Undoubtedly, the changes coming out of the new legislation, commonly referred to as the EU Audit Reform, are significant to all public interest entities (PIEs).

Although the reforms will only become applicable on June 17, 2016, we are already experiencing an increase in tenders and consequential changes in auditors, even for non- PIEs operating across borders, as best practice. The key aspects of the legislation affect mandatory firm rotation, non-audit services and audit committees.

The state of the proceedings and the further legislative steps are summarised in the graphic.

KPMG’s view remains that any measures should have a clear and unequivocal benefit to audit quality; provide for a robust framework for auditor independence; and strengthen corporate governance.

We continue to believe, however, that other aspects of the legislation, such as mandatory firm rotation, combined with significant restrictions on non-audit services, will inevitably reduce choice for shareholders, while increasing costs to business.

One of the main driving forces of the reform is that of restoring investors’ confidence through improved audit quality. The legislation addresses the need for more detailed and informative audit reports (based on the requirements of International Standards on Auditing) and includes a series of requirements designed to enhance investors’ understanding of the audit process, including the critical judgements made during the course of the audit. From the UK’s experience, expanded auditors’ reports introduced in 2013 have received positive feedback, indicating that users value the insights provided. Coupled with this is the requirement for increased communication between auditors and audit committees, with more detailed information on the results and conclusions of the audit process. In fact, the regulation provides a detailed list of what auditors are required to report in writing to audit committees and includes, amongst others, identification of key partners involved in the audit (already a requirement under Malta legislation), the extent of involvement of external experts and their independence, quantitative and qualitative factors in determining materiality levels and reporting on valuation methods.

Communication with those charged with governance only serves its purpose if external auditors (and the key audit partner in particular) divorce the business and personal relationships which inevitably develop over time, in remaining objective and independent.

Audit firms practise a partner rotation policy on a periodical basis in managing long-term audit client relationships, demonstrating independence and bringing in fresh perspectives. The EU now further imposes mandatory firm rotation to break off a perception that has been described as ‘cosy’ and excessive familiarity between companies and their auditors, despite partner rotation policies in place.

Companies defined as PIEs will, under the baseline requirements, be required to rotate their auditor at least every 10 years.

In further safeguarding auditor independence, the new rules include a strict ‘black list’ of non-audit services which prohibits the company’s independent auditor from providing several services, including tax advisory services that directly affect the company’s financial statements or services linked to the client’s financial and investment strategy. Furthermore, all permissible non-audit services provided by the auditors will be capped to no more than 70 per cent of the average statutory audit fees paid over the preceding three consecutive financial years.

Audit committees have been assigned expanded roles and entrusted with the explicit responsibility of the audit tender process. Such increased responsibilities will necessitate a heavier demand for experienced professionals who are able to challenge internal processes and ensure that auditors remain independent of those processes, besides having a more-than-average knowledge of the selection and application of key accounting policies which require the exercise of professional judgement in an ever-increasing complex financial and reporting framework.

Against this backdrop, we believe it is time for the market to question the adequacy of the remuneration of key audit committee members with such specialist knowledge and, equally important, the extent of the time they contribute to the role, if they are to be effective.

They are further required to recommend at least two options for auditor selection with a justified case for one of them. In identifying a legitimate auditor, audit committees of companies operating in more than one EU member state would need to be up to speed with the different options individual states may decide to adopt. Audit committees will also need to be acutely aware of new restrictions on the additional services that can be provided by the selected audit firm. This will affect an audit committee’s policy on non-audit services and their pre-approval. Companies are increasingly becoming aware of the efforts required in the tendering process, which can be an expensive and lengthy one.

Audit committee members have a crucial role in ensuring that mandatory firm rotation is not used abusively as a strategy for negotiating lower audit fees or to remove auditors when standing their ground with management, as this would undeniably have an adverse effect on quality, investor confidence and the auditing profession in general.

There are some other practical aspects which we see coming out of the implementation of the reform proposals. We expect the market to experience healthier competition among audit firms with more inclusion, also requiring audit firms to manage commercial decisions with respect to their preferred role with the client. In borderline cases, audit committees and statutory auditors might tend to err on the side of extra caution when taking decisions relating to the provision of non-audit services which may be perceived as tainting auditor independence.

Overall, the reforms will present a challenge to businesses, particularly the restrictions on non-audit services for those companies which have relied on their auditors to provide additional valued services.

Companies will need to balance their preference for an auditor with their preferred advisors in other areas. This is all the more challenging in a market of the size of Malta.

Hilary Galea Lauri is a partner within KPMG’s audit department.