Government proposes wide-ranging reforms in bid to restore trust in audit and corporate governance

Government proposes wide-ranging reforms in bid to restore trust in audit and corporate governance

Companies may elect to receive three month extension period for filing accounts during COVID-19

On 18 March 2021, the government published its white paper titled “Restoring trust in audit and corporate governance”. The white paper sets out a series of ambitious reform proposals intended to strengthen the UK’s audit, corporate reporting and corporate governance framework.

A copy of the white paper can be found here.

Background

Following a string of major, highly-publicised corporate collapses (including Thomas Cook, Carillion and BHS) which shook the credibility of directors’ reporting and the statutory audit regime, the government commissioned three independent reviews:

The white paper proposals (which are firmly based on the findings of these three reports) aim to:

  • Restore stakeholder and public trust in the way that the UK’s most significant corporate entities are run and scrutinised (by ensuring that they are governed responsibly and subjected to robust, challenging external audit)
  • Empower investors, creditors, workers and other stakeholders by giving them access to reliable and meaningful information on a company’s performance
  • Help companies to become stronger and better equipped to face future challenges
  • Enable the UK to remain a premier global centre for investment by keeping our legal frameworks for major businesses at the forefront of international best practice
  • Increase choice and quality in the audit market

The key areas of the proposed reforms are summarised below.

The government’s approach to reform

The proposed new measures focus on Public Interest Entities (PIEs). Currently the definition of a PIE covers predominantly publicly listed companies. In the consultation, the government acknowledges that an extended definition is required to capture not just large public companies, but also any entities in whose health and performance the wider public has significant interest. It is therefore proposed that the definition be extended to include the largest private companies (in the nature of BHS prior to its collapse) as well as large AIM quoted companies (like Patisserie Valerie, which fell outside the current regulatory regime prior to its demise). Views are sought on other types of entity that could also be included in the new PIE definition, including third sector entities with a public benefit purpose.

A new regulator 

The white paper acknowledges that the FRC currently has no meaningful statutory basis for its work or objectives and inadequate enforcement powers which prevents it from being a “modern pro-active regulator”. The consultation therefore sets out the framework for establishing a new, strengthened regulator to replace the FRC: the Audit, Reporting and Governance Authority (ARGA). ARGA will be funded by a statutory levy, governed by a simplified board (with publicly appointed non-executives and strategic direction from government) and accountable to parliament. Its statutory objectives will be to protect and promote the interests of investors, other users of corporate reporting and the wider public interest, and to promote high quality, competition and innovation in the market for statutory audit work, corporate reporting and corporate governance. 

ARGAs responsibilities are proposed to include:

  • The supervision of accountants and actuaries
  • Setting and enforcing additional requirements for audit committees in the appointment and oversight of auditors of FTSE 350 companies
  • Approving statutory auditors of PIEs
  • A more pro-active role in identifying and assessing serious issues relating to a company’s corporate reporting or audit (using strengthened information gathering and investigatory powers)

The white paper envisages that the statutory levy to fund ARGA will be paid by market participants (persons or bodies for which ARGA’s activities directly relate or which otherwise benefit from those activities) and will be calculated by reference to ARGA’s “activity blocks” (groups of activities). ARGA would estimate the costs of carrying out the activities which fall within each block, identify the persons or bodies who would need to meet the costs of those activities, and apportion those costs between the relevant persons or bodies within that block. In apportioning the costs between the different persons or bodies within a block, the regulator would take into account factors such as the size or nature of the market participant.

It is also envisaged that ARGA will be given rule-making powers to increase choice, competition and resilience of the UK’s statutory audit market through:

  • Greater regulatory powers and duties
  • Requiring operational separation between the audit and non-audit arms of certain firms
  • Statutory powers to proactively monitor the resilience of the audit market and audit firms and to take enforcement action to address anti-competitive practices

A new corporate auditing profession

The government ultimately wants to see audit become more trusted, more informative, and hence more valuable to the UK. To achieve this, it proposes:

  • A new corporate auditing profession to operate independently of the professional accountancy bodies
  • New overarching principles for auditors, to reinforce good audit practice
  • A new duty on auditors to take a wider range of information into account in reaching audit judgements, in particular whether financial statements give a “true and fair view”
  • New obligations on both auditors and directors relating to the detection and prevention of material fraud

The government proposes that ARGA should oversee the provision of these wider audit services, including through the creation of a framework for all “corporate auditing”, covering both the auditing of financial statements and also the auditing of wider (non-financial) information reported.

Shareholders

The consultation document proposes measures to improve stewardship by giving investors stronger and better opportunities to engage with companies, particularly on audit matters. These include a proposal for companies to be required to set out their approach to audit through publication of an audit and assurance policy on which there would be an advisory shareholder vote. Shareholders would also have a formal opportunity to propose to the audit committee areas of emphasis to be considered within the auditor’s annual audit plan.

Directors’ accountability for internal controls

The consultation notes that responsible behaviour is the starting point for high quality and reliable corporate governance and reporting. With a view to strengthening directors’ reporting obligations and sharpening directors’ accountability for the effectiveness of internal control and risk management procedures, three proposals are made:

  1. Directors should review and attest (as part of the annual report) the effectiveness of the company’s internal controls
  2. The audit report should describe the work the auditor is required to do to understand the internal control systems and how that work has influenced the audit (without formal opinion on effectiveness)
  3. A formal auditor opinion should be given on the attestation by the directors about the effectiveness of the company’s internal controls

The consultation notes a preference for option one, to be supported by external audit assurance at the discretion of the audit committee and shareholders.

It is proposed that these measures be phased in so that they extend to all PIEs after two years, but initially just to premium listed companies who are already familiar with the concept of an annual review (with possible temporary exemptions for newly listed companies where gross revenues remain below a specified threshold).

Directors’ accountability for dividends and capital maintenance

High profile examples of companies paying out significant dividends shortly before profit warnings and, in some cases, insolvency, have raised questions about the robustness of the legal framework for paying dividends and the extent to which the dividend and capital maintenance rules are being respected and enforced. The consultation therefore proposes the following reforms:

  • Companies (the parent company in the case of a group) disclose the total amount of distributable reserves, or, if this is not possible, the "known" distributable reserves, which must be greater than any proposed dividend
  • Parent companies disclose an estimate of distributable reserves across the group
  • Directors make a statement confirming that the 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 following two years

The government considers the new proposed disclosure requirements will be of value primarily to external investors who will, as a result, have more information about the legality and potential future sustainability of dividends. It therefore envisages the first two requirements applying to listed and AIM companies only.

In respect of the directors’ statement, the government sees a case for this requirement beyond listed and AIM companies to apply to all PIEs or even all large companies, because the rules on dividends apply to all companies alike and are of interest to creditors as well as shareholders. It is acknowledged, however, that this would be inconsistent with the proposed scope of the new distributable profit reporting requirements.

The consultation also invites views on proposals to give ARGA new powers to give guidance on how companies should calculate their distributable reserves.

New corporate reporting: resilience, assurance and payment practices

In direct response to the Brydon Review recommendations, the government proposes to introduce statutory requirements on all PIEs to publish two new reports:

  1. A Resilience Statement evidencing directors’ plans to maintain the resilience of their business over the short, medium and long-term (including in relation to climate change)
  2. An Audit and Assurance Policy to explain the directors’ approach to seeking internal and external assurance of the key business information reported to shareholders (including any external assurance planned which goes beyond the scope of the statutory audit)

The Brydon Review also recommended greater transparency within the annual report on companies’ supplier payment policies and practices – the consultation invites views on how to implement this.

Supervision of corporate reporting

Directors must be held to account for their reporting responsibilities in order to protect stakeholder interests and avoid loss of trust. The consultation acknowledges that the current framework is inadequate where directors neglect their reporting responsibilities. The government therefore proposes to strengthen the regulator’s powers relating to corporate reporting review. The key proposals are:

  • ARGA to have powers to direct changes to company reports and accounts (without a court order)
  • Increased transparency for the existing corporate reporting review process, by enabling ARGA to publish its findings
  • The extension of the reach of the corporate reporting review process across all forms of corporate reporting, such as corporate governance statements and directors’ remuneration (not just financial reports)

The government proposes the new regulator should focus most of its pro-active corporate reporting review work on PIEs but should retain its current powers to investigate reporting by non-PIE companies.

It is also proposed that:

  • ARGA be given investigation and enforcement powers in relation to PIE directors’ breaches of statutory duties relating to corporate reporting and audit.
  • Mechanisms within executive directors’ remuneration arrangements to recover remuneration already paid to directors (clawback) or to withhold pending awards (malus) be strengthened (by 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. Subject to consultation responses, the government proposes to implement these stronger arrangements through changes to the UK Corporate Governance Code, so initially this would apply to premium listed companies only. Following a review, the government will consider whether there is a need to extend this to all listed companies, potentially through the Listing Rules.

The consultation closes on 8 July 2021 at 11.45pm. The government is mindful that subsequent implementation of reforms of the scale and nature proposed will require transition periods and phasing in order to balance the need for meaningful reform against the proportionate impact on business (both now and in the future).

David Steinberg, Co-Head of restructuring and insolvency at Stevens & Bolton, comments that:

Given the recent high-profile corporate failures and the potential for more such failures on the horizon in the wake of the pandemic, it is not surprising that the government has proposed significant changes in a bid to improve public and investor confidence in the audit market and UK corporate governance regime.

Whilst the potential introduction of additional checks and balances is to be welcomed by various company stakeholders, auditors and boards of directors will no doubt be concerned that the government’s proposals, if implemented, could result in substantial practice changes, exposure to liability and costs - not to mention the potential increase in director’s indemnity insurance.

It is interesting – although not surprising, given the incidence of corporate failures amongst large non-public companies – that the white paper focuses upon the need to include large non-listed companies within the definition of a ‘PIE’. It has always been anomalous that the concept of "public interest" should apply only to listed companies, given that a large company’s insolvency poses an acute – often existential – threat to the well-being of creditors, suppliers and employees, as well as of investors. So, that proposal is welcome. 

If the proposals do come to fruition the potential added value to a board that has set up practices in compliance with the new UK corporate governance regime should not be overlooked. Improved processes, controls and accountability would no doubt motivate directors and auditors to spot business issues quicker and take decisive action to avoid business failure. Meanwhile, where a business has become insolvent, the additional scrutiny of the accounts and improved record keeping prior to the business insolvency could serve to protect directors from claims by insolvency practitioners and/or creditors.

Richard Baxter, Senior Partner in the corporate team at Stevens and Bolton, comments that: 

The corporate governance landscape for large, privately held businesses is continuing to evolve. There is no denying that many private companies have a very significant impact on employees, suppliers, customers and others, irrespective of their legal status. The extension of the Public Interest Entity definition is therefore not a surprise (or unwelcome) development. 

We are seeing more medium and large private companies voluntarily adopting internal policies taking into account the 2018 Corporate Governance Code or the newer Wates principles. This reflects a growing interest in high quality corporate governance in the unlisted corporate sector. Directors have a fine line to walk to remain entrepreneurial whilst exercising the appropriate level of prudence. Boards need to be familiar with and answerable for the company’s workings, and able to stand back to obtain an objective view. Embedding the key elements of challenge, competency and accountability within formal internal structures helps to facilitate this.

Directors should always be clear that dividends are paid lawfully from available distributable reserves – this is already a requirement of company law. Businesses will welcome clear guidance on the calculation of distributable reserves to support them in meeting this requirement. New disclosure requirements in this area for privately held companies are unlikely to be overly burdensome. 

Large accountancy businesses are already restructuring and planning for a more separate audit regime. It will be interesting to see how far auditor quality and choice will be enhanced through new regulations emerging from this consultation process.

Search our site