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Significant audit and corporate governance reform on the horizon

Posted on 22 March 2021

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 announced by Business Secretary Kwasi Kwarteng in a bumper 230 page consultation last week. The package of proposals are of particular importance to very large businesses, their directors, investors and auditors. The reforms will create a new regulatory and accountability regime for audit and corporate governance, with the creation of a new regulator, reframed audit profession and increase 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. The proposals, once implemented, will represent the final pieces in a jigsaw of reforms to the corporate governance ecosystem in the UK.

New corporate governance codes and corporate reporting requirements have already been introduced coupled with measures designed to increase investor engagement. These have played an important role in increasing public transparency from business around issues such as stakeholder engagement, corporate purpose, director pay and the long term sustainability of the business. However, the latest proposed 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.

The Business Secretary is quoted in the press release accompanying the consultation as stating 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'.  However, it is acknowledged that the changes represent an increased regulatory burden for business and so, for the sake of proportionality, many of the measures are 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. The Government is consulting on expanding this definition to include AIM companies with over EUR200m market capitalisation and very large private companies. It is consulting on different options for this, one of which is to include those very large private companies which are already required to publish an annual corporate governance statement (e.g. because they have over 2,000 employees).

Key measures include:

  • Creation of a new audit and corporate governance regulator with clear and enhanced statutory powers to be named the 'Audit Regulation and Governance Authority' ('ARGA') and that 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' '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, powers to strengthen its corporate reporting review function, its oversight of audit committees and the enforcement of corporate reporting duties of directors.
  • Reform of the audit profession – introducing 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 will include reporting against climate targets and other ESG measures and there will be a new focus and reporting on detecting and preventing fraud. These largely follow 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.'
  • Improving competition for large company audit work – FTSE 350 companies would in the main be required to use a smaller challenger audit firm to conduct a meaningful portion of their annual audit (a 'managed shared audit') to reduce the supremacy of the big four accounting firms. ARGA would have the power to take further measures (if needed, through a 'managed market share cap') if competition does not improve. These measures follow from the Competition and Market Authority's 2019 Statutory audit services market study which had recommended a dual audit.  Measures are also proposed to achieve 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 (many initially for premium listed companies, but being extended to PIEs within 2 years) around:
    • the effectiveness of internal controls. A number of options are explored in the consultation including the Government's current preferred option of a new annual internal controls review with a director statement on their effectiveness and allowing directors, audit committees and shareholders to decide the external assurance required;
    • the amount of a company's distributable reserves (currently voluntary) and introducing a new directors' statement about the legality of proposed dividends and the effects on future solvency;
    • 'resilience' – a new statement in the strategic report to replace the going concern and viability statements which would cover the company's approach to exploring and mitigating risks over a longer period; and
    • audit assurance – a policy statement would describe the company's approach to seeking assurance of its reported information over the next 3 years which (in the case of quoted companies would be put to an advisory shareholder vote).
  • Increasing director accountability – ARGA will be given powers to fine or suspend directors of PIEs for the most serious corporate reporting offences such as significant errors with accounts, withholding information from auditors or 'leaving the door open to fraud'. 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). It is also proposed to amend the UK Corporate Governance Code to strengthen and extend provisions on clawback (requiring repayment of director remuneration in a greater range of situations).

The consultation will close on 8 July 2021, following which the Government intends to introduce relevant legislation before the end of the current Parliament. It is likely that once the relevant enabling legislation is passed that some of the measures would be phased in.

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