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How finance teams should prepare for new EU audit reforms

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JUNE is to be a watershed time for audit.

EU audit reform is to kick in on 17 June, and will have a impact on 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.

In the UK, the regulations will be operated on a comply-or-explain basis among public interest entities (PIEs) – defined by the EU as “all entities that are both governed by the law of a member state and listed on a regulated market”.

Under the EU’s audit directive and regulation, PIEs are compelled to put their audits up for grabs every decade and swap auditors every 20 years, in addition to limiting the level of non-audit fees. It’s a move intended to open the FTSE 350 market up to more audit firms such as Grant Thornton and BDO.

audit 1Woefully unprepared 

However, around a fifth of FTSE 350 companies are “woefully unprepared” for the EU’s audit reforms set to take effect in June, according to research from Big Four firm EY.

EY’s survey of 100 CFOs, tax directors and audit committee chairs found that 19% of respondents were unaware their company needed to tender or rotate its audit. And of those that did, almost half hadn’t yet put a strategic plan in place.

Approximately 28% of firms said they also lacked full understanding of the proposed restrictions on non-audit services, with a handful (7%) stating they had no knowledge of the changes at all.

While 61% of those surveyed said they are planning to invite tenders from at least one non-Big Four firm, intentions aren’t necessarily becoming a reality. In the last six months there have been 25 audit tenders completed by FTSE 350 companies, but none have been awarded to a non-Big Four firm.

“As expected, some companies have been moving ahead of the regulations, with over half of the FTSE 100 having tendered their audit since the spectre of the regulations loomed,” Ball said. “But we haven’t seen the same level of preparation among the rest of the FTSE 350, with less than a quarter having tendered so far.

“This was never going to be a cost-free exercise. Choosing an auditor and managing the mix of non-audit services is one of the biggest procurement decisions a company has to make. It requires a major time investment when going through the tender process and then bringing the new team up to speed, all of which carries an internal cost to the company.”

audit 2In March, Ball told sister title Accountancy Age that mandatory rotation could “further entrench” the Big Four’s market position, and even see them encroach on traditional non-Big Four market space. However, several non-Big Four audit partners disputed his assessment, suggesting it could take as long as ten years to see the fruits of the regulation.

Flybe non-executive chairman and audit committee chairman at Quintain Estates & Development Simon Laffin agrees with Ball’s forecast for the audit market, but he is less than convinced by EY’s numbers on the FTSE’s preparedness.

“Doing an audit tender is a pain in the butt, but it’s not going to be the biggest issue a board’s going to face in a year,” Laffin explains. “My experience is your auditor, when you have an audit, will pass comment on when you need to have an audit tender. Your auditor will tell you, so every company will know. We’re talking about professional companies and I bet all the finance directors know.”

audit 4Audit restrictions 

For finance directors and their teams, though, there is a smorgasbord of elements to consider in the run-up to 17 June.

In addition to simply working out if a tender is due, there is the potential for conflicts of interest to consider, and whom is preferred for non-audit services given the strategic implications of those decisions.

“The biggest decision they have to make is who they want to be their advisers,” says ICAS director of technical policy James Barbour. “They may have someone doing their external audit, they may need someone to do their internal audit if they don’t have their own internal audit team. Then you have the tax advisers as well. We still don’t have absolute clarity in what is tax advice in relation to the prohibitions – there are still some uncertainties out there. If they decide their number one priority is their tax adviser, that may restrict who their auditor could be.”

In many cases, Simon Laffin says, those considerations are likely to still lead to a Big Four auditor, particularly for FTSE 350 businesses with multinational operations – simply because other firms don’t have the coverage overseas.

Practical considerations such as these could well distort the application of the reforms, he adds.

“They [the EU and regulators] thought having more frequent tenders would reduce the dominance of the Big Four. I think in fact the opposite is going to happen,” Laffin explains. “One of the figures that came out [of EY’s report] is that 39% of companies said they wouldn’t invite a non-Big Four [to tender]. Some of the non-Big Four don’t have the international coverage required. If you’re a big multinational company in a lot of different companies, you don’t want to be going to somebody who doesn’t have coverage in Namibia, so you’ll be drawn to the Big Four.”

Despite that stark warning, ICAS’s James Barbour does see room for firms “outside the Big Four”.

“It should lead to more [non-Big Four firms] getting more non-audit work,” he says. “Once they have their foot in the door with the non-audit work, that then increases the likelihood that at a future tender they’re a more likely candidate to get the appointment as external auditor.”

Branching out

audit 3That could particularly be the case if the Big Four’s expansion into other areas continues. Simon Laffin believes this point has largely gone unrecognised by both the market and the regulators.

He says: “There’s a growing problem as well that I don’t think the regulators have even thought about: some of these audit firms are actually competitors to the company. Nobody’s ever conceived that an auditor can be a competitor to the company it’s auditing, but it’s happening. It’s happening because the audit firms are branching out – into management consultancy, into data analysis, into IT implementation. Do you want a representative of one of your competitors crawling all over your business? Even if there’s a Chinese wall, we all know they’re paper thin and they’ll give you no guarantees that an auditor won’t emerge in another part of their business.

“I think one of the issues we’re going to face is companies scratching their heads as to who on Earth to invite as a serious competitor to the incumbent.”

It’s a situation that was illustrated in April when Deloitte divested the transactional side of its real estate arm in order to prevent conflicts with its audit team. The US Securities and Exchange Commission governing the independence of auditors had stymied potential business for the real estate team, while it also fell foul of caps on fees to auditors for non-audit services.

Property agents Knight Frank, Gerald Eve and Savills have all acquired portions of the team which was set up in 2010.

“When you stop audit firms doing non-audit work, I think people thought audit firms would sell their management consultancies and slim down to just being audit companies,” Laffin adds. “In a way that’s logical, but it also shows the naivety of the regulators, because if someone said to you in your business ‘we’re going to start chopping your main business down because we’re going to stop people using some of your peripheral businesses’, you don’t react by retrenching – you react by finding other things to diversify into. And anything an audit firm diversifies into drags it into competition with potential clients.”

While further signs of Laffin’s concerns over potential conflicts are yet to be borne out, ICAS’s James Barbour does highlight that the timescale at play is lengthy – between ten and 20 years – before we can say with any certainty whether the reform has been a success.

“We need to wait and see how things will pan out,” he says, “You could end up with a situation where if someone’s been appointed for the first time – barring anything unexpected, that firm will be there for ten years, and they’ll tender after ten years. What we don’t know is how audit committees will look at this in ten years’ time. Will the say ‘things have changed and the economy is now better. I would quite happy to appoint the same firm for another ten years’. That could be 20 years before we have another change. That’s where we’re looking before we get any potential change.”

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Jimmy Eyerman...Chief Financial Officer, EDM Group, USA