European Union: Statutory Audit Directive – Impact On Investment Funds

Last Updated: 27 April 2016
Article by Kevin Murphy, Sarah Cunniff, Dara Harrington and Adrian Mulryan

On 17 December 2013, the European Parliament and the Member States reached a preliminary agreement on the proposal for a Directive amending the Statutory Audit Directive (Directive 2006/43/EC) and the proposal for a regulation on specific requirements regarding statutory audit of public-interest entities (the "Regulation"). The publication of the amending Directive and the new Regulation on Statutory Audit in the Official Journal of the EU took place on 27 May 2014 (OJ L 158). The Regulation came into effect immediately although there is a two year delay in the application of most of its provisions. Transposition of the Directive into Irish law must take place by 17 June 2016.

OVERVIEW

Proposed amendments to the Statutory Audit Directive aimed at reforming the audit market within the EU may have implications for any EU domiciled investment funds and specialist debt instruments which are listed on a regulated market, such as the Irish Stock Exchange. The proposals feature a number of proposed changes including:

  • a requirement for the rotation of auditors after a period of ten years;
  • a limitation on audit firms providing non-audit services such as tax, consultancy or advisory to their listed clients;
  • a limitation on fees of auditors for non-audit services in specific circumstances.

WHY REFORM THE RULES GOVERNING STATUTORY AUDIT?

Statutory audits contribute to the orderly functioning of markets by improving the integrity and efficiency of financial statements. The new rules address a number of shortcomings observed on the audit market:

  • Deficiencies, and in some instances misstatements, have been observed in audit reports by Member States' competent authorities.
  • An excessive familiarity between the management of a company and its audit firm, risks of conflicts of interest, and threats to the independence of statutory auditors can challenge the ability of statutory auditors to exert thorough professional scepticism.
  • A lack of choice of audit firms emanating from high concentration levels in the top-end of the audit market leading to possible systemic risk as the audit market is effectively dominated at the top end by four networks.

IMPACTS ENTITIES CLASSIFIED AS PUBLIC INTEREST ENTITIES ("PIE") IN EU LEGISLATION

The Statutory Audit Directive targets the audit process for all public interest entities in the EU. These entities include:

  • All entities that are both governed by the law of a Member State and listed on a regulated market;
  • All credit institutions in the EU, irrespective of whether listed or not;
  • All insurance undertakings in the EU, regardless of whether they are listed or not and regardless of whether they are life, non-life, insurance or reinsurance undertakings; and
  • Entities designated by Member States as public-interest entities, for instance undertakings that are of significant public relevance because of the nature of their business, their size, or number of employees.

WHAT WILL CHANGE: KEY MEASURES

I. Enhanced information to investors

The primary objective of the reform is to increase the quality of statutory audit. This means both enhancing statutory auditors' independence and providing investors and shareholders of audited entities with better and more detailed information via the audit report.

For instance, in the case of a PIE audit, the Regulation introduces a requirement for statutory auditors auditing PIEs to report on key areas of risk of material misstatement of the annual or consolidated financial statements. In addition, statutory auditors will need to explain to what extent the statutory audit was considered capable of detecting irregularities, including fraud.

The reform aims to help reduce the 'expectation gap' that often exists between the perceptions of what auditors should be delivering and what they are bound to deliver.

II. Statutory audit of PIEs: Mandatory rotation of statutory auditors

There are obvious risks for PIEs in having the same statutory auditors or audit firms. A long professional relationship may undermine the statutory auditor's independence and negatively impact on its professional scepticism. Rotation of the key audit partner within an audit firm is insufficient because the main focus of the audit firm remains client retention. A new partner would be under pressure to retain a long-standing client of the firm.

Following the entry into force of the new rules, PIEs will be required to change their statutory auditors or their audit firms every 10 years as a maximum. The duration of the audit engagement shall be calculated as from the date of the first financial year covered in the audit engagement letter.

Member States, however, can establish shorter rotation periods (e.g. a maximum of seven or eight years). In addition, Member States can allow PIEs to extend the audit engagement: i) by an additional 10 years upon tender; or ii) by an additional 14 years in the case of joint audit.

III. Statutory audit of PIEs: Prohibition of certain non-audit services to audited PIEs

The objective of the reform is to ensure that statutory auditors and audit firms enjoy conditions of independence to perform their primary 'societal' role: statutory audit. When auditing PIEs, the provision of certain services other than audit (non-audit services) involve an inherent threat to their independence and may substantially increase the risks of conflicts of interest for statutory auditors and audit firms.

As a result, the Regulation introduces a list of non-audit services that statutory auditors and audit firms will not be able to provide to the audited entity, to its parent undertaking and to its controlled undertakings within the European Union (the so-called 'black list'), in order to avoid situations where the independence of statutory auditors or audit firms could be compromised.

Examples of services covered by the 'black list' include:

  • Specific tax, consultancy, and advisory services to the audited entity;
  • Services that involve playing any part in the management or decision-making of the audited entity; and
  • Services linked to the financing, capital structure and allocation, and investment strategy of the audited entity.

Member States can chose to derogate from the list of prohibited non-audit services to provide certain tax and valuation services when these services are immaterial or have no direct effect, separately or in aggregate, on the audited financial statements. Member States also have the possibility of prohibiting more non-audit services than those in the 'black list'.

Apart from the non-audit services listed in the Regulation, and where Member States have not adopted more stringent provisions, statutory auditors and audit firms can provide services other than audit to the PIEs they audit.

IV. Structure of fees received from PIEs

The Regulation establishes that when a statutory auditor or an audit firm has been providing non-audit services to the audited PIE for a period of three or more consecutive financial years, the total fees for such services shall be limited to a maximum of 70% of the average of the fees paid in the last three consecutive financial years for the statutory audit(s) of the audited entity and, where applicable, of its parent undertaking, of its controlled undertakings and of the consolidated financial statements of that group of undertakings.

All calculations for the cap need to be done at group level – i.e. they need to take into account not only the audited entity but also, where applicable, its parent undertaking, its controlled undertakings and the consolidated financial statements of that group of undertakings.

There is no fixed limit with regard to the amount of fees that a statutory auditor or an audit firm can receive from a given audited PIE. However, there is a percentage limit to prevent the statutory auditor or audit firm from becoming too dependent on a given audited PIE.

Thus, when the total fees received - both for audit and non-audit services - by a statutory auditor or an audit firm from a single PIE in each of the last three consecutive years exceed 15% of the total fee income received by that statutory auditor or audit firm, that fact should be disclosed to the PIE's audit committee. The audit committee should then consider submitting the audit engagement to a quality control review. If the fees received continue to exceed 15%, the audit committee should also consider whether the audit engagement should be kept; if so, the audit engagement can remain in place, but for a period no longer than 2 years.

CONCLUSION

The impact on listed Irish funds is considerable as they will have to consider not only audit rotation but also the extent of non-audit work which may be carried out by audit firms (e.g. tax advice). We expect final Irish rules to be issued imminently which will be applicable for accounting periods beginning on or after 17 June 2016 as per the timeline attached as Annex A.

To view the full article please click here.

This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.

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