Episode 17: New Audit Methodology for financial instruments in the 2021-2027 programming period

Regarding the first point, it is important to emphasise that, unlike for the period 2014-2020, when ex-ante assessment was the document that established the market deficiencies and the level of investment needs, in the programming period 2021-2027, market failures and investment needs have already been established in each programme, and the operations to be carried out through financial instruments are also identified for each specific objective of these adopted programmes. So, managing authorities can draft a simplified ex-ante document that is in line with the CPR required elements. This significantly facilitated and relieved the burden of drafting the ex-ante assessment document, which in the past period required huge engagement of significant financial resources and was time consuming, resulting in slowing down the actual deployment of financial instruments as the repayable support, while this was not a condition for grant support that is non-repayable. At the same time, once finalised, ex-ante documents had little added value considering how fast market circumstances have been changing and how often managing authorities had to prepare new versions of ex-ante assessments. Regulation states that the ex-ante assessment will be audited to ensure compliance with the minimum requirements of Article 58(3), and where the combination with grant in single operation is proposed, the audit may look at whether the use of grant is justified, either in the ex-ante assessment, or in a separate document. 

Iva, maybe I can ask, because I know that you've taken a very pragmatic approach to ex-antes in Croatia. This new audit approach very much aligns with how you've done your ex-antes more generally, doesn't it?

Iva Međugorac: Yes. Correct.

How else does it help? I'm thinking about, for example, if there is an incompatibility found, is that helpful for you as well?

Iva Međugorac: Any eventual incompatibility found between the financial instrument implemented in the funding agreement, and the financial instruments described in the ex-ante assessment is only subject to recommendations or requested justifications, but without any financial implications. Therefore, we see it as a compliance issue that is easily remedied. Secondly, the new methodology reflects one of the key changes in the requirements of the new CPR for the 2021-2027 programming period, where the bodies implementing financial instruments are required to verify that the loan or grant made through a financial instrument is to be used for its intended purpose. This means that auditors will verify the eligibility of expenditure up front based on the proposed use, as stated in the investment strategy or business plan, and will not extend to ex-post verifications of the actual use of funds, for example, the review of invoices. Not having to collect and scan thousands and thousands of invoices is the most welcomed news by the financial intermediaries we cooperate with. Namely, in the previous period, our 20 financial intermediaries have signed more than 12 000 contracts, and if we count that it is only ten invoices per contract, we come to the number of 120 000 scanned documents. You can see how an enormous administrative burden is reduced by changing just one word in the regulation. Thirdly, regarding the payments, audits will verify that the amount claimed in the first payment application does not exceed 30% of the amount of programme contribution committed in the funding agreement and verify eligible expenditure relating to subsequent payment claims, and the clearance of the advance. We expect that in the new period, it will be easier to close programmes, although from the viewpoint of the liquidity of the state's treasury, we liked it in the past when we received four advanced tranches.

That second point, what a great example, about avoiding having to scan 120,000 documents. We'll come back to that point later in the podcast, the change about verifying eligibility of expenditure, thank you for raising that. Of course, the first topic we discovered at the event was the principle that final recipients are not part of the auditor monitoring and control framework. Hopefully a well-established principle for financial instruments. Iva, I'm sure you agree with that approach.

Iva Međugorac: Absolutely. Our audits stop at the level of the beneficiaries. It is the bodies implementing the financial instruments. The final recipients are mostly entrepreneurs from real life, who received a favourable loan or guarantee or equity instrument in order to make investments that are aligned with the state policies. They should, of course, be informed about it and as we pointed out earlier, the bodies involved in the implementation must ensure that the loans will be used for its intended purpose and aligned with all other criteria of the relevant programmes. Of course, the final recipients should be familiar with the programme, publish information about the received support on their website, and make it known in other ways that they are beneficiaries of EU support. They must follow all the eligibility rules, but they should not be additionally burdened with excessive demands because they will eventually return the loan, or if not, the collaterals will be activated.

Dana Greceanu: I fully agree with Iva on that and I cannot emphasise enough this principle. I hope this is now accepted practice across the EU. At the same time, we should not forget the single audit principle, which reduces the administrative burden by avoiding duplication of audits and management verifications of the same expenditure declared to the Commission. The auditors normally should first use the information and records available at managing authorities’ level, and only request additional documents and audit evidence from the bodies implementing financial instruments where the information and the documentation is not available at the MAs level, and where it is required to support the audit conclusions.

Let's look at these key issues in turn, starting with the design and setup of financial instruments. In the new methodology, there is a very straightforward approach to the audit of the ex-ante process and the funding agreement, isn't there, Dana?

Dana Greceanu: Indeed. First, we should not forget that ex-ante assessment is a managerial tool and the auditors are not expected to reperform this ex-ante assessment or to call into question the elements fixed in the ex-ante assessment by the managing authority. Nevertheless, the auditors should perform a completeness check of the ex-ante assessment against the minimum requirement stated in the CPR. For example, the auditors will verify that the amounts of the programme allocation to financial instruments are clearly indicated. They will verify the type of financial products, the target group, they will also check for information, whether the financial instrument contributes, and how the financial instrument contributes to the specific objectives of the programme. The auditors could also request additional justifications, in case during the implementation, some deviations are noted from the ex-ante assessment. A similar approach is reserved to the funding agreement, as you mentioned, Desmond. This means that the auditors cannot challenge the substance or the content of the funding agreement, but they can look into the completeness against the CPR rules. In any circumstances, the audit work cannot lead to findings with financial impact - the audit work on both the ex-ante assessment, and on the funding agreement. Last but not least, we should not disregard the part of the audit work of the setup of financial instruments consists also in verifying the selection of the bodies implementing the financial instruments. The auditors will check, for example, the conditions to perform a direct award or the compliance with the public procurement rules. 

Iva, I guess you've completed your ex-ante process by now. How do you see the audit provisions working in practice in your country?

Iva Međugorac: Yes, we have completed and adopted the ex-ante assessment and presented it to the monitoring committee at the same time as the monitoring committee has approved selection criteria for all planned financial instruments to be implemented in 2021-2027. Our ex-ante assessment provides a summary of each planned financial instrument, its objective, proposal location, type of financial instruments, target group of final recipients, expected contribution to the relevant programme indicators, and information about the body implementing the financial instrument. Compared to previous perspective, a process of two years, has been reduced to just two months after the adoption of the relevant programme. Also, we held an informal consultation meeting with our audit authority regarding our risk-based management verification assessment that we had to prepare ex-ante, and in writing, before we conducted administrative checks, prior to executing the first payment into financial instruments. Our audit authority believes that capital rebate write offs are risky, and we hope to prove them in practice that they are not. 

Dana, we had an interesting discussion during the Knowledge Hub about how to justify departures from the ex-ante assessment. We were pleased to note that such departures should be justified, but a new or revised ex-ante is not needed.

Dana Greceanu: Deviations from ex-ante assessment during the implementation of financial instruments should be justified and those justifications should be made available to auditors at their request. However, the auditors are not expected that the ex-ante assessment will be systematically updated. A justification for the changes would be considered sufficient, and this is a much lenient approach compared to 2014-2020 programming period. That is thanks to the simplifications in the legal framework.

Let's move on and consider one of the biggest changes, in my view, the topic of verifying eligibility of expenditure. Iva, you've already mentioned this at the beginning of the podcast. The new methodology and the CPR have introduced a major change which could have a huge impact on the audit and control of financial instruments in 2021-2027, as well as, of course, the implementation of those instruments. Dana, would you like to describe the new approach?

Dana Greceanu: If I can afford a little joke, this is a little like walking on the moon. It is a small change in the regulation, which has a huge impact on the implementation of financial instruments. In terms of audit trail, the CPR requires the verification that the support provided through the financial instrument will be used for its intended purpose. It says, is to be used for its intended purpose. What does it mean in practice? In practice, it means that collecting forward-looking evidence, such as business plans or equivalent documents, applications, investment decisions or other supporting documents, related to the proposed use. This approach differs from the classical audit trail evidence, namely, the invoices. However, the bodies implementing the financial instruments can continue applying the same standard of verifications when deploying program support as when verifying their own funds, meaning that they can continue if that is their own practice to collect invoices. Last but not least, it is very important that the funding agreement sets out clearly the documentation that will be required to support the financial instruments’ audit trail.

Iva Međugorac: We welcome this novelty and in our procedures we have left the exceptional options that we, as managing authority, will control the invoices only for the purpose of confirming existence of incentive effect. That is, determining that investments did not start before the application for the support as required by the state aid rules. In general, the managing authority is authorised to exercise control over implementation of financial instruments and the bodies implementing financial instruments, and/or financial intermediaries must ensure the availability of all documentation necessary for the implementation of these controls. They must ensure that the agreements with final recipients contain appropriate provisions related to audit requirements and the availability of all documentation necessary for the audit. Through agreements with final recipients they will prescribe them the obligation to keep all documentation related to financial instruments for a certain number of years in accordance with the relevant national regulation, and to ensure its availability to audit authorities. We will retain the discretionary right to request for delivery of invoices in case of suspicion of irregularities, for example, double financing.

Dana, in response to Iva's points, what would you say?

Dana Greceanu: I would like to underline that the approach described by Iva, regarding the verification of the incentive effect, is in line with the audit expectations. The auditors will indeed check whether the investment was not physically completed or fully implemented at the date of the investment decision by the body implementing the financial instrument. Then, in case of a specific irregularity or a suspicion of fraud including, for example, the veracity and reliability of the available documents, further verifications might be necessary, taking into account the nature of the finding. For example, if the auditors identify in one audited transaction that support in the form of a loan was provided to a large enterprise instead of an SME, as required by the programme or by the funding agreement, this is further analysed to see whether the finding is a one off or whether other similar transactions are affected. Auditors might then recommend system improvements and corrective actions for the identified irregularities. For those purposes, the auditors might ask the managing authority to perform additional verifications in order to quantify the exact precise impact of those irregularities. The auditors will also do a follow up to their findings and recommendations for system improvements. For example, whether all the necessary withdrawals and deductions have been made by the body carrying out the accounting function through payment applications, and/or through the accounts. System audits at the beginning of the programming period would play a preventive role and would provide, both managing authority and the bodies, implementing financial instruments, legitimate expectations on their controls and management system in place for implementing the financial instruments. 

Am I right to say that these are all examples where that risk based, proportionate approach might justify looking at, for example, invoices in some circumstances? But, as a matter of rule, we do not need to look at the use of invoices to verify eligibility of expenditure anymore because that is all about how resources will be used, not how they have been used. Is that correct?

Dana Greceanu: That is correct. Nevertheless, we should keep in mind that the practice of the bodies implementing the financial instrument should also play a role in this. We should follow their approach, their normal business, normal way of controlling and providing resources.

It's certainly a major change which I hope is embraced by audit authorities in Member States. Maybe now we can turn to another topic that will be important to managing authorities, which is the auditing of their payment claims. It's fair to say that this is simpler than the last programming period. In the Knowledge Hub, Dana, you described how there are three stages in relation to the audit of this work. Please, could you take us through this?

Dana Greceanu: There are three stages. The auditors first will look at the advances. Then they can also look at the incurred expenditure for financial instruments. Towards the end of the programming period or towards the end of the closure of the financial instrument, they will look also into the expenditure clearing the advance. Let's start with the first one. The approach to auditing the advance is focused on the requirement that the programme contribution of up to 30% of the programme resources committed to the financial instrument is being made to the financial instrument before the date of the payment application to the Commission, so the auditors will check this. Then, regarding the eligibility of the incurred expenditure for financial instruments The auditors will look into two main aspects. First, the general eligibility rules, the compliance with the general eligibility conditions, and then the compliance with the specific eligibility rules for financial instruments. Now, regarding the general eligibility rules, the auditors will look into the compliance with the eligibility requirements set out at a national level or in the programmes. For example, they will look into those conditions that give access to finance for SMEs or the eligibility conditions for energy efficiency projects or, for example, the regional urban development aid. Those that come with specific eligibility rules set out at national level. The audit work could also focus on the verification of the eligibility of final recipients, such as, for example, SME status or state aid aspects. A particular attention is paid to the eligibility conditions laid down in the funding agreement and investment decisions. The auditors will look into the eligibility area, eligibility of expenditure, eligibility period. Then the auditors will pay a particular attention to the specific eligibility rules for financial instruments, stated in Article 68 of the CPR. For example, there will be checks of the amounts paid, or in case of guarantees, amount set aside of the management cost and fees, verification of the use of interest and other gains, and verifications of the eligibility rules in case of implementation of financial instruments across consecutive programming periods. Then somewhere at the end of the closure of programming period or towards the closure of the financial instruments, the auditors will verify that the eligible expenditure declared to the Commission does not exceed the total value of support paid. The auditors will verify that will come then towards the end, when the auditors will have to do some verifications of the expenditure that is supposed to clear the advances. This expenditure is not declared in payment applications, and because this expenditure is not declared in payment applications, it cannot enter into the audit authority's sample population, into the population to be sampled and to be audited. This expenditure, to clear the advance, will be declared by the managing authorities or by the bodies carrying out the accounting function in appendix one to the payment application. The auditors will have to do some work on that expenditure, and that because, as I mentioned, is not included in the audit population, they will have to perform some specific audit tests on those type of expenditure, clearing the advance. Those specific audit tests will be done through an audit of accounts or system audits that will have to be conducted during the accounting year when the clearance of the advance takes place. The auditors, basically the audit authorities, will have to report to the Commission on the outcomes, on the results of those audits. 

That's interesting. Especially that part about auditing the clearance of the advance towards the end of the program. It is something to bear in mind for the future. Iva, what is your reaction to this approach?

Iva Međugorac: In the past programming period, we had the opportunity to receive four advanced payments, which enabled high levels of liquidity for State Treasury. In the current period, we have the possibility to receive one payment in advance and after that to withdraw funds according to consumption, which is okay because it will be easier to make the clearance in the last accounting year. We plan to ask for a 30% advance for each financial instrument, and we are not afraid that we will fail in funds absorption because we have successfully spent the funds transferred to us for the implementation of financial instruments for the period 2014-2020 and up until today we have certified around 95% of the funds received. 

There are so many things that we could talk about, but we must be conscious of time. Perhaps I could ask you both to each mention one other feature of the new methodology that we discussed during the Knowledge Hub. Iva, do you want to go first? 

Iva Međugorac: Yes, thank you. Desmond. I would like to highlight the combination of financial instruments with grants, the so-called capital rebate, and the validation that the grant part does not exceed the level of the investment. In all our financial instruments in which we plan the combination with the grants, the so-called capital rebate, it is allowed in an amount of up to 50% of the principal in each loan agreement. In this way, there is no possibility that the grant part will exceed the maximum allowed amount at the level of financial instrument operation. Moreover, we projected it to be between 30-40% at the portfolio level. The criteria for capital rebate will be elaborated in detail and graded and known up front from the lending programmes. Final recipients who will implement their investments in accordance with these criteria, and upon completion of the project submit and evidence that the project was carried out in accordance with these criteria, will receive a capital rebate of the loan and repay the reduced amount of the principal.

The new audit methodology does cover how to audit combined operations. Operations, which combine financial instruments and grants in the same operation, so that should certainly be relevant to that sort of scenario. Thank you, Iva. Dana, would you like to mention one other key topic?

Dana Greceanu: First, I would like to compliment Iva's points about the combinations of financial instruments and grants, and to emphasise a little about the role of the auditors in these combinations. When combinations are done in one operation, auditors will focus on certain aspects that I would like to emphasise during these discussions. First, they will look for an ex-ante justification that the grant is linked and is necessary for the financial instrument. What I would like to emphasise here is that this verification will not be done for every single individual investment, but it is going to be performed at financial instrument level. Then the auditors will look whether there is only one single funding agreement covering both the financial instrument and the grant support. Then the auditors will, of course, look into the selection of final recipients and the agreements with those final recipients, and those verifications will be done by the auditors through audit of operations. The auditors will look, for example, for the conditions for financing, the expenditure supposed to be supported by the financial instruments or how much is supported through the financial instrument, and how much is going to be supported by the grant. Not later than the final accounting year, the auditors will check whether the grant component does not exceed the value of the investment supported by the financial products, and this will not be done at the level of every single individual investment, but at the level of the financial instrument. The auditors will also check the monitoring system put in place by the bodies implementing the financial instruments to ensure that the same expenditure item is not declared twice. So, the auditors will also check the double declaration of financial instrument support. The sum of the financial instrument and grant support should not exceed the project cost by the end of the implementation.

Iva, you mentioned earlier that your auditors think that the use of capital rebate might be risky. I'm sure having this kind of clarification will be helpful, both for you and for them, in terms of verifying this kind of activity in the future. Dana, what was the point you wanted to make as well?

Dana Greceanu: I wanted to highlight another aspect that may threaten many people in general, it is about sampling. The sampling rules for financial instruments have been harmonised, they have been aligned to the normal sampling rules, sampling techniques for grants. There’s nothing any more specific in terms of sampling for financial instruments. The same sampling techniques applied for grants, are applied also for financial instruments, and those are laid down in the sampling regulation. The audits authorities will be expected to include in the audit population, from where they will take the sample, both grants and financial instruments. The stratification will be just an option, but it's not obligatory. It will be up to the professional judgment of the auditors, whether they will consider necessary to stratify the financial instruments and to take the sample from those strata, or to include everything in one single population and to give a chance to both grants and financial instruments to enter in to the sample.

I really like that, because that's an example of how financial instruments are becoming part of the mainstream of ERDF activities and operations, and there's no reason why they can't be part of the same sample as grant operations. That's helpful and hopefully that will be useful for practitioners in the coming years. 

Thank you both. That was a great discussion. If I can just remind our listeners that both the methodology and the Knowledge Hub report are available on the fi-compass website. If you want to look into this topic in more detail, please check them out. I hope they prove to be valuable resources for managing authorities in the years to come. As I speak, we are in February 2024, and we are going to host an online webinar on this topic next month in March, where participants can hear from Dana and colleagues and ask questions about the new methodology. Watch out for this announcement in the coming weeks. Before we conclude, I would like to ask Iva and Dana for their final thoughts. Do you have any final thoughts you would like to share?

Iva Međugorac: Thank you, Desmond. I have nothing more to add but to wish us all involved, from the setup through implementation to audits, a successful and smooth journey with the new financial instruments on board.

Dana Greceanu: I would like to conclude that audit of financial instruments is not the same as audit of grants. First, the financial instruments, are not grants and the risk are not the same, given, for example, the repayable nature of EU support. We also have to keep in mind the lessons learned from the past. Financial instruments are not prone to errors and this is proved by the fact that irregularities in financial instruments represent only 0.5% of the total reported irregularities in 2014-2020. The areas that triggered some irregularities in the past were, for example, ineligible expenditure, ineligible final recipients, non-compliance with the selection rules, non-compliance with the rules on combinations, and an insufficient audit trail. The auditors will focus on these areas that are more prone to errors. What I would like to emphasise is that both the audit methodology and the checklist have been designed in order to cover these areas that are more prone to errors. Like this, auditors will focus on these areas. 

That's a great statistic. Irregularities in financial instruments represents only 0.5% of the total reported irregularities in 2014-2020. I think that's a great way to finish the podcast. I hope this has been interesting for everybody and thank you to Dana and Iva for sharing these insights with us.

Dana Greceanu: Thank you for having me. It was an interesting experience.

Iva Međugorac: Thank you from me as well. It was great to be able to take part in this podcast and also in the Knowledge Hub, and I hope our experiences are useful for others.

I would like to also thank our listeners for tuning in today to this episode of the fi-compass Jam Sessions podcast. If you have any questions, we encourage you to get in touch through our email contact@fi-compass.eu and we look forward to hearing from you.