The practical effects of EU audit reform – two years on

This update from BDO explains the significant changes of EU audit reform on the audit market across the social housing sector.

9 July 2018

For accounting periods ending on or after 17 June 2016, a change in ethical regime has been set in motion by EU audit reform. 

As changes bed down, there have been some significant consequences for the audit market across the social housing sector. 

Which entities are affected?

The introduction of a new ethical standard brought about by these reforms has had the most significant effect on those social housing groups that contain public interest entities. 

For the sector, this principally relates to those entities with securities (usually debt) listed on an EU-regulated market, such as the London Stock Exchange, and usually applies also to the groups they are part of. Groups are not shielded from the impact of ethical reform simply because the listed securities are held in isolation within a subsidiary.

So what has changed for the audit of public interest entities?

They key changes brought in by the ethical standard are outlined below. 

Mandatory auditor rotation

A mandatory rotation period for public interest entities of 20 years (limited to 10 years if no tender process has been undertaken within that timeframe). 
Cooling-off periods will also apply preventing auditors rotating in these circumstances from tendering again for a determinate number of years (usually five years).

Prohibitions on the provision of certain non-audit services and fee caps

While many audit-related non-audit services will be permitted, there are significant restrictions on the provision of other non-audit services. 

The general principles are that a non-audit service can only be provided where those services will not have a direct effect on the financial statements (or be clearly inconsequential) and the audit firm will not place significant reliance on the work performed by the firm in respect of those services.

Non-audit services that do not align with these principles will now be prohibited. Prohibited services will include:

  • most tax services (many of which will have been widely provided to social housing entities before reform came into effect, such as tax computations and tax advisory arrangements), unless the effect on the relevant financial statements is clearly inconsequential
  • internal audit services
  • provision of accounting advice
  • valuation services.

Even where non-audit services are permissible, the provision of such services is subject to a fee cap, which broadly equates to 70% of the average audit fee.

Non-audit services provided prior to appointment as auditor

No firm may now accept appointment as statutory auditor (and can therefore not tender) if it has provided prohibited non-audit services in the period to be audited or during the period the audit report is to be signed. Furthermore, an audit firm will be prevented from accepting appointment if it has provided non-audit services in relation to designing or implementing internal controls or risk management procedures over financial information in the year preceding the year to be audited – for example, internal audit.

How is this affecting the audit market in the social housing sector?

Entities operating in the sector are increasingly looking to the listing markets as a serious option to finance ambitious development programmes. Over recent years, a significant number of housing bodies have accessed finance in this way. This means many housing groups are subject to audit requirements relating to public interest entities.

At the same time, the legal and accounting requirements applicable to social housing organisations have become increasingly complex. This means the range of audit firms with the skills and experience of auditing social housing organisations and those firms with deep understanding of the regulatory burden experienced by public interest entities is becoming increasingly narrow.

Anecdotal evidence also suggests that many social housing organisations acquiring listed debt have limited appreciation of the significant effect this has on the audit firms operating in an environment of stringent oversight, monitoring and regulation that comes with working with listed entities. This has maintained a downward pressure on audit fees even though associated audit work may have significantly increased.

These factors may well have created a perfect storm in the sector, driving professional advisers who may traditionally have operated heavily in the audit space to focus more on non-audit service relationships with public interest housing entities – thus limiting the ability of those firms to tender for the audit service. This could reduce competition in the audit market and limit the number of firms putting themselves forward for audit opportunities.

What should boards and audit committees be doing?

EU audit reform was designed to foster audit relationships that are built on a foundation of clear and demonstrable independence, and to put audit committees at the heart of the relationship between housing bodies and audit firms. It was not intended to stifle competition in the audit market. 

While the changes are arguably a positive step in increasing stakeholder confidence in auditors, they will present challenges for boards and audit committees as well as those audit firms that have previously been able to offer non-audit services in ‘one-stop-shop’ style relationships.

For boards and audit committees of social housing bodies that do not hold listed securities but may be intending to or are considering the option, you should engage with your audit firms as you plan.

For boards and audit committees of organisations that already have securities listed on an EU regulated market you should ensure that:

  • You are familiar with the changes implemented by EU audit reform and build a general awareness of auditor independence, rotation limits and prohibitions on non-audit services.
  • You actively discuss the implications of any planned non-audit services on an existing audit relationship both internally and with your audit firms.
  • You challenge auditors on their own awareness of the requirements and ensure two-way dialogue on the threats to independence and whether safeguards employed are appropriate.
  • You consider developing and strengthening relationships with other professional advisers outside of your audit firm to ensure that an element of ‘choice’ is available.
  • You are prepared to engage with your auditors about limitations placed on non-audit services.

In all cases, boards and audit committees should ensure that consideration is given well in advance to limitations that auditor appointment will place on that firm to provide other non-audit services, and should ensure an appropriate planning exercise is carried out.  

This planning exercise could involve looking at planning audit tenders years into the future, carefully considering relationships with professional advisers (and how the audit committee may want or need those relationships to evolve in advance of a tender process), and considering the audit fees and whether fee levels encourage an open, fair and competitive tender process. 

In all cases, the issues are likely to be complex and will need careful monitoring. Closer engagement with your professional advisers is therefore essential.

For more details on this, please contact Will Jeffwitz