Corporate governance and audit – a wide-ranging programme of reforms

This article was written by Alyson Whale

Context – the need for reform

'I am determined to reinforce the UK’s position in the wake of large corporate failures that have led to job losses and uncertainty among small businesses and local communities. I want to ensure investors can get high quality, focused and reliable information on UK companies so they can invest here with even greater confidence.' KWASI KWARTENG, Secretary of State for BEIS

The message of trust and transparency in UK corporates is one the government has been advancing consistently for a number of years, with the ‘big name’ failures of, among others, Thomas Cook Group plc, Carillion plc and BHS pushing it high up the agenda. The changes proposed in this consultation build on the progress already made in the last couple of years with a new UK Corporate Governance Code and increased corporate reporting requirements (including for the very largest private companies). The aim is to create a new regulatory and accountability framework with a clear public interest focus.

The consultation addresses the findings of three independent reviews: The Independent Review of the Financial Reporting Council, The CMA’s Statutory Audit Services Market Study and The Independent Review of the Quality and Effectiveness of Audit.

Summary of proposals – a holistic approach

The consultation paper is 230 pages long, indicating how complex the issues involved are. The proposed reforms tend to focus on the largest companies where there is the greatest public interest in ensuring that the corporate reporting and audit functions are performing effectively. This shows the balance the government has aimed for – increasing regulation and oversight where needed without damaging the UK’s attractiveness as a destination for investment. The consultation refers to a holistic approach being essential, setting out how directors, auditors, shareholders and the regulator will all have a part to play in driving reform and lasting change.

We are working our way through the paper and will publish a series of articles and posts on some of the key proposals. Our first post, A new approach to dividend payments looks at the approach to realised profits and losses and the payment of dividends set out in the white paper. 

Key proposals include:

Public Interest Entities (PIEs)

PIEs are the focus of most of the proposed new regulatory measures relating to audit, corporate reporting and corporate governance. The current definition of a PIE covers predominantly publicly listed companies. The consultation sets out proposals to expand the PIE definition to include AIM companies and the largest private companies. Views are also sought on other types of entity that could be included in a new PIE definition, including third sector entities with a public benefit purpose.

Creation of ARGA

The FRC will be replaced with a proposed new Audit, Reporting and Governance Authority (ARGA). Its general objective will be to protect and promote the interests of investors, other users of corporate reporting, and the wider public interest. ARGA will have enhanced statutory powers, including new competition powers, an enhanced corporate reporting review function, more oversight of audit committees and the enforcement of directors’ corporate reporting duties (see further below). It will have a new statutory role in the supervision of accountants and actuaries and there are proposals for it to take a more pro-active role in identifying serious issues relating to a company’s corporate reporting or audit by strengthening its information gathering and investigatory powers. This includes the power to require an expert review, paid for by the company, to investigate issues in greater depth and explore the underlying causes.

Directors

The current framework is inadequate in holding the directors of the largest companies to account in the rare but serious case that they neglect their reporting responsibilities. Key proposals to addresses weaknesses in reporting and accountability include:

• Internal controls reporting – a number of options are considered with the government’s tentative preferred option being to require directors to carry out a review of the effectiveness of their company’s internal controls each year and make a statement, as part of the annual report, as to whether they consider them to have operated effectively. Unlike the US’s approach to internal controls, which in most cases mandates external auditor attestation, the decision on whether the statement should be assured by an external auditor would be left to the directors, audit committee and shareholders.
• Dividends and capital maintenance – reporting should provide more transparency around distributable reserves. Directors should be required to state that any proposed dividend is within known distributable reserves and that payment of the dividend will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years. Another proposal considers whether to give ARGA new powers in relation to how companies should calculate their distributable reserves (currently, guidance in this area rests with the professional accountancy bodies).

Other proposals relating to directors include:

• Directors’ wrongdoing – ARGA to have enforcement powers in relation to breaches by directors of PIEs of their statutory duties relating to corporate reporting and audit. ARGA could impose more detailed requirements for how directors should meet these duties. The government is considering requiring directors to meet certain behavioural standards in fulfilling these duties. Existing powers held by other enforcement agencies would not be affected.
• Remuneration - strengthen malus (withholding) and clawback provisions within executive directors’ remuneration arrangements, including the identification of minimum clawback conditions which would apply in all cases and have a minimum two-year application period. These conditions could include clawback for serious misconduct, a material misstatement of results or an error in performance calculations and failures of internal controls and risk management. It is proposed that these strengthened arrangements would be made through changes to the UK Corporate Governance Code.

Corporate reporting on resilience, assurance and payment practices for PIEs

New proposed reporting requirements for PIEs include:

• Resilience Statement – an annual statement, building on existing viability statements, setting out how directors are assessing the company’s prospects and addressing challenges to its business model over the short, medium and long-term, including risks posed by climate change.
• Audit and Assurance Policy – describing the directors’ approach (over the next three years) to seeking internal and external assurance of the information they report to shareholders, including any external assurance planned beyond the scope of the annual statutory audit.
• Payment practices – views are sought on how annual reports could include information on supplier payment policies and practices.

Strengthening the supervision of corporate reporting

Proposals for strengthening the regulator’s powers relating to its corporate reporting review work including:

• ARGA will have powers to direct changes to company reports and accounts, rather than via the current court order process.
• The existing corporate reporting review process will be extended to the annual report and accounts as a whole, ensuring that ARGA can review areas such as corporate governance statements and directors’ remuneration and audit committee reports as well as voluntary elements such as the CEO and chairman’s reports.

Audit reform

Proposals relating to audit’s purpose, audit practice and the organisation of the audit profession, as well as plans to increase choice, competition and resilience of the UK’s statutory audit market. Key points include:

• A new corporate auditing profession to operate independently of the professional accountancy bodies.
• New overarching principles for auditors, to reinforce good audit practice. Auditors will also have a new duty to take a wider range of information into account in reaching audit judgements, in particular whether financial statements give a 'true and fair view'. There will be enhanced obligations on both auditors and directors relating to the detection and prevention of material fraud.
• Increasing choice and competition in the FTSE 350 audit market, initially through a ‘managed shared audit’ regime with the aim of reducing the dominance of the big four firms. If needed, ARGA would have a reserve power for a ‘managed market share cap’ where firms could have the number of audits they perform in that market capped. ARGA will also have the power to take enforcement action to address anti-competitive practices and an abuse of dominant position within the statutory audit market.
• Requiring operational separation between the audit and non-audit arms of certain firms (determined by ARGA). This would include separate governance, financial statements prepared on an arm’s length basis, and regulatory oversight of audit partner remuneration and audit practice governance.

Audit committees

The consultation includes new powers for ARGA to set and enforce additional requirements for audit committees in the appointment and oversight of auditors, aimed at increasing audit quality. The proposals anticipate these would apply to audit committees at FTSE 350 companies. Also being considered is a power to give ARGA an independent ability to appoint an auditor where more serious problems exist with a company’s audits. A number of new measures to encourage and facilitate more meaningful engagement between a company and its shareholders on matters affecting audit quality are proposed, including a formal mechanism for shareholders of a quoted company to propose additional matters for emphasis within the scope of the company’s external audit.

Timetable – an acknowledgment of the pandemic

The consultation closes on 8 July 2021 and there is no clear timeline to implementation of the final reforms - the government has said it will introduce legislation to Parliament when Parliamentary time allows. It has indicated that it intends to take a staged approach (to 'balance the urgency of audit reform with its desire to manage additional requirements on businesses'):

• Measures that do not directly impact on businesses (including establishing ARGA) would be brought into effect quickly, as would those measures with significant impact on businesses regulated by ARGA.
• Measures with significant impacts on wider business, including the proposed extension of the definition of PIEs and introduction of a stronger internal controls regime, are likely to be implemented at a later date.
• Where reforms have direct impact on businesses, transition periods and/or phasing are likely to ensure a smooth introduction.

Wider context

The proposals for change in this consultation are part of wider piece of work by the government to improve the framework which UK companies operate within. This dovetails with its strategy to encourage economic growth through properly functioning markets and to maximise the opportunities around Brexit, ensuring the UK is a 'world class destination for investment'. The consultation sits alongside other proposals such as the Hill Review on listings, the Kalifa Review on fintech, and the planned Companies House reforms.

How can we help?

If you would like to discuss the proposed reforms, or corporate governance generally, please speak to your usual contact at Burges Salmon or Nick Graves, head of the firm's corporate team.