Restoring Trust in Audit and Corporate Governance

On 18 March 2021, the department of BEIS published its long-awaited consultation document on restoring trust in audit and corporate governance. Business Secretary Kwasi Kwarteng said: “By restoring trust in our corporate governance regime and encouraging greater transparency, we will provide investors with clarity and certainty, cement the UK’s position as the best place in the world to do business, and protect jobs across the country”.

The proposals in this consultation are focused on the UK’s largest companies, both public and private, and the responses to the consultation will inform draft legislation that the Government will introduce over time.

Below we provide an overview of the key proposals.

Resetting the scope of regulation – a wider definition of public interest entity (PIE)

The current definition of PIE focuses on companies that are listed on a regulated market and other specific types of entities in the financial sector. The Government is proposing to extend the definition of public interest to ‘large’ private companies (regardless of their ownership structures), AIM companies with market capitalisations above €200 million and potentially other third sector entities.

Two options are proposed to define ‘large’:

Option 1: Companies with either:

• more than 2,000 employees or
• a turnover of more than £200 million and a balance sheet of more than £2 billion

Option 2: Companies with both:

• more than 500 employees and
• a turnover of more than £500 million.

In the case of parent companies, the thresholds would be applied to the group headed by that company thereby including worldwide subsidiaries in the measure.

While the initial impact will be on listed PIEs, many of the proposals in the consultation summarised below will in due course be extended to those larger private companies that fall within whatever option is eventually agreed upon.

Note: the impact on private companies is a long time away with no timetable yet set to do so.

Directors’ accountability for internal controls

The consultation sets out three options for strengthening the UK’s internal controls framework. These proposals would apply to PIEs. They are not mutually exclusive.

Option A: Require an explicit directors’ statement about the effectiveness of the internal control and risk management systems.

Option B: Require auditors to report more about their views on the effectiveness of companies’ internal control systems.

Option C: Require auditors to express a formal opinion on the directors’ assessment (from Option A) of the effectiveness of the internal control systems.

The statement made by the directors may cover all aspects of internal control and risk management systems or be limited to internal financial control (similar to section 404 (b) of the US’s Sarbanes-Oxley Act framework). The auditor’s attestation requirement would match the scope of the directors’ statement.

Dividends and capital maintenance

The key proposals for strengthening the law on dividends capital maintenance, which are initially aimed at listed and AIM companies but could be extended to all PIEs, are as follows:

• the Audit, Reporting and Governance Authority (ARGA) to prepare guidance on what should be treated as realised profits and losses or make binding rules as to the meaning of realised profits and losses with which preparers will have to comply
• new statutory reporting requirements for companies to disclose distributable reserves in the financial statements and new disclosures requiring a parent company to estimate and disclose the amount of potential distributable profits across the group, and
• requiring a new directors’ statement about the legality of proposed dividends and the effects on the future solvency of the company.

New corporate reporting on resilience, audit and assurance policy and payment practices

The Government proposes two new corporate reporting requirements, initially aimed at premium listed companies but in due course to be extended to other PIEs, as set out below:

Resilience statement

This would provide a directors’ assessment of the resilience of the business over the short, medium, and long term encompassing:

• the directors existing going concern assessment
• disclosures on the company’s prospects and resilience (assessed over a medium-term period of five years), and
• consideration of the main long-term challenges to the company and its business model, for example changes in demographics, technology and customer preferences.

Audit and assurance policy

Public interest entities will be required to publish an annual Audit and Assurance Policy which would, among other disclosures, include:

• An explanation of what independent assurance, if any, the company intends to obtain in the next three years in relation to the annual report and other company disclosures beyond required by statutory audit (for example the Resilience Statement and the statement on the effectiveness of internal control).
• An explanation of whether, and if so how, shareholder and employee views have been taken into account in the formulation of the Audit and Assurance Policy.

Reporting on Payment Practices

The proposals include greater transparency through disclosure in the strategic report of a summary of how the company – or group in the case of a parent company – has performed with regard to supplier payments over the previous reporting year, and to comment on how this compares to the year before that.

Supervision of corporate reporting

The Government proposes to broaden the regulator’s review powers so that it can scrutinise the entire contents of a company’s Annual Report and Accounts, give the regulator the power to direct changes to be made to a company’s report and accounts (where it is fair to do so) and increase the transparency of the regulator’s review work through the publication of more information about its findings.

Company Directors

The Government intends to legislate to provide ARGA with the necessary powers to investigate and sanction breaches of corporate reporting and audit-related responsibilities by PIE directors. All directors of companies which are public interest entities will be in scope due to the principles of collective responsibility and a unitary board.

Audit purpose and scope

The Government propose introducing a regulatory framework to cover both audits of financial statements (referred to as statutory audit) and other types of information which companies decide to have audited via the Audit and Assurance Policy process (‘wider audit’).

The new regulator would oversee the provision of these wider audit services referred to as ‘corporate auditing’.

Tackling fraud

The Government proposes to:

• legislate to require directors of Public Interest Entities to report on the steps they have taken to prevent and detect material fraud
• require auditors of Public Interest Entities to report on the work they performed in their statutory audit to conclude on whether the proposed directors’ statement (above) is factually accurate, and
• require auditors to report on the steps they took to detect any material fraud and assess the effectiveness of relevant controls.

Audit committee oversight

The Government proposes to require ARGA to impose additional requirements on audit committees in relation to the appointment and oversight of auditors. These requirements will cover the need for audit committees to continuously monitor audit quality, and consistently demand challenge and scepticism from auditors.

Any new requirements imposed by ARGA should allow for audit committees to exercise discretion and professional judgement and for innovative best practice to develop.

It is proposed that the new additional requirements should initially apply to audit committees of FTSE 350 companies and could then be extended to other PIEs in due course.

ARGA will have a duty to monitor compliance with the new audit committee requirements, including through a power to require information and/or reports from audit committees, to meet audit committee chairs to discuss issues and a power to place an observer on audit committees if necessary.

It will have appropriate powers to take action in relation to breaches of the new requirements against the company directors and/or the audit committee.

Engagement with shareholders

Several new measures are proposed to encourage and facilitate more meaningful engagement between a company and its shareholders on matters affecting audit quality which include:

• A formal mechanism by which shareholders of premium-listed companies can propose additional matters for emphasis within the scope of the company’s external audit, and
• Proposals for better communication to shareholders following the resignation or dismissal of the auditor of a PIE.

Competition, choice, and resilience in the audit market

The Government plans to increase choice, competition, and resilience of the statutory audit market through:

• Introducing a managed shared audit regime for FTSE 350 companies or, if needed, exercising a reserve power for a managed market share cap
• Operational separation between the audit and non-audit arms of certain firms, as determined by ARGA. This will include separate governance, financial statements, regulatory oversight of audit partner remuneration and audit practice governance; and statutory powers for the regulator to proactively monitor the resilience of the audit market and audit firms, including powers to require audit firms to address any viability concerns that are identified.

Supervision of audit quality

The Government proposes that:

• the new regulator be assigned responsibility for the determination of whether individuals and firms are eligible for appointment as statutory auditors of PIEs, rather than continuing the present delegation of this task to the recognised supervisory bodies (e.g. ICAEW)
• legislation will allow for Audit Quality Review reports on individual audits to be published by the regulator without the need for consent from the audit firm and the audited entity
• The regulator be provided with powers to require a UK group auditor to provide it with access to overseas component working papers.

Our initial view

The proposals represent important steps to rebuild trust and confidence in business and in the profession, which has been shaken following a number of high-profile corporate collapses. It is vital that stakeholder perceptions of the integrity of these businesses and the industry are restored. This is true both domestically and on the world stage, with the UK widely recognised as a destination of choice for businesses around the globe.

The measures to enhance corporate accountability, improve transparency in corporate reporting, expand the scope of audit and strengthen regulatory oversight should be viewed positively. However, consideration needs to be given to appropriately conclude on the scope of new measures, in particular the definition of public interest entities, when considering larger private companies to ensure that the proposals are applied proportionately and do generate a net benefit outcome.

Would you like to know more?

You can read our more detailed analysis of the consultation in the following briefing paper.

We encourage our clients to consider and comment upon the proposals using the Government’s consultation website at this link. The consultation closes on 8 July 2021.

If you have any questions about the above and how it may affect you, please get in touch with your usual Blick Rothenberg contact or Sunil or Milan using the details on this page.