New EU regulatory regime on statutory audit in force 17 June 2016

Background

An EU directive amending the Statutory Audit Directive (the Amending Directive) came into force on 16 June 2014 and had to be implemented into national law by 17 June 2016. The Amending Directive applies to all audits required by EU law.

The Amending Directive was published in conjunction with a new regulation (the Audit Regulation) which governs the statutory audit of “Public Interest Entities” (PIEs.) PIEs are companies with a significant public interest, including companies admitted to trading on a regulated market (such as the Main Market of the London Stock Exchange), credit institutions and insurance undertakings. The Audit Regulation is directly applicable and also applies in Member States from 17 June 2016.

Both the Amending Directive and the Audit Regulation provide options to Member States in relation to certain aspects of the new legislation. As such, the Department for Business, Innovation & Skills (BIS) and the Financial Reporting Council (FRC), amongst others, published a number of discussion and consultation papers seeking views on implementation of the mandatory requirements and also on which of the optional requirements should be introduced.

During these consultations, BIS published the Statutory Auditors and Third Country Auditors Regulations 2016 (the SATCA Regulations). The SATCA Regulations implement the Amending Directive and make the necessary legislative provisions to apply the Audit Regulation in the UK. They were made on 15 June 2016 and came into force on 17 June 2016. They amend a number of legislative provisions, including the Companies Act 2006 (CA 2006), the Companies (Audit, Investigations and Community Enterprise) Act 2000 and the Statutory Auditors and Third Country Auditors Regulations 2014.

In addition to the SATCA Regulations, the implementation of the new audit regime is supported by a number of other publications, including the FRC’s ethical and auditing standards, changes to its UK Corporate Governance Code (effective for financial reporting periods beginning on or after 17 June 2016) and its Guidance on Audit Committees. Guidance on audit requirements is also available from Companies House.

The European Commission has also published a series of non-binding questions and answers on the implementation of the new audit framework. The latest questions were published on 31 May 2016 and supplement those published in September 2014 and February 2016.

For further information on the new statutory regime and the implementation process in the UK, see “Reform of EU statutory audit market: Amending directive and Regulation come into force,” “FRC and BIS consult on EU audit reform” and “BIS consults on implementation of EU audit reform.”

Main features of the reform

Definition of PIE and changes to scope of Part 42 CA 2006

The SATCA Regulations insert the following new definition of a PIE into the CA 2006:

• an issuer whose transferable securities are admitted to trading on a regulated market
• a credit institution within the meaning given by Article 4(1)(1) of Regulation (EU) No. 575/2013 (other than one listed in Article 2 of Directive 2013/36/EU), or
• an insurance undertaking within the meaning given by Article 2(1) of Directive 1991/674/EEC.

The Government decided not to extend the definition of a PIE (under the power set out in the Statutory Audit Directive) and, therefore, companies traded on AIM will not fall within the definition of a PIE (as AIM is not a regulated market.)

The SATCA Regulations also insert a new definition of “public interest company” into the CA 2006 using the same definition as for a PIE. “Public interest company” is used in the CA 2006 in a number of circumstances, including in relation to mandatory auditor rotation, retendering for PIE audits and allowing shareholders to secure the removal of the auditor of a PIE.

The Statutory Audit Directive was originally implemented in 2006 into Part 42 CA 2006 (Statutory Auditors.) The SATCA Regulations have now amended Part 42 to reflect the fact that the amended Statutory Audit Directive will apply, for the first time, to all entities whose accounts are currently required to be audited under EU law (as opposed to those required to be audited in 2006.) The scope of Part 42 has, therefore, been extended to include entities whose securities are admitted to trading on a regulated market (other than companies and other entities already covered), electronic money institutions, payment institutions, MiFiD investment firms, Undertakings for Collective Investment Transferable Securities and Alternative Investment Funds.

The Amending Directive has also removed the option to exclude non-listed entities from the requirements that applied to PIEs under the Statutory Audit Directive. As a result, unlisted insurers and unlisted banks and building societies will have to have an audit committee and, auditors of unlisted banks and insurers will need to comply with more stringent ethical standards of independence and objectivity.

Single competent authority

The Audit Regulation and Amending Directive set out a regime where the Government must either be or must designate a “single competent authority” with ultimate responsibility for all the regulatory tasks provided for in the Statutory Audit Directive (as amended.)

Under the SATCA Regulations, the FRC is designated as the UK’s competent authority. It continues to be the standard setting body for auditors and will conduct inspections, investigations and disciplinary cases in relation to the audits of PIEs. The FRC may delegate tasks to recognised supervisory bodies (such as the Institute of Chartered Accountants in England and Wales).

Appointment of auditors to PIEs

The SATCA Regulations insert new sections into the CA 2006 to require additional procedures for the appointment of auditors to PIEs.

Subject to specified exceptions, where a PIE (whether private or public) has an audit committee, that audit committee or the directors of the PIE must carry out a selection process in accordance with Article 16(3) of the Audit Regulation. This selection process involves putting the auditor position out to tender. Following this selection process, the audit committee should then recommend its top two choices of auditor to the directors (and also state that its recommendation is free from third party influence and that there is no contractual restriction on the choice of auditor.) The directors should then make their own proposal for appointment of an auditor and if the directors do not agree with the audit committee’s recommendations, the directors must state their reasons for this disagreement.

The selection procedure under the Audit Regulation and the statement of matters in the audit committee’s recommendation are not required if the appointment is for a financial year beginning in a transitional period or a specified selection procedure has been carried out in the past ten years.

For PIEs without an audit committee, the directors must, subject to specified exceptions, carry out a selection procedure in accordance with Article 16(3) of the Audit Regulation before proposing an auditor for appointment. Again, this procedure will not be required if the appointment is for a financial year that begins in a transitional period or if a specified selection procedure has been carried out in the past ten years.

Restrictions on choice of auditor

The SATCA Regulations (regulation 12) state that any contractual clause that restricts an entity’s choice of statutory auditor will have no legal effect. This regulation does not apply to PIEs, however, as the equivalent provision in the Audit Regulation (Article 16(6)) will be directly applicable to PIEs and does not take effect until 17 June 2017.

As referred to above, from 17 June 2016, an audit committee of a PIE is required (under the Audit Regulation and new sections 485A(5)(c)(ii) and 489A(5)(c)(ii) CA 2006) to state that its recommendation of a particular auditor is free from influence and that no such contractual clause has been imposed on it. This means that, in practice, the prohibition on such contractual clauses will also apply to PIEs from 17 June 2016 despite the later effective date of the relevant provision in the Audit Regulation.

Tendering and duration of audit engagements for PIEs

The SATCA Regulations insert new provisions into the CA 2006 (ss 487(1A) - (1D) and 491(1A)-(1D)) to set the maximum term of office for the auditor of a PIE.

Subject to the FRC’s ability to extend the maximum engagement period by two years in exceptional circumstances and subject to various transitional provisions, the maximum engagement period is, broadly, the longest of:

• the period of ten years beginning with the first day of the first financial year in respect of which the auditor was appointed
• the period of twenty years beginning with the first day of the first financial year in respect of which the auditor was appointed, provided that specified selection procedure provisions are satisfied for at least one financial year which begins every ten years in that period, or
• such other period of no more than twenty years beginning with the first day of the first financial year in respect of which the auditor was appointed and ending on the last day of the relevant ten year period.

The practical effect of these provisions is that PIEs must retender their audit engagement at least every ten years, with any one auditor being able to hold office for no more than 20 years (subject to the FRC granting up to a further two years in exceptional circumstances.)

Once the maximum duration of an engagement has expired, the auditor or any member of their EU network, will not be allowed to undertake the statutory audit of the same PIE within the following four years (ss 487(1E) and 491(1E) CA 2006).

Removal of auditors of PIEs

New section 511A CA 2006 provides that specified persons may apply to court for an order removing an auditor of a PIE from office if there are proper grounds for that removal. An application may be made by the FRC (as the competent authority) and by shareholders representing at least 5% of the company’s voting rights or nominal value.

The CA 2006 does not prescribe what may constitute “proper” grounds for dismissal other than to state that divergence of opinion on accounting treatments or audit procedures will not constitute “proper grounds.”

The CA 2006 has always provided for the removal of an auditor of any company by ordinary resolution and this option remains unchanged.

Prohibition of certain non-audit services to PIEs and cap on fees for those services

The Audit Regulation introduces a list of non-audit services that statutory auditors and audit firms will not be able to provide to the audited entity where that entity is a PIE. The auditor will also be prohibited from providing those non-audit services to the PIE’s parent undertaking and to its controlled undertakings within the EU. Prohibited services include:

• specific tax, consultancy and advisory services
• 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 investment strategy of the audited entity.

The Audit Regulation’s provisions on non-audit services are set out in the FRC’s revised Ethical Standard, published in June 2016. The revised Ethical Standard applies to accounting periods beginning on or after 17 June 2016 and it consolidates the Auditing Practices Board’s five Ethical Standards for Auditors and the Ethical Standard for Reporting Accountants. When setting out the list of prohibited services, the FRC did not make additions to the EU’s own list of prohibited services (as it had the option to do) and also did not adopt a “white list” of approved non-audit services. Auditors may continue to provide non-prohibited services to PIEs provided that the provision of those services does not create a threat to the integrity, objectivity or independence of an audit.

The Audit Regulation introduces a cap on fees for non-audit services provided to PIEs and provision has also been made for this in the FRC’s revised Ethical Standard. When a statutory auditor or an audit firm has been providing non audit services to an audited PIE (or another entity in its group), the total fees for those services must not exceed 70% of the average fees paid over the last three consecutive financial years for the audits of the audited entity, its controlled undertakings and the consolidated accounts of that group.

Miscellaneous amendments

Minor changes have been made to the UK Corporate Governance Code (the Code) to implement the requirements of the Amending Directive and the Audit Regulation. The changes take effect for financial periods commencing on or after 17 June 2016. Changes include the following:

• Provision C.3.1 has been amended to require the audit committee to have competence relative to the sector in which it operates. The FRC decided not to change the provision requiring the audit committee to have “competence in accounting and/or auditing” and has retained the requirement for at least one member of the audit committee to have “recent and relevant financial experience.”
• Provision C.3.8 has been amended to provide that the annual report should include advance notice of any external auditor retendering plans.

A summary of the differences between the 2014 and 2016 editions of the Code is set out in the Appendix to the FRC’s Feedback statement to its consultation on “Enhancing Confidence in Audit: Proposed Revisions to the Ethical Standard, Auditing Standards, UK Corporate Governance Code and Guidance on Audit Committees."

Changes have also been made to both the FRC’s Guidance for Audit Committees (to reflect changes to the Code and developments and good practice in relation to risk management and internal audit) and also to its Auditing Standards to accommodate the Audit Regulation and recent changes made by the International Auditing and Assurance Standards Board.

Amendments have been made to the Disclosure Rules and Transparency Rules Sourcebook (DTR 7.1) for financial years beginning on or after 17 June 2016 to take account of the new regulatory regime. These changes include:

• extending the independence requirement from at least one member of the audit committee to a majority of the members of the relevant body
• requiring the members of the audit committee as a whole to have competence relevant to the sector in which the issuer is operating, and
• amending the responsibilities of the audit committee to reflect the amended scope of responsibilities under the Amending Directive.