FRC issues Position paper on restoring trust in audit and corporate governance
James Barbour CA highlights the FRC’s Position Paper on audit and corporate governance reform.
On 31 May 2022, the UK Government published its plans to revamp the UK’s corporate reporting and audit regime through a new regulator, greater accountability for big business and by addressing the high level of concentration in the public interest entity (PIE) audit market and advised that it intends to do so through a range of measures. Some will require primary legislation and others will be taken forward via secondary legislation, changes to existing regulatory measures (including codes, standards and guidance), and market driven measures.
The Financial Reporting Council (FRC) has now published a Position Paper setting out how it will support the government’s reforms as it transitions into the Audit, Reporting and Governance Authority (ARGA). The purpose of the paper is to provide clarity on how the FRC will address issues in the government response which currently falls within the FRC’s remit.
It enables stakeholders to understand how that work will be delivered, by building on the ‘what’ in the government response and explaining ‘how’ and over what period, and covers proposed reforms affecting corporate governance, corporate reporting and audit. It also sets out how the FRC will incorporate developments in international standard setting into the reforms so that each applicable code, standard or piece of guidance only has to be opened up once to address the total reform.
The Position Paper focuses on five broad areas:
- Revisions and additions to the existing suite of codes, standards and guidance to implement reforms;
- The development of new standards in shadow form to allow for voluntary adoption ahead of legislation e.g., minimum standards for audit committees;
- Setting expectations for the markets that the FRC regulates to drive behavioural changes ahead of statutory powers, following the approach taken regarding the operational separation of the audit practice in the largest UK audit firms;
- The development of guidance to address issues set out in the government response; and
- 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 document.
As the government moves forward with legislation, the FRC expects there will be further actions required of it to support the transition to ARGA, particularly to address revised statutory regulatory requirements for directors and preparers. The FRC will communicate such proposals to stakeholders publicly in due course.
The key proposed revisions and other matters set out in the Position Paper are outlined below.
UK Corporate Governance Code
The focus of revisions to the Code will be to:
- Provide additional support in the existing Code provisions, where reporting is currently weaker, taking account of issues highlighted in the FRC’s recent annual report on the use of the Code and Culture report
- Revise those parts of the Code which deal with the need for a framework of prudent and effective controls to provide a stronger basis for reporting on and evidencing the effectiveness of internal control around the year end reporting process;
- Make necessary revisions to reflect the wider responsibilities of the Board and Audit Committee for expanded Sustainability and ESG reporting and, where commissioned by the company, appropriate assurance in accordance with a company’s audit and assurance policy;
- Include a provision for boards to consider how audit tendering undertaken by the company takes account of the need to expand market diversity; and
- Update the Code to ensure that it covers proposed changes to legal and regulatory requirements as set out in the government response, including strengthening reporting on malus and clawback arrangements.
The revised Code will be supported by updating the FRC’s guidance on:
- Audit Committees
- Board Effectiveness
- Risk Management, Internal Control and Related Financial and Business Reporting.
In line with the recommendation made by the Competition and Markets Authority (CMA), the FRC will develop for use, initially on a voluntary basis, a set of minimum standards for Audit Committees, setting out expectations on how Audit Committees should work to address the issues raised by the CMA in its report. It is proposed that round tables will be held with stakeholders in the second half of 2022 to develop these standards, so they are available for 2023 financial year ends. Supervision against the standards will commence in c. 2024, subject to legislation.
It is intended that the revised Code will apply to periods commencing on or after 1 January 2024 to allow for sufficient implementation time. The FRC plans to consult on a revised Code and supporting material from Q1 of 2023.
When ARGA is created, the government’s intention is that the scope of the FRC’s Supervision Division’s Corporate Reporting Review team will extend to include the whole annual report and accounts. Whilst the precise legislative detail is awaited the FRC expects that corporate governance disclosures will be in scope. Therefore, they intend to commence formal inclusion of these disclosures in their reviews from the first year of Code implementation and, in the meantime, will continue their inclusion of corporate governance reporting in a sample of routine reviews, initiate an initial pilot for remuneration reporting, and seek to engage with companies on a voluntary basis.
No further revisions to the Stewardship Code are to intended to be considered in this period. Rather, the FRC, working with the Financial Conduct Authority (FCA), the Department for Work and Pensions and the Pensions Regulator, will carry out a review of the regulatory framework for effective stewardship including the operation of the Code in the latter part of 2023, to allow two full years of reporting under the revised Code.
The changes proposed in the Government Response will require either primary or secondary legislation. The FRC will, however, support these reforms by developing implementation guidance on:
- The Resilience Statement;
- Fraud Reporting by Directors;
- The Audit and Assurance Policy and related disclosure requirements; and
- Capital Maintenance and Dividends, including distributable profits – to succeed the existing ICAS/ICAEW guidance.
The FRC will also revise its guidance on the Strategic Report, in recognition of the significant changes and the expansion in proposed reporting to ensure that the Strategic Report is a source of decision-ready information. The completion of this work will be delayed until the Government has set out its policy in respect of the use of International Sustainability Disclosure Standards in the UK, so that this can also
take account of reporting changes that will be driven by their implementation.
The FRC strongly support the efforts of the International Sustainability Standards Board (ISSB) to develop a global baseline to support sustainability reporting and will actively engage with the ISSB to raise the profile of its work and to make recommendations to further their proposals, working closely with other international regulators and standard setters.
Subject to the extension of Corporate Reporting Review (CRR) powers, the FRC intends to include new reporting disclosures in its review processes from the date at which any new reporting requirements commence. The FRC also intends to expand its ‘What Makes a Good…’ series to include ‘What Makes a Good Annual Report and Accounts’. CRR case outcomes will continue to be published on a quarterly basis, including reference to any findings related to non-financial disclosures where appropriate. The FRC Lab will also carry out a series of projects to assist with the development of the new reporting requirements set out in the Government Response (including resilience statements, capital maintenance disclosures and audit and assurance policies).
As the Government has determined, the fundamentals of what an audit is will remain unchanged. However, the FRC will consult on changes to address some of the policy points in the government
response through revisions to standards, including revisions to its Ethical Standard. There will also be significant changes to ethical requirements driven by changes to the International Code of Ethics, not least a revised global public interest entity definition, which includes market traded entities.
The FRC’s Supervision division will continue to build on its engagement and outreach with Audit Committees, seeking improvement in audit quality outcomes and will continue to work on non-legislative developments in its Audit Quality Review (AQR) team, with a view to providing a more effective and efficient AQR process. Supervision will also implement the new PIE auditor registration process and undertake a project on improving auditor education.
Significant changes to the FRC’s Ethical Standard will include:
- Revisions to take account of the new proposed framework that contains three levels of public interest entities: historical; new proposed UK public interest entities; and new public interest entities caught as a result to the changes to the international definition;
- Changes to address those situations where the role of Those Charged with Governance is discharged by the Board, in the absence of an Audit Committee;
- A consultation on whether it is desirable to exclude sustainability assurance work carried out in accordance with a performance standard adopted by the FRC from the UK aspect of the non-audit services fees cap;
- Revisions driven by international changes to the fees and non-audit services sections of the Code of Ethics;
- Consulting on whether to maintain the ‘Other Entity of Public Interest’ definition;
- Revisions to simplify and clarify provisions incorporated as a result of European Law in 2016;
- Necessary revisions to address issues identified as a result of the FRC’s Supervision and Enforcement work; and
- Any changes necessary to address the expansion of audit-related assurance work driven by sustainability and ESG, and the proposals around an audit and assurance policy.
The FRC’s intention is that the effective date for changes will align with the effective date for changes to the Code of Ethics, which means consulting on a revised Standard in Q1 of 2023. Supervision against any new or revised standards, including the Ethical Standards, will follow the respective commencement dates.
Significant thought has been given in the Government Response to the useability and informativeness of the audit process to stakeholders. Addressing these issues will require consultations on a number of existing ISAs (UK). However, in doing so, the FRC’s approach will be to minimise divergence between the UK and international standards.
The scope of those revisions will mainly focus on:
- Revisions to Auditor Reporting Standards – ISAs (UK) 700, 701 and 720;
- Revisions to Auditor Communication Standards – ISAs (UK) 260 and 265;
- Revisions to Auditing Standards covering Law and Regulation and Reporting to Regulators, to include Brydon’s recommendations on a ‘duty to report’ – ISAs (UK) 250 Sections A and B;
- Conforming amendments to other ISAs (UK); and
- Necessary updates to Bulletins and Practice Notes in support of revised standards, and to provide illustrative reports.
The FRC will also consult on proposed guidance in the form of performance standards to support a consistent approach to assuring internal controls reporting and the new resilience statement. The FRC’s expectation is that although new standards will be developed over the next 18 months, the effective date would align with the revised Ethical Standard, with the development of guidance following the development of revised standards.
The FRC will also develop and consult on a policy paper setting out its approach in respect of the Government’s proposed market resilience/ competition objective for ARGA, and the work it will be doing to prepare ahead of legislation. This will include a framework for ARGA’s competition objective, and how they propose to set success measures for assessing the effectiveness of market opening measures.
Having consulted on a new PIE auditor registration process in Spring 2022, the FRC expects to transition to the new process from Autumn 2022 onwards and will continue to develop its audit firm supervision model, including assessment of the Big Four firms’ progress in voluntarily implementing operational separation. Ahead of legislation, the FRC will start to develop the policies and procedures necessary to deliver on the full set of audit supervision powers, including the use of expert reviews.
The FRC views a high-quality, well-respected audit profession which attracts and retains the brightest and best candidates as an essential ingredient for a functioning audit system and improved audit quality. The Government response noted that “the Government expects the existing professional bodies to make substantial improvements to audit qualification, training and skills” over the next five years. This work is not dependent on legislation, and a project led by the FRC’s Professional Oversight Team will engage with the professional bodies on their plans for these improvements. The FRC expects this will involve consultation in late 2022/ early 2023 and implementation across 2023 to 2024.
The FRC also proposes to use its newly developed Audit Sandbox to assist with the implementation of new or revised requirements in auditing and ethical standards. The Sandbox will provide a safe regulatory space to allow for auditor-regulator dialogue on audit and competition policy related issues.
Local Audit Systems Leader
The Government has indicated that ARGA will be the systems leader for local authority financial reporting and audit. The FRC highlights that the financial reporting landscape is complex, the timeliness of reporting is poor, and the audit market is far from resilient. The FRC has recruited a director to lead this work, and the current priorities are to:
- Carry out stakeholder outreach to determine priorities and early action areas for the systems leader;
- Work with the Department for Levelling Up, Housing and Communities (DLUHC) and the National Audit Office to facilitate the transfer of the Code of Audit Practice, when legislation allows;
- Work with the DLUHC, HM Treasury and CIPFA LASAAC to determine whether the current complex financial reporting framework for local authorities can be simplified, whilst still meeting HM Treasury’s reporting requirements in support of the Whole of Government Accounts; and
- Build on the success of Practice Note 10 for the Central Government Sector, by consulting on proposals for a specific practice note for local public audit in England.
The FRC has have issued revised guidance to the Recognised Supervisory Bodies for recognising Key Audit Partners for local audit, which is applicable now. Taking on the systems leader role in shadow form, the FRC’s new Director of Local Audit will join in September 2022 to develop an industry-led workforce strategy, with support from DLUHC.
Transfer of Independent Supervision of the Comptroller and Auditor General to Parliament
The FRC’s Professional Oversight Team will support the transition of the Independent Supervisor role to an appropriate Parliamentary body, working with BEIS to achieve this, and subject to legislation. Shadow arrangements have been in place for the 2021 reporting cycle, and these will continue in 2022.