Government consultation on reforming the UK’s audit and corporate governance regime

The UK Government is launching a major overhaul of the UK’s audit regime to avoid company failures and safeguard British jobs. The Business Secretary is launching a consultation on wide-ranging reforms to modernise the UK’s audit and corporate governance regime (the “Consultation”) to improve corporate transparency. The reforms aim to strengthen the UK’s position as a world-class destination for investors targeting the UK’s biggest businesses and ensure markets work effectively.

BACKGROUND

The UK has been a leading destination for foreign investment in Europe and around the world for many years. However, in recent years investor and public confidence has been shaky in the wake of Brexit, the impact of the Covid 19 pandemic and large-scale company failures, such as Carillion, Thomas Cook and British Home Stores, leading to severe job losses.

Considering this, the new framework is targeted at the UK’s largest companies, as the government has recognised the economic importance of the largest privately owned companies, and how crucial it is for them to meet the highest standards of reporting to ensure that investors and financial market participants can continue to reliably depend on big players in the financial markets.

The government is proposing the creation of a new audit profession overseen by a new regulator, which will aim to drive up quality and standards in the market and increase choice for businesses. Currently, the audit of companies accounts across the UK is dominated by four accountancy firms: Klynveld Peat Marwick Goerdeler (“KPMG“), Deloitte, PricewaterhouseCoopers (“PwC“) and Ernest Young (“EY“) (the so called “Big Four”). Following its review of the statutory audit market, the Competition Market Authority (the “CMA”), identified that a key risk in the market is the concentration of audits carried out by the Big Four firms. The CMA stated that while the risk of one of the Big Four failing was low, there would be a significant adverse impact if a failure was to happen. Therefore, the CMA has proposed to break up the dominance of the Big Four by increasing the size of the market from public interest entity (“PIE”) definition changes to boost competition and the viability of non-Big Four market participants. As such, one proposal put forward is that large companies can now use smaller audit forms to conduct part of their annual audit to reduce the dominance of the Big Four firms.

As such, the reforms proposed in the Consultation implement the recommendations of three previous reviews in the area, addressing: (i) Sir Donald Brydon’s recommendation for a new audit profession (the “Brydon Review”); (ii) the CMA’s findings that the Big Four firms dominate the audit of FTSE350 companies, harming audit quality and undermining market resilience (the “CMA Review”); and (iii) Sir John Kingman’s recommendation that the current audit regulator, the Financial Reporting Council, is not well equipped to tackle the current challenges in the audit market and should be replaced (the “FRC Review”).

CONSULTATION PROPOSALS

In the Consultation, the government is seeking views on proposals to strengthen the UK’s framework for the way companies are audited. The proposals set out:

  • how companies should report on their governance and finances;
  • the way in which reports should be audited;
  • how audits and the audit market should change; and
  • the reasons for a new regulator.

The government has confirmed that the objectives of these reforms are to:

  • restore public trust in the way that the UK’s largest companies are run;
  • ensure that the UK’s most significant corporate entities are governed responsibly;
  • improve stakeholder interaction by giving stakeholders access to reliable and meaningful information on a company’s performance; and
  • ensure the UK’s audit regime is in line with global best practice.

As indicated above, the proposals are far reaching, setting out responsibilities of directors, auditors, shareholders and a new audit regulator, the details of which are set out below.

THE PROPOSALS

The proposals in the Consultation aim to make directors of the UK’s biggest companies more accountable if they have been negligent in their duties, which the government views as appropriately reflecting the level of responsibility that comes with holding such a position.

The Consultation includes the following proposals:

A new and strengthened regulator

The government is proposing establishing a new and strengthened regulator, the Audit, Reporting and Governance Authority (“ARGA”) as a way to restoring public confidence and trust in audit and corporate governance.

The aim is that ARGA will replace the Financial Reporting Council, with a general objective to protect and promote the interests of investors, other users of corporate reporting, and the wider public interest. ARGA will also have two operational objectives, on quality and competition, and several regulatory principles set out in legislation. ARGA will be governed by a simplified board with strengthened oversight, and non-executive members including the Chair, which will be public appointments. The regulator will be accountable to Parliament, with strategic direction from the government and be funded by a statutory levy, paid for by market participants.

Transparency in respect of director’s accountability for internal controls, dividends and capital maintenance

An option proposed is to require directors to publish an annual statement about the effectiveness of the internal control and risk management systems of the company which should explain: (i) the outcome of any annual review of these systems, (ii) how they have assured themselves that the system is appropriate, and (iii) setting out any remedial action when deficiencies are identified. This in turn would allow audit committees and shareholders to have the final determination as to whether the internal control effectiveness statement should be subject to external audit.

Dividends and capital maintenance

The government has commented that large business will need to be more transparent about the state of their finances. For example, it is the government view that companies should not pay out dividends and bonuses at a time when the company could be facing insolvency. It is proposed that companies disclose the total amount of reserves that are distributable, or if this is not possible, the “known” distributable reserve. Additionally, directors should state that any proposed dividend is within known distributable reserves and that payment will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years.

The government is also proposing to give new powers to ARGA in relation to how companies should calculate their distributable reserves.

In making its proposals, the government has commented that it is aware of the importance of dividends to pension funds and savers and the efficient re-allocation of surplus capital. It is therefore seeking feedback of any potential adverse effects and to avoid measures which will unnecessarily reduce the level of dividends paid by UK companies.

New corporate reporting on resilience, assurance and payment practices

The Consultation contains a proposal for directors to publish annual ‘resilience statements’ that set out how their organisation is mitigating short, medium and long-term risks, encouraging directors to focus on the long-term success of the company and consider key issues like the impact of climate change. Additionally, the proposals recommend for companies to adopt an ‘audit and assurance policy’  describing the directors’ approach (over a rolling five year forward look) to seeking internal and external assurance of the information they report to shareholders, including any external assurance planned beyond the scope of the annual statutory audit.

Strengthening the supervision of corporate reporting

The government’s proposals for strengthening the regulator’s powers relating to its corporate reporting review work, primarily respond to recommendations made in the FRC Review, which are as follows:

  • ARGA to have powers to direct changes to company reports and accounts, rather than having to seek a court order (which is currently required position);
  • increased transparency for the existing corporate reporting review process, by enabling ARGA to publish summary findings following a review and, if necessary, full correspondence;
  • the extension of the corporate reporting review process to the whole of the annual report and accounts. This will ensure that ARGA can review areas that are not currently within the scope of its powers such as corporate governance statements and directors’ remuneration and audit committee reports as well as voluntary elements such as the CEO and chairman’s reports.

Company directors

New company director proposals involve:

  • giving ARGA investigation and enforcement powers in relation to wrongdoing by directors of PIEs; and
  • strengthen malus (provisions in respect of withholding pending awards) and clawback (provisions relating to recover remuneration already paid to directors) provisions within executive directors’ remuneration arrangements.

The proposals of ARGA’s investigation and enforcement powers would apply to breaches of statutory duties relating to corporate reporting and audit of Public Interest Entities. It is anticipated that ARGA will also have powers to impose more detailed requirements for how directors should meet these duties.

The government is also considering requiring directors to meet certain behavioural standards in fulfilling these duties.

The strengthened malus and clawback arrangements involve the identification of minimum clawback conditions which would apply in all cases and have a minimum two-year application period. For example, the government has proposed that following updates to the UK’s Corporate Governance Code, companies could be expected to write into directors’ contracts that their bonuses will be repaid in the event of collapses or serious director failings up to two years after the pay award is made.

Additionally, the Government commented that directors of large companies could face fines or suspensions in the extreme cases of failures, such as significant errors with accounts, hiding crucial information from auditors, or not having proper oversight in respect to deterring fraud.

Audit purpose and scope

Following the major reform of the audit market proposed by the Brydon Review, the Consultation sets out the government’s proposals in response, including changes relating to audit’s purpose, audit practice and the organisation of the audit profession. The government’s proposals include:

  • a new corporate auditing profession to operate independently of the professional accountancy bodies;
  • new overarching principles for auditors, to reinforce good audit practice;
  • a new duty on auditors to take a wider range of information into account in reaching audit judgements, in particular whether financial statements give a “true and fair view”; and
  • new obligations on both auditors and directors relating to the detection and prevention of material fraud.

NEXT STEPS

The Consultation is open to anyone with an interest in this area, but in particular, amongst others, the government would like to hear from investors, shareholders, business stakeholders (including creditors) and other regulatory bodies such as professional associations that represent their members’ interests.

The deadline for responses to the consultation is 8 July 2021.

For a copy of the Consultation, please click here.

For more information, and any guidance or advice on corporate governance Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.

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