EU audit reform: agreement on draft legislation

Key issues and deadlines

  • The EU has agreed draft legislation that’s likely to be effective in May 2014
  • Mandatory audit firm rotation and restrictions on non-audit services will be required
  • It’s important for business to support the UK government and the FRC with sensible implementation of the options in the legislation

The European Commission, Parliament and Council of Ministers have reached agreement on draft legislation to reform the audit market within the EU. A number of approvals remain outstanding, but it’s now likely that the new legislation will be introduced this year.

If approved, this legislation will mean that mandatory rotation of audit firms will be introduced for all public interest entities in the EU. There will also be additional restrictions on the non-audit services that audit firms can provide to audit clients.

These changes are significant and may cause complexity for business. They are also the latest in a series of regulatory reforms impacting the audit marketplace. In the UK, debates on this topic have focused on the large company audit market. These reforms have a much more profound impact, as they apply to all EU public interest entities, whatever their size.

Since 2003, reform in EU audit regulation has been a recurring topic of discussion. Michel Barnier, the current EU Commissioner for Internal Markets, began the legislative process in November 2011 by proposing that a number of radical reforms should become part of EU law. “Investor confidence in audit has been shaken by the crisis,” he said at the time. “I believe changes in this sector are necessary: we need to restore confidence in the financial statements of companies.”

What reforms have been proposed?

The debate has been complex and the proposed legislation covers many areas, including European-level supervision of auditors and changes to European audit opinions. However, the reforms that will have the greatest impact on UK business are in the areas of mandatory audit firm rotation for public interest entities and provision of non-audit services by auditors of public interest entities.

The draft legislation defines public interest entities as including all EU-domiciled entities with instruments listed on a regulated EU exchange, all banks and all insurance undertakings. There are no exemptions for subsidiaries of groups owned outside the EU.

Mandatory audit firm rotation

Under the proposals, all EU public interest entities will be required to rotate their auditors every ten years. If member states choose to allow it, this period can be extended to 20 years if a competitive tender is performed at the 10-year point, or 24 years in the case of a joint audit appointment. Member states can also implement a shorter rotation period, without the extension options.

Transition arrangements will vary depending on the length of the audit appointment at the date the new rules come into force; we estimate this will be in May 2014. If the auditor has been in place for 20 years or more, the first rotation must take place within six years. If the auditor has been in place for between 11 and 20 years, the first rotation must take place within nine years. Otherwise, the new regime will apply two years from the legislation implementation date (so from May 2016).

The public interest entity definition applies even where a company is part of a group listed outside Europe. This could cause complexity by forcing subsidiaries to rotate auditors even if the parent (listed outside Europe) is not required to rotate.

Restrictions on non-audit services

The new legislation will also restrict the non-audit services that can be provided by the auditor of a public interest entity – this is likely to apply from around May 2016.

In this area, the proposed legislation is complex and, in some cases, unclear. There are a number of options for member states and national supervisors (the FRC in the UK) to consider whereby they can make national application less onerous or more stringent; they will also interpret the areas of uncertainty.

Fees received for non-audit services cannot exceed 70% of the audit fees received. The wording prescribing the calculation of the cap is complicated, but the test is likely to apply to the average of fees over the last three years. And there is a list of non-audit services that cannot be provided by the auditor of a public interest entity to that entity, or to its parent or subsidiaries within the EU. These are summarised in the table below:

Prohibited non-audit service Comment
Tax advice and compliance Member states can allow these services if they are deemed to have no direct effect on, or are immaterial to, the audited financial statements.
Services that involve playing any part in the management or decision-making process of the audited entity The introduction to the draft legislation includes working capital and cash management, providing financial information and creating supply chain efficiency as examples of such services.
Designing and implementing internal controls over financial information or systems These services are all prohibited in the 12 months prior to an audit appointment, and throughout the audit appointment.
Valuation services Member states can allow these services if they are deemed to have no direct effect on, or are immaterial to, the audited financial statements.
Legal services/Internal audit/Human resource services Restrictions may be more extensive than those currently applied, depending on the final application of the legislation.
Services linked to financing and investment strategy The draft text confirms that providing assurance services, including the provision of comfort letters on prospectuses, will still be permitted. The introductory text to the proposed legislation also suggests that due diligence services will be permissible.
Source: PwC 2013

What happens next?

The draft text now goes to vote at the JURI (Legal Services) Committee of the EU Parliament in January 2014, before proceeding to a plenary vote of the EU Parliament. We expect the plenary vote will be scheduled in March or April. Following formal approval from the Council of Ministers, the legislation will be written into the Official Journal and come into force within 20 days. We estimate that the earliest date of implementation would be mid-May 2014.

Note

Audit Committees will need to monitor and manage auditor rotations carefully to minimise the risks that disruption brings to audit quality.

The mandatory rotation requirements will be imposed “on top of” the existing UK-specific tendering requirements; companies and their auditors will need to work carefully through the transition arrangements of the different regimes to understand how they will fit together.

Businesses that use auditors for the provision of non-audit services may find that their choice of supplier for some of those services changes in the future. As well as choosing a high-quality supplier, boards will also need to bear in mind future audit rotations, and the need to have independent audit firms available to appoint. 

It will be important to support the UK government and the FRC in implementing the legislation sensibly and proportionately here in the UK, in particular when considering the options available to member states. We encourage boards with concerns over implementation to contact BIS and the FRC to discuss these further.