At the end of last month, 200-year old asset manager Schroders ended its 57-year relationship with its auditor PwC. The move was widely seen as preparation for new EU-wide auditor rotation rules that will come into force on 17 June this year— rules based on an EU directive that was originally published in May 2014, following a series of meetings and endorsements by the EU parliament that began in December 2013.
The impetus behind the redrafting of EU audit regulations was the string of deficiencies in financial accounts, and in some instances misstatements, as well as doubts among investors regarding the credibility and reliability of audited financial statements that were highlighted by the financial crisis. An excessive familiarity between the management of a company and its audit firm was seen as presenting the risk of conflicts of interest. Finally, there were concerns of a systemic risk, because the audit market was effectively dominated by just four audit firms.
The Audit Regulation and Directive introduces mandatory audit firm rotation and retendering for “public interest entities” (PIEs). PIEs are defined as listed companies, credit institutions, and insurance undertakings. In addition, Member States can designate as PIEs other undertakings that are of significant public relevance, because of the nature of their business, their size, or the number of their employees.
In the United Kingdom, the new rotation requirements replace the Financial Reporting Council’s (FRC’s) U.K. Corporate Governance Code provision that requires FTSE 350 companies to put their audit out to tender at least every ten years. Companies had to either comply or explain their lack of compliance. PIEs will be required to appoint a new audit firm at least every ten years. However, EU member states have the option to extend the audit engagement period to 20 years as long as the contract is put out to tender at least every ten years. The United Kingdom intends to take up this option.
In addition to mandatory rotation rules, the Directive increases prohibitions on the types of non-audit services auditors can provide. These prohibitions will, for example, end the provision of payroll services, corporate finance mandates and, in most cases, tax services by statutory auditors. The Directive also places a cap on fees from non-audit services. For example, the FRC in the United Kingdom is implementing a cap on non-audit service fees of 70 percent of the average audit fees paid over the previous three years.
Clearly these mandatory rotation rules will have a tumultuous effect on the EU’s audit market. Figures from EY indicate that 26 percent of companies have had the same provider for 10 to 20 years, indicating that such audits must either be put out to tender or a new auditor hired. Only one—Deloitte—of the big four audit firms, EY, PwC, Deloitte, and KPMG, would field anyone to speak to Compliance Week about how they would handle the end of such long-term relationships, though clearly the firms are readying themselves for significant change.
Stephen Griggs, managing partner for audit at Deloitte, said: “We’ve already seen a lot of tendering activity amongst FTSE 350 companies, as a result of the Competition and Markets Authority’s requirements and changes to the Corporate Governance Code, but this will be new territory for other listed companies and unlisted banks and insurers. Nearly half of the FTSE100 have tendered so far, around a quarter of which were our audit clients. Of Deloitte’s FTSE 100 audit clients that have yet to tender, nine have been clients for 10 years or more, two of which we’ve audited for over 20 years. Long-term auditor relationships are not the norm.” Asked about how a partner would handle the end of a long-standing client relationship, Griggs commented: “Partners of listed company audits have to rotate off an audit after five years, so it is a normal part of life. When an audit changes from one firm to another, this can affect the whole team. However, the firms are used to transitioning from one to another, with a well-trodden path in place for handling audit team changes. For example, an incumbent auditor can shadow the existing audit team and attend key meetings to make sure the transitions are as smooth as possible.”
To prepare its clients for the changes, EY commissioned FT Remark to survey 100 senior-level executives and non-executives in the FTSE 350 to gauge opinions on and preparations for the new rules. The results of the survey were published last week. The survey found that while a majority, 83 percent, understands the rotation rules, only 42 percent have a plan in place. There is less understanding of the rules pertaining to service prohibition and non-audit fee caps. Only just over a quarter of individuals were negative about the changes, while almost half were either positive or very positive, with most seeing benefits from fresh insights into the business and improved investor sentiment from hiring a new auditor.
Most companies will be inviting between three and four audit firms to tender, and more than four-fifths will be involving investors in this process, although almost 90 percent say the audit committee chair will have the most influence on the final decision. On investor involvement, Griggs noted: “We are seeing more evidence that companies are talking to investors about auditor appointments during conversations about the business and governance arrangements. Within these conversations, they may discuss when to tender and why, and which firms will be invited to pitch. This is a welcome move as investors are essentially the owners of the business and it’s healthy they’re interested in ensuring quality audits.”
All of the respondents to the EY survey said they purchase non-audit services from their auditors, so the new prohibitions are going to have an effect, as at the same time as tendering for a new auditor, companies also have to tender for non-audit services. Griggs felt that the restrictions on non-audit services would be unlikely to have a major effect, however: “There are already restrictions on the non-audit services (NAS) an auditor can provide to its audit clients,” he said. “As a result, Deloitte does not generate a significant amount of NAS revenue from its audit clients. The new EU rules will undoubtedly result in a reduction in the services that public interest entities will seek to commission from their auditors. However, there will still be permissible services that the auditor is best-placed to provide and the new rules allow for that.”
As a corollary to the rotations, almost two thirds of those surveyed said the rules have increased their choice of provider. This level of change will also, undoubtedly, open up the field to many small- to medium-sized audit firms, as was intended. But Griggs felt that the new rules would not result in a diminution of work for the major audit firms: “These are business opportunities. The market is still the same size, with companies spending about the same amount as before. If a company cannot use its auditor for specific services, due to regulatory restrictions, they will seek other firms to do the NAS work.”
According to KPMG, only three EU countries have finalised their implementation of the directive—Spain, Portugal, and Slovakia. Portugal’s implementation requires auditor rotation every eight or nine years, for example, while Spain and Slovakia have implemented rules closer to the directive. In the United Kingdom, the FRC has issued a consultation paper on its proposed changes to bring its own rules in line with the directive. The deadline for responses is 4th May 2016 and these can be sent to firstname.lastname@example.org.