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Significant audit and corporate governance reform on the horizon

Posted on 6 June 2022

The Government is pressing ahead with wide-ranging reforms to modernise audit and corporate governance. They are designed to restore trust 'in the wake of big-name company collapses' and were confirmed by Business Secretary Kwasi Kwarteng in the Government's response last week to its bumper 230 page consultation from March 2021. The package of proposals are of particular importance to very large businesses, their directors, investors and auditors. The reforms will create a new regulatory regime for audit and corporate governance, with the creation of a new regulator – to be called the 'Audit Regulation and Governance Authority' ('ARGA'); 'improved' audit profession; and increased director and auditor accountability. They are the result of a series of consultations and independent reviews which came in the wake of high-profile corporate collapses in 2016 and 2018.  

In the response, the Government confirms its commitment to introducing appropriately high standards but doing so in a way that minimises disproportionate cost to businesses and allows businesses sufficient time to adjust. It has scaled back a number of its original proposals including on legislating to create a new audit profession covering non-financial as well as financial corporate reporting; on internal control reporting and the number of companies in scope for the highest standards of reporting and regulation. It has also accepted that some of the required change should be delivered without primary legislation including through changes to the UK Corporate Governance Code; in secondary legislation – allowing flexibility to make changes more quickly in future - and in codes of practice and guidance which will be consulted on separately. It is preparing a draft bill and intends to legislate 'when Parliamentary time allows'.

Background

This is the latest in a line of reforms including new corporate governance codes and corporate reporting requirements which have already been introduced to improve corporate transparency and investor engagement in response to corporate collapses. However, these measures aim to tackle the additional and important question of how to ensure there are checks and balances on what are otherwise voluntary reporting and disclosure regimes.

In the press release accompanying the original consultation the Business Secretary stated that 'When big companies go bust, the effects are felt far and wide with job losses and the British taxpayer picking up the tab.'  It is for this reason that the Government has said it is looking to make 'decisive changes'.  In recognition that the changes represent an increased regulatory burden for business and for the sake of proportionality, many of the measures are therefore focussed on the very largest companies – those with a public interest.  So-called 'Public interest entities' or 'PIE's (main market listed companies, credit institutions and insurance undertakings) are currently already subject to more stringent regulation in relation to their audits and (for those with over 500 employees) in the non-financial disclosures they must make. This 'PIE' definition will be expanded  to cover very large private companies and LLPs and public companies admitted to AIM which have both 750 employees and an annual turnover of over £750 million – so called '750/750 companies'.

Key reforms

The reforms will include:

  • Creation of a new audit and corporate governance regulator – ARGA - with clear and enhanced statutory powers which will succeed the FRC. This was proposed in the 2018 Kingman independent review of the Financial Reporting Council together with a package of other measures, some of which are already being implemented by the FRC where legislation was not required. Sir John Kingman had described the system of audit regulation in the UK as 'a ramshackle house' and 'built on weak foundations'. ARGA's role will include not only the regulation of auditors of public interest entities, but it will be given new competition powers, increased oversight of audit committees and powers to strengthen its corporate reporting review function. These will, for example, allow ARGA to scrutinise the entire annual report and accounts, not just selected parts, and direct companies to amend their reporting rather than needing to go to court. ARGA will also have the power to set minimum requirements on audit committees of FTSE 350 companies in relation to the appointment and oversight of auditors, and shareholder engagement with audits and monitor their compliance.
  • Reform of the audit profession – The original proposals were to introduce a 'new, stand-alone audit profession, underpinned by a common purpose and principles – including a clear public interest focus – and with reach across all forms of corporate reporting, not just the financial statements'. The new audit profession would 'operate independently from the professional accountancy bodies'. Notably, the extension of audits beyond financial results was to include reporting against climate targets and other ESG measures and a new focus and reporting on detecting and preventing fraud. These largely followed proposals made by the 2019 Brydon Independent Review into the quality and effectiveness of audit. In that review Sir Brydon recommended that 'ARGA acts as the midwife to create a new profession of corporate auditing, establishing the necessary professional body, to encompass today’s auditors and others with appropriate education and authorisation.'  However, rather than legislate to set a new purpose and statutory audit framework at this stage, the Government is looking: to ARGA as 'improvement regulator' to deliver better standards and guidance, ensuring auditors are consistently considering wider information (beyond that provided by companies); and to the existing professional bodies (such as the ICAEW) to improve auditor qualification, training and skills. It considers that a new requirement for companies to publish audit and assurance policies – see below – will act as a catalyst for the development of enhanced wider assurance services.   
  • Improving competition for large company audit work – FTSE 350 companies will in the main be required to use a smaller challenger audit firm to conduct a meaningful portion of subsidiary audits (a 'managed shared audit') to reduce the supremacy of the big four accounting firms. ARGA will have the power to authorise exemptions and also to take further measures (if needed, through a 'managed market share cap') if competition does not improve. These measures seek to address findings of the Competition and Market Authority's 2019 Statutory audit services market study which had recommended a dual audit.  ARGA will also be given the power to require an operational separation between the audit and non-audit side of multi-disciplinary large firms due to concerns that behavioural and financial incentives within firms could undermine the independence and professional scepticism of auditors - key attributes to ensure a quality audit.
  • Increasing corporate reporting for companies qualifying under the new wider definition of 'public interest entity' (or 'PIE'), to cover:
    • The effectiveness of internal controls: The Government received push back on the original preferred proposal to introduce a mandatory requirement for a statement by directors on the effectiveness of internal controls. Instead, it will invite the FRC to consult on amending the UK Corporate Governance Code to provide for an explicit statement from the board about the effectiveness of internal control systems - covering financial, operational and compliance systems - and the basis for that assessment;
    • The detection and prevention fraud: directors will be required to report on the steps they have taken to detect and prevent material fraud. Proposals for this statement to be reported on by auditors and for auditors to give their own report on steps the auditors have themselves taken will not be included in legislation.  This is because ISA (UK) 70 already sets out auditor responsibilities on reviewing 'other statutory information', which would include the directors' new statement; and other revised audit standards cover auditor fraud reporting – so the Government will wait to see how effective these standards are.
    • The amount of a company's distributable reserves – Public interest entities, or the parent if a group, will be required to make a statement as to the amount of their distributable reserves in their accounts which would be audited. They must also report on their long-term distribution policy and its application in the reporting year; and their directors confirm the legality of interim and final dividends for the year. ARGA will be mandated to provide guidance on what should be treated as 'realised profit or losses' for the purposes of the law on what a company may distribute (voluntary guidance is currently published by the ICAEW and ICAS).
    • 'Resilience' – a new statutory resilience statement to be included in the strategic report will replace the going concern and viability statements provided for in the UK Corporate Governance Code. The new statement will cover the company's approach to exploring and mitigating risks over a longer time frame, covering short, medium and longer term periods.
    • Audit assurance – a new statutory public interest policy statement provision will require PIEs to describe their approach to seeking assurance of their reported information over the next 3 years including: a description of internal audit and assurance; policy on audit tendering; and the extent to which independent assurance has been obtained including on the resilience statement and internal control reporting.
  • Increasing director accountability – ARGA will be given civil remedies including powers to fine or suspend directors of PIEs for breaches of directors' statutory duties relating to corporate reporting and audit – for example, significant errors with accounts or withholding information from auditors. These will be in addition to powers already held by the Insolvency Service (for example, to disqualify directors) or the FCA (for example for listing rule breaches or market abuse). While currently these powers are limited to directors of PIEs in the response the Government comments that it is 'also considering whether in exceptional circumstances ARGA's powers could also be applied to a non-PIE's directors if doing so was justified by the public interest'. 
  • Executive pay - The Government will also invite the FRC to review the UK Corporate Governance Code to strengthen and extend provisions on clawback and malus so as to encourage greater transparency and encourage a broader range of conditions in which executive remuneration could be withheld or recovered.

Comment

The timetable for implementation of these changes is not yet clear. We await publication of the audit reform bill and Parliamentary time. Once enacted, there is also likely to be a delay to certain measures coming into force to allow industry time to prepare. Revisions to the UK Corporate Governance Code and industry guidance, will be also subject to consultation before changes are made. These measures, whilst extensive, are perhaps not as wide-ranging as the authors of the reports from which they derive recommended. It remains to be seen whether, as companies face the challenges of tightening economic growth, another corporate collapse could trigger swifter or stricter reform. 

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