Analysis: Audit and corporate governance reform
BEIS proposes to broaden the scope of the definition of a public interest entity.
Public interest entities (PIEs) are currently broadly defined in the UK as:
- entities whose transferable securities are admitted to trading on a regulated market;
- credit institutions; or
- insurance undertakings.
When implementing the 2014 EU audit legislation the UK Government decided not to mandate any other entities as being PIEs, however, it is now revisiting this decision. There are currently roughly two thousand PIEs in the UK and the statutory audits and auditors of those entities are subject to more stringent measures e.g.:
- mandatory tendering, and mandatory audit firm rotation requirements;
- the statutory auditor’s functions including additional requirements as to the content of their report, and a requirement for a report to be made to the PIE’s audit committee (or equivalent body); and
- their regulation including a requirement for the FRC to take direct responsibility for inspecting, investigating and imposing sanctions in relation to audits of PIEs.
Companies in scope of the PIE definition with more than 500 employees are also required to produce a non-financial information statement within their strategic report. The FRC also inspects, investigates and imposes sanctions in relation to the audits of certain entities which are not PIEs, namely Lloyds syndicates and certain AIM listed companies. But these entities are not subject to the more stringent regulation which otherwise applies to PIE auditors and audits.
The Kingman Review expressed a concern that “the UK’s current PIE definition may be too narrow and exclude entities whose audit arrangements are a matter of public interest”, particularly large private companies.
In BEIS’ initial consultation on the Kingman Review’s recommendations, respondents indicated some support for extending the definition of PIE to include other large entities (particularly large private companies and large AIM-quoted companies). However, they were broadly opposed to smaller entities being included within the definition on the basis of proportionality.
There was support for the public interest as the test for determining where the regulator should target its resources. This was reflected by consultees who thought that PIEs should be designated because of the nature of their activities and not simply because of their size. The Government recognises that the activity of an entity may mean that it is of public interest. However, the Government believes it is appropriate to focus a test on companies given its intention to restore trust and retain public confidence in business.
The Government’s aim in expanding the PIE definition is broadly to ensure that:
- there is a clear articulation of the public interest in any group of entities being added to scope e.g. to provide increased investor protection, where their purpose has public benefit or in recognition of wider economic significance;
- the impact is proportionate; and
- as far as possible, the definition is aligned with existing thresholds used to determine the entities in scope of audit, corporate reporting and corporate governance requirements.
The Government proposes that an expanded PIE definition would operate to:
- extend the scope of the existing audit and corporate reporting requirements which already apply in relation to PIEs; and
- generally frame the scope of any new regulatory measures in relation to audit, corporate reporting and corporate governance.
The Government believes that size is a significant factor in determining if a company is a PIE. Larger companies tend to have a higher number of employees, creditors and investors with greater social and economic impact should they fail. The continued success of large companies, whatever their legal status, also has a sizeable impact on the economy at large as well as on its various stakeholders.
The Government proposes to extend the UK’s PIE definition to include certain large companies regardless of whether they are admitted to trading on a regulated market. This will, for example, ensure that certain large private companies are within scope. Two alternative approaches are being considered.
Large companies which are already required to include a corporate governance statement in their directors’ report. (approx. 1,960 additional PIEs)
That provision covers all companies with either:
- more than 2,000 employees; or
- a turnover of more than £200m and a balance sheet of more than £2bn.
The threshold for additional non-financial reporting requirements for existing PIEs (approx.. 1,060 additional PIEs), and would mean the definition of a PIE was only extended to large companies with:
- over 500 employees, and
- a turnover of more than £500m.
The second option focuses specifically on businesses which have high numbers of employees and turnover that would not necessarily be captured in the first test.
The thresholds used under either option would apply to all companies in their own right. Additionally, in the case of parent companies, the thresholds would be applied to the group headed by that company. It is proposed that a parent company would therefore qualify and be regulated as a PIE if the relevant thresholds for options 1 or 2 were met when applied to the accounts of the group headed by that company (i.e. its consolidated financial statements), where the parent company is required to file group accounts in the UK.
Option 1 captures companies in two different ways. It would cover companies with large numbers of employees but relatively few assets or turnover (for example, a services business with many staff but limited capital assets), as well as those with a high turnover and strong balance sheet but relatively few employees (for example, a high-tech manufacturer with significant physical or intangible assets). Option 2 may not capture those types of businesses as it requires companies to have a minimum threshold of both employees and turnover and so it will capture a different type of entity.
The FRC currently exercises monitoring and sanctioning powers in relation to the audits of AIM quoted companies incorporated in the UK with a market capitalisation of more than €200m. That means that while they are not currently PIEs, their audits are subject to monitoring and enforcement by the regulator rather than the professional bodies.
The Government has identified that such AIM companies would not necessarily meet the size thresholds under either of the options proposed above. It therefore intends that any new definition of PIE should also include companies on the exchange-regulated AIM market with market capitalisations above €200m. Such companies would therefore be subject to the range of existing and proposed requirements which will apply in respect of PIEs (approx.105 AIM companies).
Private companies listing on a regulated market
Listing on a regulated market automatically entails a company becoming a PIE. High standards of reporting and governance are rightly expected of listed companies, but the Government does not want to deter private companies from seeking a listing. It is therefore considering whether to make the transition to listed status easier by making compliance with some or all of the proposed new PIE requirements optional for a period of time after flotation, subject to gross revenues remaining below a specified threshold.
Qualifying and ceasing to qualify as a PIE
Large companies and AIM companies will need some certainty as to when they would be brought into or fall outside of the new PIE definition. Therefore, the Government will consider what provision should be made to ensure that the thresholds are applied over an appropriate period (e.g. a company might be required to meet the thresholds for three consecutive financial years or to meet the thresholds for two out of the last three years before qualifying as a PIE). The Government will also consider whether similar provisions could be applied for ceasing to qualify where these are not met.
Lloyd’s Syndicates are also already subject to enhanced audit monitoring and enforcement by the FRC. Lloyd’s Syndicates are an important part of the UK’s financial and insurance sector which means there is a public interest argument that they should become PIEs alongside the rest of the sector. They are currently subject to different regulatory requirements from PIEs.
Lloyd’s Syndicates are technically set up on an annual basis, but in practice many function like permanent insurance operations where the providers of capital (Lloyd’s members) may change from year to year. Due to their structure the risks of failure and wider economic significance of such failure are considered by the Government to be less than those of AIM and large private companies. The Government recognises this might mean the need for additional scrutiny and regulation as a PIE is disproportionate.
Third sector entities
Third sector entities (e.g., universities, charities and housing associations) that responded to the initial BEIS’ Kingman consultation expressed an interest in extending regulation to ensure there is no gap in oversight, given the public benefit purpose that is common in such organisations.
The Government does not wish to create a gap in regulation for large third sector entities, but it also recognises that many of these will already be subject to sectoral regulation. The Government is open to large third sector entities being classed as PIEs where they meet a suitable threshold but that a different threshold might be required for such entities given their relative scale and the nature of their activities.
Until 2016, the FRC inspected the audits of charities with incoming resources exceeding £100m. A similar threshold might usefully be applied to third sector entities for present purposes. (0.03% of all charities had income exceeding £100m in 2017/18)
Currently, the Government does not consider that there are any further types of entity that ought to be added to the PIE definition beyond those addressed above. However, it is open to arguments that other types of entity should be included as PIEs if there is a strong public interest in doing so.
Impact on the statutory audit market
Significant growth in the number of PIEs could impact on the market for statutory audit services of PIEs. Some believe this represents an opportunity for growth in the number and scale of market participants; whilst others warn of potential bottlenecks in the availability of registered PIE statutory auditors.
In the first option above (companies with 2,000 employees or £200m turnover and £2bn assets and AIM companies with over €200m market capitalisation), it is anticipated that around 90 additional audit firms could be brought into scope. Under the second option (companies with 500 employees and £500m turnover and AIM companies with over €200m market capitalisation), it is anticipated that only around 20 additional firms would be brought into scope.
In either case the overall size of the PIE audit market would increase. There would also be a larger number of potential PIE audit firms operating within the market. However, the scale of this change would depend on the choice made by the audit firms brought into scope to continue to audit an existing large client as PIE auditor, or to exit that segment of the audit market. Consequently, the new PIE definition could lead to increased competition within the PIE audit market, or it could create a capacity bottleneck.
Accepting the need to reduce the potential for bottlenecks and provide companies with the time they need to prepare, whilst also giving audit firms the opportunity to build capacity to exploit a potentially significant opportunity for a step change in competition, the Government proposes allowing a significant lead-time before introducing a new PIE definition.
The Government recognises that it could also be appropriate to allow for a phased introduction for a new PIE definition i.e. to introduce this in two or more stages, rather than all at once.
The deadline for comments on the Government’s consultation ‘Restoring trust in audit and corporate governance’ is 8 July 2021.