FRC finalises regulations and guidance to implement EU audit reforms

EU game changer - June 2016

Contents

2Introduction

4Key points

6Key questions

13Want to know more?

14Appendix

Comments and questions on audit committees and non-audit services

On the 27 April 2016 the Financial Reporting Council (FRC) published final drafts of its Revised Ethical Standard 2016, Revised Guidance on Audit Committees 2016, UK Corporate Governance Code 2016, International Standards on Auditing (UK & Ireland) together with a Feedback Statement and Impact Assessment.

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The “draft” status applies until the end of May 2016 when secondary legislation from the Department of Business Innovation & Skills (BIS) is passed, and changes to the UK Listing Rules by the Financial Conduct Authority (FCA) are finalised. This paper provides a high level overview of these drafts. A separate EY paper covering the secondary legislation will be published separately in due course.

We trailed these developments in earlier EY publications, from December 2014 to October 2015. They can be found on our EU audit reform pages on ey.com alongside other related papers. If you are unacquainted with the background, or have not followed the story of these developments, we encourage you to visit this section of our website.

The FRC’s recent publications mentioned opposite run to over 250 pages, in addition to revised ISAs (averaging approximately 30 pages each). Therefore, in the interest of brevity, we have limited our comments to two key areas: audit committees and Non-Audit Services (NAS). We have not commented in any detail on the revised ISAs and provisions available for small entities.

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Key PointsAs an introduction it is worth clarifying whether you will be affected by these developments. The answer is yes if your company is a Public Interest Entity (PIE) i.e., incorporated in an EU member state with equity or debt traded on an EU regulated market (e.g., London Stock Exchange’s main market). You are also caught if your business is in banking or insurance whether listed or not, subject to the laws of an EU member state.

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¹ Some requirements take effect sooner e.g., a one year cooling-in period for prospective auditors which have previously delivered services related to the design and implementation of the PIE’s financial controls/systems. Also, requirements on tendering and firm rotation will be subject to transition rules.

New legislation takes effect from

17 June

2016

Some developments will affect all UK entities, whether PIEs or not. Therefore, all UK entities should be planning for these changes now. This is because the legislation takes effect from 17 June 2016¹, and new prohibitions and restrictions on Non-Audit Services (NAS) apply to financial years beginning on or after 17 June 2016.

Entities in the Republic of Ireland will have to wait a little while longer for clarity on how the FRC’s standards will apply to them, because the Irish government has not yet passed the relevant legislation. The FRC is currently in discussions with the Irish authorities.

Independence of audit committee members and other PIE employeesPIEs will have to reassess the independence of their employees e.g., executive directors and non-executive directors, as well as members of the audit committee and other committees. This is because the FRC’s rules will require any alumni from any potential audit firm (holding one of these positions at the PIE) to ensure they did not have a close working relationship with the audit pursuit team over the past two years. If they did, the proposed audit firm cannot be selected as the next auditor. Either the client chooses another firm or delays the appointment of that firm until two years hence.

Non-Audit Services (NAS)New restrictions on NAS will affect PIEs’ procurement strategies. They will need to make strategic decisions about which professional services they wish to receive: when, where and from whom. For audit committees of group PIEs incorporated in the UK, this means they have to bolster their NAS approval policies and procedures worldwide. This is because they will have to pre-approve each permissible NAS and monitor the 70% cap on fees for those services provided by the audit firm’s network to the PIE and its subsidiaries worldwide. Note that the 70% cap will first apply to permissible NAS after a three-year average group audit fee has been established in 2019/2020. Thereafter the cap will apply every year based on a three-year rolling average group audit fee.

Lastly, and perhaps most notably, the FRC has pursued its objective of applying its Ethical Standard (ES) extraterritorially for PIEs based in the UK. This is a significant extension beyond the EU legislation, which places the new UK regime on a par with the US SEC approach in terms of global reach.

70%cap on fees for those services provided by the audit firm’s network to the PIE and its subsidiaries worldwide

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Key QuestionsThis section looks at questions covering audit committees (composition and role) and NAS (cap and tax/other services).

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²The Disclosure and Transparency Rules come under the ambit of the FCA.

Q What will your audit committee chair and board need to look out for in the future, when assessing the experience and capabilities of existing and prospective audit committee members?

A: The UK Corporate Governance Code 2016 (“the Code”) includes a provision (C 3.1) that ‘the audit committee as a whole shall have competence relevant to the sector in which the company operates’. A footnote is also added referring to DTR 7.1.1.² This rule states that ‘the majority of members of that body [the audit committee] must be independent and at least one member must have competence in accounting and/or auditing’. The Code and DTR differ in terms of what level/type of experience is required of an audit committee member. The Code states that: ‘The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience.’(C 3.1)

Q Can you appoint former audit firm partners or employees to positions at your company?

A: Yes but if, for example, your audit committee is looking to replenish or grow its membership it will face new challenges. It will need a succession plan (looking forward at least two years hence) to take account of a broader group of audit partners now caught by the “cooling-off” rules and the “lead times” required if the board wishes to offer appointments to former partners from their external auditor.

The committee will have to think twice about offering appointments to partners or anyone else from an incoming firm who may have had a close involvement with the audit pursuit team (see ‘Independence of audit committee members’, page 5).

There is also likely to be more competition for candidates to fill future vacancies on audit committees. This is because unlisted banks, insurers and UK designated investment firms will be required for the first time to have audit committees.

Q What do you have to tell the market about your plans for an upcoming audit tender?

A: In response to earlier recommendations from the Competition and Markets Authority, the Code requires an ‘advance notice of retendering plans in the audit committee’s annual report’ (C 3.8). The Revised Guidance on Audit Committees 2016 adds that changes to an intended date of tender should be explained in the same report.

These disclosures should be helpful for companies and audit firms alike, who need to keep a broad perspective on the rate of tenders over a given period of time so they can plan ahead accordingly. Similarly, investors will be interested to know if there are any issues or concerns behind a change in the timing of a tender, and those interested in this may also wish to engage with the company as it undertakes the tender process.

Audit committee composition and role

the audit committee as a whole shall have competence relevant to the sector in which the company operates

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³ Paragraph 81, page 14, Revised Guidance on Audit Committees 2016 ⁴Paragraph 81, page 15, Revised Guidance on Audit Committees 2016

Audit partner rotation

Q Will your audit committee be expected to be more hands- on than before with the appointment or re-appointment of external auditors?

A: Yes. Consistent with the new EU legislation, the FRC requires that audit committees have primary responsibility for the audit tender and appointment process. This change places the emphasis for this activity squarely on the shoulders of the audit committee.

It should be noted that the comply-or-explain requirement for premium listed companies to tender the audit, at least once every ten years, has been removed from the Code. This is because the Code’s requirement is effectively superseded by the EU legislation.

Q Will your audit committee face closer scrutiny from shareholders and others?

A: Yes, undoubtedly. The Revised Guidance on Audit Committees 2016 calls for additional communications with investors including disclosures on the ‘nature and extent of the company’s interaction (if any) with the FRC’s Corporate Reporting Review Team’³.

It also includes a statement to the effect that if the company’s audit has been reviewed by the FRC’s Audit Quality Review Team, the committee should ‘discuss the findings with their auditors and consider whether any of those findings are significant and, if so, make disclosures about the findings and the actions they and the auditors plan to take’⁴. These disclosures will bring to the fore the FRC’s audit quality inspections and the committees’ own work in this area.

Q When do audit partners have to rotate?

A: The FRC still requires audit partners to rotate off a listed client after five years, but they have extended this to other partners auditing material subsidiaries within the group. Both categories of partner are also prohibited, for a further five years, from re-engaging with the audit client.

A key point to note is that this requirement now extends to unlisted banks and insurance companies. Also, there will be no “grandfathering” or transition of this extension, so audit committees and audit firms will need to be mindful of how firms manage their audit partner succession planning.

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5 Paragraph 3, page 7, FRC Feedback Statement, April 2016

Non-Audit Services (NAS)

Q Has the FRC extended the EU’s list of NAS that you may not procure from your auditor? Has it provided a list of permissible NAS?

A: The answer to both questions is no. The FRC has adopted the EU’s list of prohibited NAS and it has not added further NAS to this list (although it has added further restrictions applicable to all UK audit clients on certain tax services). It has also adopted the derogation on valuation services and selected tax services, although it applies a much tougher standard under this derogation to determine which tax/valuation services may be permitted (see Appendix). In general these prohibitions go significantly further than prohibitions in the previous UK regime.

The FRC has largely repeated the EU legislation in its ES without providing any guidance as to how these restrictions or the derogation should be applied. This will inevitably lead to uncertainty for audit committees and audit firms as they try to implement these new restrictions. However, the FRC plans to issue guidance at some stage over the coming months through the establishment of a Technical Advisory Group.

Q Do the NAS restrictions for your auditor apply outside the EU?

A: Yes, the FRC’s ES will be extraterritorial on a worldwide basis unlike the EU legislation which is largely restricted to the EU. The FRC requires that the group auditor of a UK based PIE can only rely on the audits of those subsidiaries if the subsidiary auditors (that are part of the group auditor’s network) have complied with all of the ES, including the NAS prohibitions. If not, the group auditor has to undertake additional audit procedures in the non-UK location.

The FRC has stated that ‘investors strongly advocated that in a global network there is an expectation that an entity is being audited across the network under the standards applicable to the group auditor.’5 This will create significant challenges for audit firms as they enforce their global network to comply with the FRC ES. For committees of EU PIEs incorporated in the UK, they will need to approve NAS provided by the audit firm network to the parent and all of its subsidiaries worldwide.

Q Can audit firms be prevented from taking up appointments as auditor, if those firms provide prohibited NAS to you?

A: Yes. Previously the FRC allowed certain NAS (otherwise prohibited) to be completed if safeguards could be deployed. This no longer applies and all prohibited relationships, including NAS, will have to be terminated before the auditor accepts an appointment and commences audit activities. Although the onus here is on the audit firm to ensure it is independent when it accepts an appointment as an auditor, the audit committee still has a responsibility to review and monitor the external auditor’s independence and objectivity.

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Q Has the FRC changed the limit of the NAS fee cap?

A: No. The FRC is not reducing the level of the cap below 70% as set by the EU based on the average group audit fee paid in the last three years, but it has removed the requirement to reset the three-year calculation period if NAS are not provided in any year. Another major distinction from the EU is that the 70% cap will be based on permitted NAS provided by the auditor and its global network to the EU PIE and its worldwide subsidiaries.

Q Which permitted NAS are exempt from the cap because they are “required by law”?

A: The FRC exempts from the cap permitted NAS “required by law” which extends to services required under rules issued by a regulator using powers granted by legislation. These are exempt regardless of whether these NAS have to be delivered by the auditor.

This exempts from the fee cap services such as those required by the PRA or FCA (including UKLA’s Listing Rules). However, this will not apply to private reports traditionally prepared for a UK IPO or Class 1 transaction, such as a working capital report as there is no requirement in law or regulation for such a report.

Q How will your audit committee’s oversight of NAS, including the 70% cap, change?

A: The Revised Guidance on Audit Committees 2016 now encourages audit committees to pre-approve all permitted NAS provided by any part of the audit firm’s network on a case-by-case basis, unless “clearly trivial” and in compliance with the committee’s policy on NAS. We believe this will create an additional burden for committees which will no longer be able to rely on a NAS merely being in compliance with its policy on NAS.

It may also be difficult to distinguish between permitted and prohibited NAS, if some NAS are described differently when compared with the FRC’s list of prohibited NAS. In addition, permitted NAS required by law will have to be clearly identified and separated from those not required by law. The committee is also required to have a policy on the company’s use of NAS subject to the derogation.

Audit committees will also need to be alert to the application of the 70% cap on NAS fees. This may be particularly challenging for committees of UK incorporated group companies using a multitude of NAS from various parts of the audit firm’s international network. The cap applies to all NAS provided by the firm’s network to the group worldwide. Therefore the committee will need to be absolutely clear about which NAS the firm’s network provides to the group: when and where. It will also need to be clear about the anticipated fee for each individual NAS. Clearly the committee will require support from the auditor to do this.

The fee cap on the provision of permitted NAS

The FRC is not reducing the level of the cap below

70%as set by the EU

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Tax Services Q What are the restrictions on the provision of tax services?

A: The FRC’s list of prohibited services (including tax services) that may not be provided by an audit firm to its PIE audit clients are shown in the Appendix.

The FRC has adopted the derogation to permit certain otherwise prohibited tax services to PIEs. However, these services will only be permitted if (amongst other things) they have no direct effect, or would have an inconsequential effect, on the audited financial statements. The interpretation of these conditions remains one of the key areas of uncertainty but the FRC is expected to issue guidance on this over the coming months. Therefore, audit committees will need to pay particular attention to the current providers of tax services, in case such services are provided by the current auditor or by any firms in contention to become the PIE’s next auditor.

On other changes, which apply to all UK entities (not just PIEs), the FRC has indicated that its changes to the rules on tax advocacy are intended to extend the prohibition on “acting as an advocate” (on an item material to the financial statements) to certain dealings with HMRC and other Revenue authorities before a matter gets to a court or tribunal. However, further guidance is awaited from the FRC on this matter.

One last point regarding tax services is that the use of contingent fee arrangements will become prohibited for tax services provided by the auditor to listed entities (with a market cap greater than Euro 200 million) and their significant affiliates. Existing contingent fees that are already in place by 16 June 2016 appear to be unaffected without a time limit.

Q What are the restrictions on other NAS?

A: Another category of NAS (in addition to tax) that will become significantly restricted for audit firms to provide to PIE audit clients is transaction related advisory services. The FRC will prohibit any services linked to financing, capital structure and allocation and investment strategy. Because of the broad nature of this prohibition it is expected that activities typically falling within the term “transaction related advisory services” will be prohibited. However, due diligence services are expected to remain permitted. Again further guidance is expected from the FRC in this area.

Lastly, audit committees will need to be mindful of a new NAS prohibition that is primarily targeted at PIEs considering a change in their external auditor. Where an incoming auditor has performed any design or implementation services relating to the PIE’s financial reporting controls, procedures or systems in the 12 months prior to the period to be audited, the committee will be unable to appoint that auditor. This “cooling-in” restriction will be critical for committees to navigate when selecting a new auditor.

Other NAS

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ContactsHywel BallManaging Partner Assurance, UK and Ireland & UK Head of Audit +44 131 777 2318hball@uk.ey.com

Andrew WaltonHead of Markets Assurance+44 20 7951 4663awalton@uk.ey.com

Jason LesterHead of Tax+44 20 7951 0884jlester@uk.ey.com

Andrew HobbsPartner, Corporate Governance & Public Policy+44 20 7951 5485ahobbs@uk.ey.com

Want to Know More?If you have any questions, please speak with your usual EY contact or get in touch with one of us:

13EU game changer - June 2016

Appendix: Summary FRC NAS prohibitions for PIEsFinal Draft, Revised Ethical Standard 2016.5.167R An audit firm carrying out the statutory audit of a public interest entity, or any member of the network to which the audit firm belongs, shall not directly or indirectly provide to the audited entity, to its parent undertaking or to its controlled undertakings within the Union any prohibited non-audit services in:

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a the period between the beginning of the period audited and the issuing of the audit report; and

b the financial year immediately preceding the period referred to in point (a) in relation to the services listed in point (e) of the second subparagraph.

For these purposes, prohibited non-audit services shall mean:

a tax services relating to: i preparation of tax forms; ii payroll tax; iii customs duties; iv identification of public

subsidies and tax incentives unless support from the audit firm in respect of such services is required by law;

v support regarding tax inspections by tax authorities unless support from the audit firm in respect of such inspections is required by law;

vi calculation of direct and indirect tax and deferred tax;

vii provision of tax advice;

b services that involve playing any part in the management or decision-making of the audited entity;

c bookkeeping and preparing accounting records and financial statements;

d payroll services;

e designing and implementing internal control or risk management procedures related to the preparation and/or control of financial information or designing and implementing financial information technology systems;

f valuation services, including valuations performed in connection with actuarial services or litigation support services;

g legal services, with respect to: i the provision of general

counsel; ii negotiating on behalf of

the audited entity; and iii acting in an advocacy role in

the resolution of litigation;

h services related to the audited entity's internal audit function;

i services linked to the financing, capital structure and allocation, and investment strategy of the audited entity, except providing assurance services in relation to the financial statements, such as the issuing of comfort letters in connection with prospectuses issued by the audited entity;

j promoting, dealing in, or underwriting shares in the audited entity;

k human resources services, with respect to: management in a position to exert significant influence over the preparation of the accounting records or financial statements which are the subject of the statutory audit, where such services involve:

i searching for or seeking out candidates for such position; or

ii undertaking reference checks of candidates for such positions;

iii structuring the organisation design; and

iv cost control. [AR 5.1]

5.168R By way of derogation from the second subparagraph of paragraph 5.167R, the services referred to in points (a)(i), (a)(iv) to (a)(vii) and (f), may be provided if the following requirements are complied with:

a they have no direct or, in the view of an objective, reasonable and informed third party, would have an inconsequential effect, separately or in the aggregate on the audited financial statements;

b the estimation of the effect on the audited financial statements is comprehensively documented and explained in the additional report to the audit committee;

c the principles of independence laid down in Section 1 of this Ethical Standard are complied with;

d for the purposes of the statutory audit of the financial statements, the audit firm would not place significant reliance on the work performed by the audit firm in performing these services.

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