The Government’s approach to reform
- Public Interest Entities (“PIEs”) are the focus of most of the proposed new regulatory measures relating to audit, corporate reporting and corporate governance.
- The White Paper proposes expanding the definition of ‘PIE’ beyond publicly listed companies to include the largest private companies. There are two alternative proposals to achieve this: (i) adopting the test already used to identify those large companies that must include a corporate governance statement in their directors’ reports, or (ii) a narrower test which incorporates the threshold for additional non-financial reporting requirements used by existing PIEs. The Government invites views on whether other vehicles in the ‘third sector’, such as entities with a public benefit purpose, should also be brought within the expanded definition of PIE.
- The Government proposes to establish the Audit, Reporting and Governance Authority (“ARGA”) as the new regulator with enhanced powers by bringing forward the necessary legislation when Parliamentary time allows. The new regulator will be funded by a statutory levy on market participants. The White Paper intends that ARGA will receive strategic direction from the Government and will be accountable to Parliament, for example in relation to the performance and speed of its enforcement activity. The paper consults on proposals for ARGA’s general objective, operational objectives and regulatory principles. The general objective proposed for ARGA is “to protect and promote the interests of investors, other users of corporate reporting and the wider public interest”.
New elements of corporate reporting
- In the wake of by Sir Donald Brydon’s report, the Government wants to drive a new, more holistic, reporting mindset across all forms of corporate reporting, not just the financial statements.
- The Government proposes requiring PIEs to publish:
- an annual Resilience Statement in which directors assess the company’s prospects and challenges over the short, medium and long term. The Government invites views on whether the Resilience Statement should specifically address the impact of climate change on the company’s business model and financial planning, and whether it could provide a means for companies to provide disclosures consistent with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD);
- an Audit and Assurance Policy in which directors explain how they are seeking, over a rolling three year period, to obtain internal and external assurance of the information being reported to shareholders.
- The Government also seeks views on whether PIEs should report on supplier payment policies and performance.
- The Government is minded to keep under review the case for a public interest statement, and does not plan to introduce a new statutory requirement within this current reform package. The White Paper notes the progress made in proposals for the design of a public interest report in the Financial Reporting Council’s October 2020 discussion paper on ‘The Future of Corporate Reporting’.
Audit quality and the purpose of an audit
- The Government broadly agrees with Sir Donald Brydon’s views as to the purpose of an audit and his recommended changes to the extent of an auditor’s role, with an emphasis on meeting the needs of stakeholders and addressing future challenges to the audited business. The Government is minded to create a statutory responsibility for auditors to consider relevant director conduct and wider financial or other information in reaching their judgements. It proposes to require ARGA to incorporate Sir Donald’s concept of the purpose of an audit in its work as regulator, and to empower ARGA to oversee all non-statutory audit and assurance services provided by auditors under the expanded concept of audit envisaged by Sir Donald.
- The Government intends to implement many of the other recommendations of the Brydon Review:
- The Government is attracted to the recommendation for a creation of a new professional body for corporate auditors, but recognises the complexities this would present if the new body is to stand entirely separately from existing members’ bodies.
- The creation of overarching binding requirements on auditors, including in their non-statutory work, in relation to matters of ethics, scepticism, and transparency.
- A statutory requirement for directors of PIEs to report on the steps they have taken to prevent and detect material fraud, with an accompanying statutory requirement for auditors to report both on the factual accuracy of the directors’ fraud prevention/detection report and on steps the auditors took to detect any material fraud and assess the effectiveness of relevant control. However, the Government is unpersuaded by Sir Donald’s suggestion that a separate Fraud Tribunal is required in order to review issues relating to frauds that audits have not detected.
- The extent of work performed on matters falling outside the scope of statutory audit, such as assurance on Alternative Performance Measures and KPIs, is for companies to decide with their auditors on the basis of an audit and assurance policy determined by each company.
- Mechanisms for enabling greater shareholder engagement in audit, in particular in relation to the audit plan and encouraging both attendance by the auditor at AGMs and questions about the audit to be put at AGMs (though the Government does not favour requiring auditors to attend the AGM or requiring questions about audit to be a standing agenda item for AGMs).
- Measures to improve communication to shareholders and the regulator of an auditor’s reasons for resignation. The Government has not set out detailed proposals of its own for addressing this but is consulting on the specific recommendations made in the Brydon review.
- Establishment of a new independent body the Audit Users Review Board to discuss audit quality and ideas for improvement, with the involvement of representatives of the Investment Association.
- The Government does not agree with Sir Donald’s recommendation for changing the form of audit opinion on the accounts from “true and fair” to “present fairly, in all material respects”.
- The Government is not minded to legislate further on audit liability, whether in respect of liability limitation or the extensions to the auditor’s role envisaged by Brydon, but is encouraging a dialogue to establish the reasons why liability limitation agreements have not been made, and whether this is acting as an obstacle to audit innovation.
- The White Paper accepts the CMA’s view that ARGA should be given additional powers over audit committees of PIEs, starting with FTSE 350 companies, in relation to their role in appointing auditors and overseeing the audit including the ability to enforce compliance by them.
- The Government is not minded to give ARGA the power to appoint an auditor, and appears reluctant to introduce powers to compel an auditor to accept an appointment but is nevertheless consulting on that question in its White Paper.
The role of the regulator
- A key recommendation made by Sir John Kingman in his review of the FRC concerned the fact that the FRC’s enforcement powers under its Accountancy Scheme arise from the voluntary arrangement put in place by the members’ bodies. The Government agrees that this should be replaced with new enforcement powers for ARGA to be based in statute, which would be similar to the AEP in terms of powers and sanctions, and which would be available against firms and individuals who belong to one of the members’ bodies. The Government has also agreed that the current “misconduct” test (involving conduct which falls significantly short of reasonably expected standards) should be replaced, by a power to take enforcement action in respect of any breaches of specific requirements which apply to accountants, including breaches of a standard ethical code which ARGA is to introduce for all accountants. The enforcement power would not be restricted, as Sir John Kingman had envisaged, to engagements for public interest entities, but could be exercised where a public interest concern arises.
- The Government has adopted various other recommendations by Sir John Kingman and now proposes that:
- ARGA, rather than the members’ bodies, should have responsibility for approval and registration of firms and individuals as statutory auditors of PIE entities.
- ARGA will have statutory power to publish its Audit Inspection Reports on individual company audits, without the consent of the audit firm or the company, using a template under development by the FRC, which will need to incorporate safeguards to address sensitivities.
- ARGA will have powers to require a UK group auditor to provide it with access to overseas component working papers, but it is not proposed that it will have enforcement powers against overseas component auditors.
- The members’ bodies for chartered accountants shall be required by legislation to comply with oversight arrangements set by ARGA in relation to the accountancy profession generally, and ARGA would be responsible under these arrangements to monitor a wide range of activities undertaken by those bodies such as training and qualifications, licensing, practice assurance, complaint handling, disciplinary procedures, and governance arrangements.
- ARGA should have power to require rapid explanations from PIEs where it has concerns relating to a PIE’s compliance with its corporate reporting or audit obligations.
- ARGA should have power to require an expert “skilled person” review, and to publish a summary of it if that is in the public interest, where it has identified concerns relating to a PIE’s corporate reporting or audit.
- No specific proposal is made for the regulator’s information-gathering powers to override legal professional privilege. However, the White Paper seeks views on how the principle of privilege may be respected without adversely affecting the ability of the regulator to investigate audits.
- The White Paper also consults over the possibility of requiring auditors to be more proactive in reporting serious concerns about an audit client (such as its viability) to the regulator, and contemplates that statutory protection from disclosure might be provided.
- The Government plans to strengthen ARGA’s powers in relation to corporate reporting review work. In particular through:
- powers to direct changes to company reports and accounts, rather than having to seek a court order;
- powers to publish summary findings and, if necessary, full correspondence following a corporate reporting review, thereby increasing transparency; extending the corporate reporting review process to the whole of the annual report and accounts, so that ARGA can review novel areas such as corporate governance statements, directors’ remuneration and audit committee reports and voluntary elements such as the CEO and Chairman’s reports.
- ARGA is to retain its responsibility for regulating the actuarial profession, despite Sir John Kingman’s recommendation that this be transferred to the PRA. Its powers (including enforcement) are currently derived from the voluntary arrangement with the relevant members’ bodies for individuals in the profession. The Government intends to place this on a statutory footing, with ARGA enjoying a strengthened role and powers, such as being able to require correction to work that falls below the requirements of technical standards. The Government is also considering extending the enforcement regime to include actuarial work undertaken by entities (as well as individuals who are members of the relevant professional body).
Market choice and resilience
- Having considered the CMA’s proposals, the Government intends to introduce a managed shared audit requirement for all FTSE 350 companies, to be phased in by introduction at the time of each company’s process for re-tendering for audit services (but not at annual re-appointments). This would be subject to exceptional circumstances. The Government envisages that challenger firms would most likely undertake work on one or more subsidiaries, and be liable for that work (but not jointly or severally liable for the group audit). The Government also proposes to create a reserve power under legislation to enable it to introduce a market share cap in relation to FTSE 350 companies, with the potential to use it in the event of one firm experiencing a collapse, which is to be the subject of future consultation.
- The Government has endorsed the concept of operational separation of audit and non-audit services within firms, without the CMA’s proposal for separate profit-sharing arrangements, alongside strengthened governance and additional powers for ARGA over the audit services operation and remuneration of auditors. The operational separation requirement would apply initially to audit firms who carry out statutory audits of 15% or more of the FTSE 350 by audit fees, with a view to this requirement being extended further. The Government intends to create powers for ARGA to require full structural separation in future, subject to consultation.
- The White Paper sets out proposals for ARGA to be given additional powers to monitor and report on resilience in the audit market, including statutory powers to require information from PIE audit firms and enforcement powers against anti-competitive behaviours. Other proposed new powers include rights to information about insurance arrangements and capital reserves, the possibility of setting minimum insurance and capital requirements for particular firms, and the power to require firms to take action to address concerns about viability.
- The Government has opted not to introduce legislation in respect of some of the CMA proposals that were not so far-reaching, relating to remuneration deferral, audit firm ownership, technology licensing, notice periods and non-compete clauses. The Government has also made clear it does not intend to shorten the current tendering and rotation periods for audit.
- In the Government’s view, there is often a failure to hold directors sufficiently to account for significant corporate collapses, and it is necessary to sharpen directors’ accountability in key management areas within the largest companies.
- The Government proposes that ARGA will be given the necessary investigation and enforcement powers to hold all directors of PIEs to account for wrongdoing in cases where there have been breaches of directors’ duties regarding corporate reporting and audit. Existing powers held by other enforcement agencies would not be affected; responsibility for bringing directors disqualification proceedings would remain with the Insolvency Service.
- A related proposal is that ARGA should be empowered to impose more detailed requirements, and separate behavioural standards (such as acting with honesty and integrity), as to how PIE directors should comply with their existing statutory duties relating to corporate reporting and the audit of PIEs, and make clear that directors will be liable to civil enforcement action for breach of those requirements.
- The White Paper details proposals for new director reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning, in keeping with the recommendations made in recent reviews and consultations. The White Paper seeks views on three options for strengthening internal controls:
- An annual review by directors of the effectiveness of the company’s controls resulting in a statement in the annual report as to their effectiveness which would need to explain the basis for making the statement. This is tentatively the preferred proposal.
- A description in the audit report of the work undertaken for the audit to understand the company’s internal control systems, and a statement of how that work has influenced the audit. However, this would not be a formal opinion by the auditor on controls.
- A formal opinion by the auditor on the directors’ annual attestation as to the effectiveness of the company’s internal controls. This would be comparable to the model typically seen in US reporting.
- In relation to dividends and capital maintenance, the White Paper proposes that reporting should provide greater transparency around distributable reserves, and that directors should give a statement that any proposed dividend is within the known distributable reserves and would not, in their reasonable expectation, threaten the company’s solvency over the next two financial years. The White Paper invites a discussion as to whether ARGA should be responsible for guidance in relation to the calculation of distributable reserves.
- The White Paper also sets out proposals for subjecting executive directors’ remuneration arrangements to mandatory malus (withholding of pending awards) and clawback terms for a minimum term of two years after an award is made. Such default minimum provisions would be triggered in cases of serious misconduct, material misstatement of results or an error in performance calculations, and failures of internal controls and risk management. It is proposed that these changes would be implemented by the regulator through changes to the UK Corporate Governance Code.