Brexit and audit: risk factors

When the transition period ended, the UK’s trade agreements also ended with non-EU countries with which the UK traded through EU trading agreements. The UK government is currently working to negotiate replacement trade agreements with non-EU countries (further information is available here on current agreements). However, in the absence of a replacement agreement, trade with other World Trade Organization (WTO) members will take place on WTO terms.

The UK government has published a transition hub providing guidance to businesses. This includes guidance for auditors and audit firms, as well as an interactive questionnaire for businesses and citizens to understand how they might be impacted.

Management will need to identify, assess, and respond to these changes and associated uncertainties for their businesses. Auditors will also need to identify, assess, and respond to Brexit-related risks to the extent that they have the potential to have a material effect on the financial statements.

Understanding Brexit risk factors is now particularly important considering the additional risk factors associated with COVID-19. Entities and auditors will need to analyse and understand the combined impact of these two significant economic events.

ISA 315 'Understanding the entity and its environment' requires auditors to undertake a risk assessment, which will be key to understanding the risks posed by Brexit and COVID-19.  While undertaking risk assessments, audit teams should consider:

• What are the potential risk factors arising from Brexit? 
• How significant is the risk of material misstatement associated with these risk factors?
• Are there any risks exacerbated by the dual impact of Brexit and COVID-19? 
• What audit procedures need to be performed to respond to the levels of risk identified?

We explore the following potential Brexit risk areas below: industry specific risks, entity specific risks, uncertainties in estimates and forecasts, and other practical risks. Further guidance on general ISA 315 risks can be found on the Audit and Assurance Faculty hub.

ISA 315 requires auditors to understand the entity and its environment, including industry, regulatory and other external factors. Understanding changes in the economic and business environment arising from Brexit will form a key part of this understanding.

The longer-term impact of Brexit on UK business is unclear and is likely to vary from entity to entity. While some industries and entities will face difficulties, others may benefit commercially. Certain industries are more likely to be impacted than others, for example, those with business models which rely on supply chains and customers located in the EU. Others may be indirectly impacted, for example, by knock-on delays in other industries and the general economic environment.  

When understanding the entity and its environment, auditors may find it useful to consider whether there are industry or sector specific risks applicable to the entity. Questions to consider include (but are not limited to): 

• Does the industry rely on fast turnaround of imports or exports, for example, those trading in perishable goods such as food or pharmaceuticals, or ‘trend’ items with rapid obsolescence, like clothing? Increased delays, for example due to customs compliance obligations at borders and ports could result in unsellable goods. The UK is phasing in full border controls for imports over a six-month period, which could ease some delays in the short term, although this may not be replicated in the EU.
• Does the industry rely solely on EU supply chains, or are alternative suppliers available domestically or internationally? Supply chains can impact many aspects of a business model, from bottlenecks in production to increased costs of meeting customs compliance obligations, such as Rules of Origin documentation. This could particularly impact business operating on a just-in-time basis. These risk factors are likely to be exacerbated by ongoing delays in global supply chains and bottlenecks at UK ports of entry.
• How dependent is the industry on wider supply chains based in countries with EU trade agreements? When the transition period ended, the UK’s trade agreements also ended with non-EU countries with which the UK traded through EU trading agreements. The UK government is currently working to negotiate replacement trade agreements with non-EU countries.
  
  Where the industry is largely reliant on supply chains from countries without EU trade agreements, for example, China and Australia, these may be less affected by Brexit-related risk factors. However, the wider supply chain should be considered, both for positive and negative impacts. 
• Does the industry rely on access agreements or licenses from the EU to operate or sell within the EU, for example, passporting arrangements for banks or rights to operate airlines between the UK/EU? Businesses will need to understand industry specific requirements to operate within EU territories. Some rights have been preserved, for example, traffic rights to fly to and from the UK and EU have been preserved. However, this is not the case for all industries.
  
  For example, the trade agreement does not include an equivalence agreement between the UK and the EU for financial services. Market access arrangements will be based on unilateral equivalence decisions by the UK and the EU. The UK and the EU have pledged to agree a Memorandum of Understanding by March 2021, setting out the framework for cooperation on financial service regulation.
  
  Auditors need to understand how the trade and cooperation agreement impacts the businesses they audit, as well as any local restrictions imposed by EU states the business operates in, and/or requirements affecting their ability to continue to operate. 

• Is the industry impacted by EU quotas, for example, fishing rights and aquaculture? Although the Brexit deal guarantees “zero tariff and zero quota” trade, there are some high-profile exceptions, mainly the rights for reduced rates of fishing by EU boats in UK waters. This will be phased in over a number of years.
• How reliant is the sector on tax, grant funding or other incentives from the EU? Some sectors, for example, biomedical research, rely significantly on EU grant funding and tax incentives for research and development. Understanding the impact of future funding plans may impact on the viability of such entities.
• Is the industry dependent on general economic well-being? Industries such as hospitality, travel, entertainment, and leisure tend to be impacted significantly by the general economy. Uncertainty over Brexit may impact the general economic environment combined with the impact of COVID-19, will likely lead to increased risks for such entities. These industries, for example, may be particularly affected by travel restrictions and if the UK is seen as a less desirable holiday destination for EU travellers. 
• Does the industry typically depend on tight cash flow management? Restaurants, food and general retailers typically operate on narrow cash margins and have been particularly affected by COVID-19. Significant economic shocks may present major challenges to short term liquidity and potentially going concern. Increased costs due to Brexit customs arrangements could further erode narrow margins in these industries.
• Does the industry tend to have significant market-linked portfolios? Pension funds typically have significant property and corporate investments, which can fluctuate significantly with market volatility.

In addition to the industry risk factors outlined above, auditors will need to consider the potential impact on the financial statements of potential entity-specific Brexit-related risk factors. Questions to consider include (but are not limited to):

• Will the business be able to continue to operate in the EU, without changes to operations? Some businesses have relied on ‘passporting’ rights under EU law to provide services in the EU, such as broadcasting, financial services, airlines and hauliers.
  
  The trade agreement includes differing provisions for individual industries. Entities need to understand how the trade agreement impacts them, as well as any local restrictions imposed by EU states the business operates in, and/or requirements to continue to operate. They could fundamentally reshape the business or result in significant segments ceasing operations. 
• Does the entity rely on UK staff regularly working in the EU or vice versa? The trade agreement allows employees to work across UK/EU borders, provided it is for less than 90 days in a six-month period and for eligible types of work which are determined by each EU member state. If staff need to either work for longer time periods or undertake other ineligible types of work across UK/EU borders, they will need work visas. Depending on the availability and cost of visas, this could impact business operations.
• Are products and services subject to EU regulatory and compliance law? Under the agreement, the UK and the EU have separate regulatory regimes. This means where businesses sell products and services into the EU they may need to comply with two separate legal and regulatory regimes, which could diverge over time, and this will likely result in additional administration costs. The trade agreement includes provisions to tackle barriers to trade in certain industries (such as the automotive, chemical, pharmaceutical, organic products and wine sectors), including mutual recognition of inspections, certifications or approvals. 
  
  Businesses will need to be aware of risks in areas governed by EU law, such as licensing, product compliance with human, plant and animal health measures, technical restrictions, trademarks and intellectual property, insolvency proceedings and competition law. 
• Does the entity rely on EU labour, in particular to fill business-critical roles? The loss of EU labour may make it difficult to fill critical operational roles, perhaps leading to increased labour costs, particularly if competition for that labour becomes intense. There may be additional administration costs relating to changes in employment contracts and the cost of EU worker Settled Status applications and visas. For example, entities in the agriculture, hospitality and healthcare sectors are likely to be affected.
• What legal and compliance issues impact the entity’s operations? Are there any risks of non-compliance with laws and regulations? Differences and changes in laws and regulations may impact trading. Any business restructuring to move operations or administration functions into or out of the EU could be impacted by these changes. Compliance may result in additional administrative costs. Non-compliance with laws and regulation (NOCLAR) could result in penalties and fines. 
• What effect would provisions in the trade agreement have on NOCLAR? Auditors will need to consider their responsibilities in relation to NOCLAR. ISA (UK) 250A identifies two categories of NOCLAR for auditors to consider: those which have a direct effect on the determination of material amounts and disclosures in the financial statements; and those which do not have a direct effect but where compliance is fundamental to operations, an entity’s ability to continue in business or avoiding material penalties.
  
  Given the additional customs and other administration requirements in the trade agreement, there may be a heightened risk of NOCLAR; for example, businesses that import and export from and to EU counterparties will need to complete proof of origin documentation. Auditors will need to consider risks of non-compliance with the trade agreement and what additional audit work may be required. 
• Will the entity face increased administration costs relating to importing from the EU or exporting to the EU? While the trade agreement eliminates customs duties on all trade in goods originating from the UK or the EU, administrative costs could arise from importing goods. In addition to general rules of origin that apply to all products, product-specific rules set out requirements for a particular product to be considered ‘originating’.
  
  These costs could arise from a variety of sources. For example, there is likely to be additional administration required at ports and bonded warehouses for collection, declaration and customs forms, including demonstrating compliance with rules of origin requirements– these costs are likely to be passed onto the entity. Delays could also cause direct and indirect operating costs.
• Will the entity face increased tariffs and duties on goods exported to the EU? While the trade agreement eliminates customs duties on all trade in goods originating from the UK or the EU, goods exported to the EU will attract import VAT in the EU.
  
  Exporters will need to document that goods meet origin requirements for zero tariff trade – this will give rise to administrative costs. Costs could also arise due to the need to meet EU regulatory regimes, for example in relation to sanitary requirements for animals, plants and products, that differ from UK requirements. 
  
  Guidance on VAT and other taxes is available on our Brexit hub.
• Will the entity face increased tariffs and duties on goods imported from the EU and elsewhere? When the transition period ended, the UK’s trade agreements also ended with non-EU countries with which the UK traded through EU trading agreements. The UK government is currently working to negotiate replacement trade agreements. Further information is available here on what agreements exist. 
  
  However, in the absence of a new agreement, trade with other World Trade Organization (WTO) members will take place on WTO terms. Entities may be particularly impacted if they import goods, for example, from countries previously benefiting from the EU Generalised Scheme of Preferences (GSP) rules for developing countries, countries benefitting from EU Free Trade Agreements, non-EU countries not benefitting from EU GSP or Free Trade Agreements, EU countries and Turkey, and EFTA countries.
• Will increased administration, tariffs and duties costs potentially result in additional risk to the entity being able to purchase supplies, produce goods and services, and / or deliver its goods and services? For example, delays due to administration at ports could result in goods being received too late. Additional administration from customs and VAT compliance could potentially result in some suppliers no longer exporting to UK markets. A need to find new suppliers could result in lower quality products, resulting in a risk of increased returns.
• How exposed to macro-economic changes, such as currency fluctuations, unemployment, interest rates and inflation rates, is the entity? Does COVID-19 exacerbate this? Entities that have transactions or balances in foreign currencies may be positively or negatively affected by currency fluctuations depending on whether exchange rate movements are in their favour or not. Entities with different functional and presentational currencies may also see significant impacts on reporting, as well as on margins. If the entity has significant third-party financing, interest rates may present additional financial challenges. Increased costs relating to Brexit may also drive up inflation.
• How has the control environment been impacted by Brexit, including the impact on control over subsidiary operations? Control environments may be strained in entities needing to change suppliers, diversifying their operations or benefiting from Brexit due to increased demand. Additional systems, processes and controls will be needed over import/export documentation, customs declarations and tax requirements. Risks related to the control environment are likely to be exacerbated by the ongoing challenges of remote working due to COVID-19.
• Has the risk of fraud increased in the entity? Do factors of the fraud triangle, namely, incentive/pressure, opportunity, and rationalisation, exist and may influence management? If Brexit has a negative impact on a business, this may increase pressure on management. Changes to the control environment, for example, from remote working, and new systems/controls required around import/export, may provide the opportunity to commit fraud. There may be additional rationalisations of saving jobs or protecting the business due to the dual pressures of Brexit and COVID-19.
• Does management have a consistent view on future risks? Consider whether there may be inconsistent approaches or views on risk management. Management may identify different Brexit-related risks and/or have differing assessments or assumptions about the same risk.

Estimates and forecasts are inherently uncertain. The combined impact of Brexit and COVID-19 is likely to lead to increased risk in estimate and forecast accuracy. There might also be an increase in the risk of management bias in developing estimates and forecasts linked to fraud risk in the current environment. In particular, risks may arise from uncertainty in management estimates and forecasts relating to, for example: asset impairments; going concern; fair value calculations; loss provisions in contract accounting; and the recovery of deferred tax assets. Measurement may also be affected by changes in discount rates.

Assessment of financial statement level risks (such as going concern) may be higher than usual when management has undertaken no or limited analysis of the impact of Brexit. It may also be higher even where analysis has been undertaken if management has not considered or addressed relevant risks or material uncertainties. 

Other financial statement risks could include:

• Covenant breaches – consider whether the entity is at a higher risk of covenant breaches. This could impact the classification of liabilities and the going concern assessment.
• Complex financial instruments – complexities may arise when auditing entities which use interest rate swaps or forward exchange contracts to mitigate risks, or instruments issued to obtain third party finance.
• Contract modifications – accounting for modifications to contracts for leases, loan agreements or share-based payments can be complex and involve judgement.
• Going Concern – Brexit alone may lead to increased going concern challenges for some entities and even more so when combined with the additional risks around COVID-19. Auditors will need to be mindful of going concern risks and also longer-term challenges requiring disclosure in viability statements.
• Subsequent events – For some entities Brexit may occur after the year end resulting in adjusting or disclosable events.  In 2021 reporting the short to medium-term impact is more likely to be reflected in the reported position and performance.  
• Other accounting issues – Brexit may impact revenue recognition and existence, returns provisions, taxation, contingent liabilities and discontinued operations.

Substantive analytical procedures may be more difficult to undertake, given the significant uncertainty and unpredictability of Brexit and COVID-19, and the associated difficulties with developing a reasonable expectation and obtaining corroboration for management explanations.

Management and auditors may find it helpful to undertake reverse stress testing potentially in combination with traditional stress testing when considering estimates and forecasts. 

Auditors need to consider whether the disclosures in the financial statements appropriately reflect their understanding of the business and are consistent with the narrative in the annual report. 

Brexit may result in additional practical audit risks. The trade agreement that was signed on 24 December 2020 contains a number of gaps in the area of services, especially on the mutual recognition of qualifications and data transfer. The preparations made for no trade agreement in relation to the regulation of audit therefore apply from 31 December 2020, until subsequent negotiations dictate otherwise. Guidance on auditor registration is available here.

Guidance from the UK Government recommends auditors check with the relevant local competent authority when auditing groups with subsidiaries in the EEA. 

It may also be helpful in group audits involving the consolidation of subsidiaries located in the EU for the group auditor to communicate at an early stage any Brexit-related risk factors identified and any additional work required and to have early conversations with the component auditor on the local impact of Brexit. Additional reporting considerations seem likely to apply to UK groups listed on EEA exchanges. Auditors may need to consider the need for work permits and issues such as data sharing. 

For periods beginning on or after 1 January 2021, the subsidiary audit exemption by parent company guarantee will only be available to UK subsidiaries if they are subsidiaries of a UK parent.  UK subsidiaries of an EEA parent may now have to be audited - unless they still qualify for audit exemption by meeting other criteria (are small and member of a small group or are dormant). Auditors taking on these engagements should consider the additional risks of first year audits and additional work required on opening balances.

Finally, the lack of mutual recognition of professional qualifications, as well as local registration requirements may impact auditors working in the EU and auditing EU incorporated entities. The UK government recommends auditors check with the relevant competent authority to understand their registration status.

The Department for Business, Energy and Industrial Strategy has published two important guides: one for UK auditors operating in the EEA and the other for EEA auditors operating in the UK. Both cover auditing from 1 January 2021. Further resources are available at icaew.com/brexit.