these are not significant to auditors and the companies they audit

The Regulation applies to the audit of ‘Public Interest Entities’ (‘PIEs’) (see below). The Regulation in particular, imposes additional independence requirements for PIE audits, over and above those in the original APB Ethical Standards and ICAEW’s Code of Ethics section 290. 

FRC has issued a number of staff notes and additional comments by way of a rolling record of actions arising from its Technical Advisory Group. ICAEW, following discussions with FRC, has also issued guidance to assist members in applying the Ethical Standard. Both of these sets of guidance can be expected to evolve.

• As with previous audit regulation, a number of requirements differ for the audit of PIEs, compared to other audits. Hitherto, the FRC in the UK defined PIEs for most purposes as being listed companies (plus some other large entities for the purposes only of determining which of the FRC or the accountancy bodies undertake monitoring work).
• The meaning of a PIE has been redefined (Directive, Article 1.2f) to include all companies listed on an EU regulated market and in addition, unlisted banking and insurance companies and groups, unless they are small.
• Note that the AIM market in the UK is not an EU regulated market, but the FRC previously included AIM-listed companies as a PIE for purposes of the UK auditor independence standards). How AIM is treated under the new requirements is set out in the FRC’s late 2015 consultation document set out above. In essence, for standards purposes, AIM will continue to be treated as a ‘non-PIE listed entity' applying the existing requirements (not the enhanced PIE requirements), but with some significant reliefs, especially for companies with a market value of less than €200m.

• This is a completely new requirement (Regulation, Article 4.2, included in the new ES at 4.34-4.36R), limiting the proportion of non-audit fees that can be incurred in a year, by reference to the average audit fee. A number of aspects of the requirement remains subject to some interpretation issues but in essence the requirements appear to work as follows:
  • The requirement applies at a group audit fee level, for PIE audits
  • Group NAS fees may not exceed 70% of the average of group statutory audit fees over the previous three years. As application does not use retrospective data, this provision therefore does not apply until three years of audit fee data post 17 June 2016 are available. 
  • As applied by the FRC, the provision does then apply in any year in which at least some NAS is provided: a tightening up from the requirement in the Regulation.
  • As amended by the FRC, the restriction applies to NAS fees charged by the audit firm itself and, at a group level, its network.
• The Regulation permits the ‘competent authority’ (in the UK, the FRC), on request, to grant a short term exemption from the fee cap. The FRC has published guidance on how to apply for such an exemption
• Accountancy Europe has produced a set of frequently asked questions on this area, from a European perspective.

• The basic notion in the previous auditor independence standards has been preserved, of an overall requirement for independence, the analysis of threats and the application of safeguards, together with a list (primarily for PIE audits) of prohibited non-audit service (NAS) activities in respect of services by audit firms to the entities they audit.
• The Regulation (Article 5, as amended by the 11 June correction) includes a new list of prohibited activities for PIE audits. This, as slightly amended by the FRC, is repeated in the ES at 5.167R. In general terms, this covers broadly similar types of activities to those covered in current independence requirements but have a wider scope and fewer exceptions. For example:
  • Tax – current requirements prohibit various types of tax service: the new ones cover substantially all tax work unless it has no material effect on the financial statements being audited;
  • There is a virtually complete prohibition on several other activities where there are currently a number of caveats and exceptions, including internal audit and corporate finance;
  • The prohibition on being involved in management activities now specifically includes (according to a Recital to the Regulation) working capital and cash management and providing financial information;
  • The current exception for immaterial items is now restricted only to tax and valuation services;
  •  The provision of design and implementation of internal control over financial information and systems is now prohibited in the 12 months before appointment as auditors, as well as during the period of appointment.
• Accountancy Europe has produced a set of frequently asked questions on this area, from a European perspective.

• Mandatory audit firm rotation is introduced (Regulation, Articles 16 and 17, hardwired into UK law in the Statutory Audit and third Country Auditors Regulations part 3 (amending the Companies Act 2006, s490 et seq)), such that PIEs have to appoint a new firm of auditors every 10 years. The UK has taken up a member state option to extend this maximum period to 20 years provided the audit is subject to a public tendering carried out at least every 10 years.
• Tendering at least every 10 years is required for all PIEs. This compares with (in the UK)
  • current FRC requirements (UK Corporate Governance Code, C3.7 for FTSE 350 companies to retender or explain why not every 10 years, and
  • a prospective Competition and Markets Authority requirement for FTSE350 to retender every 10 years with no ‘explain’ option.
• The Regulation permits the ‘competent authority’ (in the UK, the FRC), on request, to grant an extension of up to 2 years. The FRC has published guidance on how to apply for such an extension.
• Transitional arrangements allow the longest tenure audits (over 20 years in June 2014) until 16 June 2020 to change, and medium tenure audits (over 11 years in June 2014) until 16 June 2023. As regards companies having changed auditors within the last 11 years, BIS has confirmed that the period before implementation date of 17 June 2016 will count towards the ten years for tendering and rotation purposes.
• FEE has produced (and continues to update) a set of frequently asked questions on this area. BIS and FRC are producing supplementary guidance on a variety of issues in respect of tendering and rotation.