It has now been over five years since the collapse of the British construction company Carillion. Many industry experts and MPs are again pushing the authorities to implement their plan for stronger powers to regulate the audit sector and changes to corporate governance.
As previously outlined in our article "Significant audit and corporate governance reform on the horizon", the Government aims to "restore trust in audit and corporate governance" by creating a new regulator called the "Audit Regulation and Governance Authority" or "ARGA". The transition of the existing regulator, the Financial Reporting Council (FRC) to ARGA however requires new legislation to be passed by Parliament. In the May 2022 Queen's Speech, proposals for an Audit Reform Bill were outlined and proposed to be published in draft in the current Parliament, but so far these have not materialised. We can however, derive some clues from the FRC's recently updated three year plan, which now predicts a start date of April 2024.
Despite the delay to primary legislation, the FRC is progressing those changes which can be implemented via guidance or using its existing powers. We highlight some of these below.
FRC powers
Following the publication in May 2022 of the "Government Response to the BEIS consultation on strengthening the UK's audit, reporting and governance systems", the FRC set out in a position paper (published July 2022), how it anticipates supporting the incoming reforms. The FRC broke these down into five sections:
"1. Revisions and additions to the existing suite of Codes, Standards and Guidance to implement reforms;
2. The development of new standards in shadow form to allow for voluntary adoption ahead of legislation e.g., Minimum Standards for Audit Committees;
3. Setting expectations for the markets we regulate to drive behavioural changes ahead of statutory powers, following the successful approach we have taken regarding the Operational Separation of the Audit Practice in the largest UK Audit Firms;
4. The development of guidance to address issues set out in the Government Response, subject to that guidance meeting the bar set by Sir John Kingman, that ARGA should be sparing in its issuance of guidance and focused on those areas where it has expertise; and
5. Setting high-level expectations around the future supervision and monitoring activities which will flow from the proposed revisions to existing Codes, Standards and Guidance and the creation of any new such documents."
We have recently seen the FRC begin to put these points into action with the publication of a consultation on a Minimum Standard for Audit Committees (the Standard). The Standard covers the committee's role in appointing the auditor (and related tender process), ongoing audit and auditor oversight, and reporting responsibilities. The Standard is proposed to be introduced on a comply or explain basis for companies in the FTSE 350. It is a response to reform proposals which would afford ARGA, as regulator, the power and requirement to mandate minimum standards for the appointment and oversight of auditors – a role fulfilled by audit committees under the Corporate Governance Code. As such, it moves forward on one aspect of a package of measures intended to help tackle criticism that auditors are often too close to the companies they audit and that the audit market is lacking in competition. The deadline for responses passed on 8 February 2023. The FRC has confirmed it intends to make the Standard available to Audit Committees in time for the 2023 financial year end.
In addition to publishing the Standard, the FRC has been implementing the operational separation of audit from non-audit services in firms. However, in a further policy paper on "Competition in the audit market" published December 2022, the FRC reiterated the objective of a market that "consistently delivers high quality audit and is resilient" and made clear the "need for the package of measures proposed by the Government in its response to the consultation on Restoring Trust in Audit and Corporate Governance". The paper looks at recent developments in the market which indicate that "increased competition and choice has more recently tailed off, and that more entities tendering for an auditor are struggling to identify firms willing to bid". The report further notes, "The top four audit firms still dominate the market, resulting in limited choices for businesses and ongoing concerns about resilience".
Alongside the Standard, the FRC expects to publish further information on its competition policy (including updates on the extent/changes in competition in the audit market).
Revisions to the Corporate Governance Code
The FRC also indicated in its July 2022 position paper that it would consult on a revised UK Corporate Governance Code from Q1 this year, with the revised code applying to periods commencing on or after 1 January 2024. The consultation is expected to propose a number of changes to the Code, including implementing recommendations from the Government's response to the audit and governance reform consultation. This includes:
- strengthening reporting on the circumstance in which director pay can be withheld or repaid (malus and clawback);
- guidance on internal control reporting;
- amending the provisions in the code to address areas where the FRC has observed that reporting is weaker; and
- provision on audit tendering and the need to expand market diversity.
Conclusion
Despite continued pressure for reform as a result of further corporate failures since Carillion, it is still unclear when legislation will be brought forward. The proposals in the Government Response set out a sizable package of reforms which are no doubt taking some time to work into legislation. Furthermore, there is already considerable pressure on the Parliamentary agenda and, whilst a draft Audit Reform Bill was proposed to be published in draft in the Queen's speech, it did not make the list of bills to be scheduled in the current Parliament.
In the meantime, listed companies and their audit committees should monitor FRC proposals and its review of the quality of corporate reporting, taking account of these, as well as market expectations of best practice.