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Audit reformChallenges to supervisory boards and audit committeesYour guide to implementation – a German perspective

Germany has elected not to designate undertakings that are of significant public relevance as PIEs. In a multinational group, the different national PIE definitions as applicable in the differentEU member states have to be observed.

2 | Audit reform Challenges to supervisory boards and audit committees

Who is affected?The audit reform has many challenges for public interest entities (PIEs) and their audit committees.

PIEs are:

• Listed entities as defined by Sec. 246d HGB [“Handelsgesetzbuch”: German Commercial Code];

• CRR (Capital Requirements Regulation) credit institutions as defined by Sec. 1 (3d) Sentence 1 KWG [“Kreditwesengesetz”: German Banking Act], i.e., institutions other than those specified in Sec. 2 (1) No. 1 and 2 KWG; cooperative banks and savings banks do not qualify as PIEs; or

• Insurance undertakings as defined by Article 2 (1) of Directive 91/674/EEC.

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Background and affected companies 2Governance 4Obligations 6Enforcement 12

Contents

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Auditcommittee

Composition

Financial reporting process

Auditorcommuni-

cation

Auditors’appointment

Monitoring auditors’

work

Quality

Indepen-dence

External rotation

In the absence of an audit committee, all of these tasks pass to the supervisory board.

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Your guideIn 2014, the European Commission adopted the EU Audit Reform, comprising Directive 2014/56/EC and Regulation No 537/2014. The German Audit Reform Act [“Abschluss prüfungs reformgesetz”: AReG] implements the new rules for audits of PIEs in German law. The amendments are effective for fiscal years beginning on or after 17 June 2016. Any transitional arrangements and their earlier effective dates are mentioned separately below.

T h e ch an g es at a g l an ce

Under the German Audit Reform Act the establishment of an audit committee is (still) not mandatory. The legal situation is unchanged for listed entities according to Sec. 264d HGB. However, private CRR credit institutions and insurance undertakings without a supervisory board are also required to set up an audit committee.

Does an audit committee have to be established?

Financial expertThe supervisory board must have at least one financial expert; this member is no longer required to be independent (Sec. 100 (5) AktG [“Aktiengesetz”: German Stock Corporation Act]). This guidance equally applies to the audit committee (Sec. 107 (4) AktG).

Composition of the audit committee and supervisory board

Relevant for members appointed on or after 17 June 2016

According to Sec. 5.3.2 Sentences 2 and 3 of the German Corporate Governance Code, the chairman of the audit committee should be independent and have specialist knowledge and experience in the application of accounting principles and internal controls.

4 | Audit reform C h al l en g es to superv i so ry bo ards an d audi t co mmi ttees

Composition of the audit committee

IndependenceStricter independence requirements only apply in the absence of a supervisory board (“fallback solution”): The majority of the audit committee members, including the chairman, must be independent (Sec. 324 (2) HGB1).

Sector competence The members of the supervisory board and audit committee must, as a whole, have competence relevant to the sector in which the company operates (Sec. 100 (5), Sec. 107 (4) AktG).

According to the statement of legislative intent, expert knowledge can be acquired by obtaining practical experience in the sector, by intensive further training or by many years of professional advisory practice within the sector.

Sec. 5.4.2 Sentence 1 of the German Corporate Governance Code prescribes an adequate number of independent members of the supervisory board.

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➢Audit committee and supervisory board have adequate expert knowledge

➢Supervisory board rules of procedure are in conformity with the new membership requirements

➢Fallback solution: half of the audit committee members, including the chairman, are independent

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1 Sec. 324 (2) HGB applies to CRR credit institutions and insurance undertakings via Sec. 340k (5) and Sec. 341k (4) HGB.

This option is not open to CRR credit institutions and insurance undertakings or to such subsidiaries of industrial enterprises.

Depending on how the options granted to member states are exercised, the rules in EU countries may differ.

For fiscal years beginning on or after 17 June 2016. Note the transitional periods defined in Art. 41 of Regulation No 537/2014.

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➢➢The formal appointment procedure is followed and control reports from the Auditor Oversight Body [“Abschlussprüferaufsichtsstelle”: APAS] are considered

➢➢External auditor rotation is observed

➢➢Cooling-in rules are not breached (see page 7)

➢➢Fair appointment procedure is adequately documented for submission to APAS

External rotation

6 | Audit reform C h al l en g es to superv i so ry bo ards an d audi t co mmi ttees

Auditors’ appointment

The audit committee is responsible for appointing the auditor (Sec. 107 (3) Sentence 2 AktG) and must follow the formal appointment procedure prescribed in Art. 16 of Regulation No 537/2014.

PIEs are required to rotate their auditor regularly (external rotation obligation). Art. 17 of Regulation No 537/2014 stipulates a maximum audit engagement duration of ten years. In Germany, audit engagements may be extended by a maximum of ten years when a public tender procedure has been conducted or by a maximum of 14 years for joint audits by two or more auditors (Sec. 318 (1a) HGB).

Cooling-in constraints can already apply earlier. Non-audit services for designig and implementing internal control and risk management systems relating to financial information must not have been performed in the previous fiscal year.

The appointment procedure pursuant to Art. 16 of Regulation No 537/2014

• Four-year cooling-off period

• Small and medium-sized audit firms must not be excluded from tender

• Transparent tender documents (e.g., description of entity’s business activities, type of audit required)

• Transparent, non-discriminatory selection criteria

• Auditor selected on the basis of defined criteria

• Observe mandatory rotation and cooling-in rules

• Report on conclusions from selection procedure

• Consider APAS control reports

• At the request of APAS: demonstrate that the selection procedure was fair

• Duly justified recommendation of two or more auditors to the supervisory board and a (duly justified) preference for one auditor

• Statement that the recommendation was free from influence by a third party and that there were no constraints on selection

• Attempts to influence the recommendation must be reported to APAS without delay

• Auditor nominated at the recommendation and preference of the audit committee

• If the supervisory board does not follow the committee’s recommendation, reasons must be given

• Nominated auditor must have participated in the selection procedure

Phase 1: Public tender procedure

Phase 2: Non-discriminatory selection

Phase 3: Submission of a duly justified recommendation

Phase 4: Nomination of auditor to shareholder meeting

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Pre-approval-policy has been introduced and/or revised, incl. general pre-approval-catalogue Independence declaration pursuant to Sec. 7.2.1 of the German Corporate Governance Code has been obtained Information obligations relating to auditor independence:• Ad hoc reporting in the event of reasons for exclusion or bias as recommended in

Sec. 7.2.3 of the German Corporate Governance Code• Guidelines for the handover of the responsible audit partners• Report on any circumstances indicating bias; report on additional services

(Sec. 171 (1) Sentence 3 AktG)

8 | Audit reform Challenges to supervisory boards and audit committees

Monitoring auditors’ work

The EU restricts the performance of non-audit services. Non-audit services are all services that the auditor provides other than the statutory audit of the (consolidated) financial statements.

Art. 5 of Regulation No 537/2014 lists the prohibited non-audit services (blacklist). Permitted non-audit

services are subject to a fee cap of 70 % of the average audit fees for the last three consecutive years (Art. 4 (2.1) of Regulation No 537/2014).

The audit committee has to pre-approve all permitted non-audit services (Art. 5 (4) of Regulation No 537/2014).

The audit committee should satisfy itself that the auditor is subject to quality control in the form of a peer review and therefore complies with the obligation to provide notice of compulsory statutory audits. The audit committee should also develop an entity-specific scorecard to evaluate the quality of the auditor.

Relevant criteria may include:• Skills of core team• International presence (network)• Motivation• Market share of the audit firm• Experience of similar organizations• Nature and manner of conducting the audit• Fees

Quality of the auditor

Auditor independence

Black List pursuant to Art. 5 of Regulation No 537/2014

Prohibited non-audit services

• Payroll services

• Bookkeeping and preparing accounting records and financial statements

• Services that involve playing any part in management or decision-making

• Tax services related to payroll tax or customs duties

• Designing and implementing internal control or risk management procedures related to financial information

• Legal services: Negotiating on behalf of the audited entity, provision of general counsel, acting in an advocacy role in the resolution of litigation

• Services related to the internal audit function

• Services linked to financing, capital structure and allocation and investment strategy, except due diligence services and providing assurance services in relation to the financial statements, such as the issuing of comfort letters in connection with prospectuses

• Promoting, dealing in, or underwriting shares

• Human resources services, with respect to management, structuring the organisation design and cost control

Permitted non-audit services in Germany

• Valuation services

• Tax services relating to ...

• Preparation of tax forms

• Identification of public subsidies and incentives

• Calculation of direct and indirect taxes, and deferred taxes

• Support regarding tax inspections by tax authorities

• Provision of tax advice

Tax and valuation services (Sec. 319a (1) HGB):

• Services have no direct or immaterial effect, separately or in the aggregate on the audited financial statements

• Prohibition of aggressive tax planning (continuance of previously established practice)

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10 | Audit reform Challenges to supervisory boards and audit committees

Improved communication with the auditor

Significant changes in German reporting:

Description of audit approach

Detailed description of audit approach for each item of the financial statements (substantive or test of controls)

Disclosure of materiality level for the financial statements as a whole and, where applicable, for specific items, transactions and disclosures

Disclosure of materiality levels

Disclosure of (quantitative/qualitative) effects of changes in valuation methods and inputs

Effects of valuation changes

Names of all audit firms involved in (group) auditsNames of all auditors involved

The new audit report pursuant to Art. 11 of Regulation No 537/2014

Standard textpossible?

• Title

• Address

• Report on the audit of the financial statements

• Opinion 1 • Basis on which the opinion is issued 2 • Key Audit Matters 3 • Management’s responsibility 4 • Auditor’s responsibility 5

• Other statutory and other legal disclosures

• Report on the audit of the management report 6 • Other legal requirements (especially relating 7

to Art. 10 of Regulation No 537/2014)

• Name of the responsible auditor

• Place, date and auditor’s signature

Major changes• Report on key audit

matters• If applicable, extended

report on the going concern assumption

• Name of the responsible auditor

• Date of first appointment as auditor

• If applicable, disclosure of any non-audit services

➢More company and audit-specific content

The new audit opinion pursuant to Sec. 322 HGB

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Integrity of financial reporting

The audit committee can – and is expressly called upon to – make recommendations or suggestions to ensure the integrity of the financial reporting process (Sec. 107 (3) Sentence 3 AktG). The audit committee should discuss whether any amendments or improvements are required while the management board decides upon the implementation.

Art. 39 (6) of Directive 2014/56/EC requires the audit committee to inform the supervisory board of the results of the audit, explaining how the audit contributed to the integrity of financial reporting and discussing the audit committee’s role in this process.

Recommendations to ensure integrity

Reporting to the supervisory board

In order to properly fulfil its oversight duties, it is in the audit committee’s and supervisory board’s interest to encourage the management board to establish a robust financial reporting process. To avoid breaches of duty of care, the audit committee and the supervisory board have the same responsibility as for monitoring the effectiveness of the business control systems.

The German Corporation Act already contains this obligation based on the general duty to report pursuant to Sec. 107 (3) Sentence 5 AktG. Nevertheless the audit committee should verify whether its reporting practice is appropriate and sufficient.

12 | Audit reform Challenges to supervisory boards and audit committees

Public oversightBreaches of duty in the context of the audit and/or the auditor carry sanctions against members of audit committees and supervisory boards of PIEs.

The German Audit Reform Act introduced equivalent regulations in the AktG, GmbHG, HGB (CRR credit institutions, insurance undertakings and fallback solution), VAG, GenG and PublG2, 3.

Insufficient monitoring of auditor independence(Breach of Art. 4 (3.2), Art. 5 (4.1.1) or Art. 6 (2) of Regulation No 537/2014)

Breaches of the aforementioned obligations

To gain an actual or prospective financial benefit (bribery and corruption) or if persistently repeated

Fine of up to EUR 50,000Depending on the significance of the administrative offense, the allegations, the financial circumstances and the financial benefit (Sec. 17 (3) and (4) OWiG [“Ordnungs widrig-keitengesetz”: German Administrative Offenses Act]

Minor violations: Caution, in some cases with an on-the-spot fine of between EUR 5 and EUR 55 (Sec. 56 OWiG)

Imprisonment of one year or less, or a fineIn cases covered by Sec. 70 StGB [“Strafgesetzbuch”: German Criminal Code], engagement in a profession can be prohibited for one to five years

Improper recommendation for the choice of auditor(Breach of Art. 16 (2.2), (2.3) or (3.1) of Regulation No 537/2014)

Improper nomination of an auditor to the shareholder meeting/competent body(Breach of Art. 16 (5.1) of Regulation No 537/2014; if a supervisory board and audit committee are in place, also Art. 16 (5.2.1) or (5.2.2.) of Regulation No 537/2014)

Administrative offense

Criminal offense

1

2

4

3

2 In the case of cooperatives and savings banks, only breaches of the duty to monitor auditor independence are sanctioned.

3 GmbHG [“Gesetz betreffend die Gesellschaften mit beschränkter Haftung”: German Limited Liability Companies Act]; VAG [“Versicherungs­aufsichtsgesetz”: German Insurance Supervision Act]; GenG [“Gesetz betreffend die Erwerbs­ und Wirtschaftsgenossenschaften”: German Industrial and Commercial Cooperatives Act]; PublG [“Publizitätsgesetz”: German Disclosure Act].

Reporting duties

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The Federal Office of Justice determines breaches and imposes fines; this responsibility lies with BaFin [“Bundesanstalt für Finanzdienstleistungsaufsicht”: German Federal Financial Supervisory Authority] for credit institutions and insurance undertakings.

APAS discloses all sanctions in anonymized form.

CautionFinePublic declaration naming the person

and the nature of the violation

Prohibition of engagement in a profession

Imprisonment

• PIEs have to inform about and explain the audit committee’s activities and the outcome thereof on request (Sec. 324 (3) HGB)

• But APAS must first obtain information from public sources

• At the request of APAS, PIEs must demonstrate that the appointment procedure was conducted fairly

• Attempts to influence the appointment procedure must be reported to APAS directly and without delay

Competent authority

Disclosure

PIEs and the members of their audit committees or supervisory boards have duties to report to APAS.

Activity report Appointment procedure

14 | Audit reform Challenges to supervisory boards and audit committees

Mathieu Meyer Managing Partner Audit GermanyTel. +49 711 9881 24424mathieu.meyer@de.ey.com

Prof. Dr. Sven Hayn Partner AssurancePublic Affairs and RegulatoryTel. +49 40 36 132 12277sven.hayn@de.ey.com

Prof. Dr. Peter OserProfessional Practice Group AssuranceNational Director of AccountingTel. +49 711 9881 15562peter.oser@de.ey.com

Claus-Peter WagnerManaging Partner Financial Services GermanyTel. +49 6196 996 26512claus-peter.wagner@de.ey.com

Daniela Mattheus Head of Corporate Governance ServicesGermany Switzerland AustriaTel. +49 30 25471 19736daniela.mattheus@de.ey.com

Hendrik HollwegRegional Lead Partner WestTel. +49 211 9352 20140hendrik.hollweg@de.ey.com

Our EY Governance Matters® information and network platform keeps you up to date on statutory and regulatory developments, topics and trends in corporate governance in your industry: www.governancematters.de

Audit reform Challenges to supervisory boards and audit committees | 15Last updated December 2016

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