Reviewing the UK Government’s feedback to its 2021 ‘Restoring trust in audit and corporate governance’ white paper
James Barbour CA provides an overview of the Government’s feedback paper to its 2021 ‘Restoring trust in audit and corporate governance’ white paper.
On 31 May, 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. Some of the key points are set out below.
Firstly, the reforms are focused on public interest entities (PIEs) with a number of the proposals restricted to larger PIEs.
ARGA – New regulatory body
The Financial Reporting Council (FRC) will be replaced by a new, stronger regulator – the Audit, Reporting and Governance Authority (ARGA) – with tougher enforcement powers and funded by a levy on industry. Work on this has already begun, with the Business Secretary already acting to enable the regulator to ban failing auditors from reviewing large companies’ accounts.
Widening of PIE definition
For the first time, the largest private companies, those with over 750 employees and with over £750m annual turnover, will come under the scope of the regulator, reflecting the impact they have on the wider economy. The Government therefore intends to include only third-sector entities that meet the new 750:750 size threshold.
Breach of directors’ duties
Directors at the biggest companies who breach their legal duties to be open with auditors, or lie about the state of their firm’s finances, will face sanctions such as fines, and the Government will act to address ‘rewards for failure’.
The Government will invite the FRC to consult on strengthening the internal control provisions in the UK Corporate Governance Code to provide for an explicit statement from the board about their view of the effectiveness of the internal control systems (financial, operational and compliance systems) and the basis for that assessment. The Government expects that this would be underpinned with guidance on how boards should approach the preparation of the statement, which would be developed following a review of the FRC’s existing Guidance on Risk Management, Internal Control and Related Financial and Business Reporting. This guidance would cover the identification of acceptable standards, benchmarks or principles and address definitional issues and the circumstances in which external assurance might be considered appropriate. Additionally, as part of the proposed 'minimum content' for the new Audit and Assurance Policy, companies will be required to report whether or not they plan to seek external assurance of the company’s reporting on internal controls.
The Government therefore intends to require qualifying companies or, in the case of a UK group, the parent company only, to disclose their distributable reserves, or a 'not less than' figure if determining an exact figure would be impracticable or involve disproportionate effort.
ARGA will issue guidance on what should be treated as ‘realised’ profits and losses. The Government is not legislating to require parent companies to provide an estimate of the dividend-paying capacity of the group as a whole. Such disclosures are to be encouraged rather than be a required element of reporting.
Managed shared audit
To reduce the level of concentration in the FTSE 350 audit market, FTSE 350 companies will be required to have a ‘meaningful proportion’ of their audit conducted by a challenger firm. The Government plans to legislate to give ARGA the power to set this percentage.
The new regulator, ARGA, will also be given the power to make big audit firms keep their audit and non-audit functions operationally separate and to enforce a market cap if the state of the market doesn’t improve. The FRC is already taking this forward with the firms on a voluntary basis.
Code of ethics
The Government recognises the concerns raised regarding its proposal for ARGA to set and enforce a code of ethics. Accordingly, the Government intends that ARGA will instead use the IESBA International Code of Ethics for Professional Accountants as the basis for enforcement action. The Government believes that this will allow the professional bodies to retain autonomy to set their own ethical standards while ensuring that there is a single set of standards, consistent with those of the professional bodies, as the basis for enforcement action by ARGA. The same code could also be applied to non-member accountants, should the scope of the regime need to be expanded in the future.
The Government has previously confirmed its commitment to publish a draft Bill to revamp the UK’s audit and corporate reporting regime this parliamentary session.
Table of key reforms:
Public Interest Entities (PIEs)
The UK definition of PIEs is inherited from the EU: companies listed on the stock exchange, banks & building societies, and insurance firms.
Very large unlisted companies (>750 employees and >£750m annual turnover) will also become PIEs, so the new regulator will scrutinise their reporting and audit and they will need to meet new transparency requirements.
The Financial Reporting Council (FRC) has a complicated mixture of statutory, voluntary, and contractual functions, funded by levies that are partly voluntary.
A new statutory regulator – the Audit, Reporting and Governance Authority (ARGA) – will replace the FRC, funded by a mandatory levy on industry. It will have new powers, including to direct companies to restate their accounts without going to court.
The FRC has no power to take action against company directors (unless they are accountants).
The regulator will be able to investigate and sanction directors of large companies for breaches of duties around corporate reporting and audit.
It is often unclear under what circumstances an executive director’s bonus would be withheld or clawed back.
The FRC will consult on amending the Corporate Governance Code to increase transparency around bonus clawbacks.
Accountants & the accountancy profession
The FRC has powers to investigate and sanction auditors, but in the case of other accountants it relies on voluntary arrangements with the chartered professional accountancy bodies.
The regulator will have statutory powers to oversee the professional bodies’ regulation of the accountancy profession and to investigate and sanction accountants in public interest cases relating to corporate reporting.
Companies are not doing enough to demonstrate how they are identifying and addressing future risks.
Large PIEs will have to explain how they are identifying and addressing risks, and to set out the steps taken to prevent and detect fraud. Directors of Premium listed companies will also be expected to state whether their internal controls are effective, under the Corporate Governance Code.
Companies don’t have to disclose their distributable reserves and accountancy bodies provide guidance as to what counts as ‘realised’ profits and losses (which is the legal basis for issuing dividends).
Large PIEs will have to publish their distributable reserves and confirm the legality of dividend payments. ARGA will issue guidance on what should be treated as ‘realised’ profits and losses.
The audit market
The FTSE350 audit market is heavily dominated by four large audit firms.
FTSE350 companies will be required either to appoint an auditor outside the Big Four or to allocate a certain portion of their audit to a smaller firm, bolstering the competition while avoiding replication of efforts. If necessary, the Business Secretary will be able to introduce a market share cap.
Companies do not have to state how they assure non-financial information in their annual reports (such information lies largely outside the statutory audit).
Large PIEs will have to set out how they assure the quality and reliability of information in their annual reports outside the financial statements, including on climate, risk, and internal control.