Change is on the cards

A look at some of the changes that can be expected following the publication of the government’s response to the consultation on strengthening audit and corporate governance systems.

Last month, I mentioned in my column that the Queen’s Speech included the promise of the long-awaited draft Audit Reform Bill. As I went on to explain, ‘A draft bill is one that is published for pre-legislative scrutiny by a select or ad hoc committee before formal introduction into Parliament.’ We have still to see the draft bill – indeed on 1 June, in response to a parliamentary question, Lord Callanan, Minister for Business, Energy and Corporate Responsibility, said that ‘The government’s draft bill on audit, corporate governance and insolvency reform is expected to be published during the third session.’ That is, between now and spring 2023, with legislation expected the following year.

That said, on 31 May, the government published Restoring Trust in Audit and Corporate Governance, its formal response to the consultation on strengthening the UK’s audit, corporate reporting and corporate governance systems. At 197 pages, it is not a quick read – although we must be grateful for small mercies in that it is shorter than the original 232-page consultation.

There are two main themes that I have drawn from the introduction to the government response:

  • There is widespread agreement on the need for reform: ‘The overall positive response to the case for reform set out in the white paper confirms the government in its view that reform is necessary.’
  • But not on what the reforms should be: ‘Given the high volume of responses, there was inevitably a wide range of views on individual proposals.’

The government has subsequently reviewed the proposals from the consultation document, and the feedback statement gives us a good picture of what will, and what won’t, be included in the draft bill. In this, and a further article in the next issue of G+C, I will look at some of the changes we can expect.

Public interest entities

PIEs are the most economically and systemically important companies and entities and the government is extending this definition beyond listed public companies to include any entity with 750 employees or more and an annual turnover of at least £750 million. This is a slightly higher threshold than originally proposed but seems proportionate as a ‘halfway house’ between the two options outlined in the consultation, which seem to have attracted roughly even support. On balance, our marginal leaning was towards the other option, but as our concern was about creating additional thresholds, the higher one is preferable. As we recommended, third-sector entities are only included where they meet the PIE thresholds and there will be no exemption for newly listing companies as that is the time when they most need high audit standards. We were not the only respondent to express concern about the position of groups of companies where one or more members of the group – although perhaps not the parent – meet the PIE thresholds; the government has undertaken to ‘consider a mechanism to remove or reduce this risk [of duplication of reporting within a group structure] ahead of introducing primary legislation. For example, there could be an option of either reporting at subsidiary level or reporting on a consolidated group basis.’

Tiered approach

Helpfully, the government has also decided on a tiered approach to audit and reporting, so some of the more expensive requirements that currently apply to PIEs – for example, requirements to have an audit committee, to retender the audit every ten years and to rotate auditor every 20 years – will not be extended to PIEs that only qualify because of the new size thresholds. Similarly, some existing and new reporting requirements will only apply to PIEs that meet the size thresholds and not those which are PIEs solely because they are listed.

Directors’ accountability for internal controls, dividends and capital maintenance

As we said in our consultation response, ‘We believe that current internal control frameworks generally work well and see no advantage in adding layers of additional requirements on internal controls. However, we believe it would be appropriate to review and strengthen existing requirements in specific areas where they may be needed to increase effectiveness.’ This is the approach that the government has taken. The FRC will be asked to include a requirement in the UK Corporate Governance Code for ‘an explicit directors’ statement about the effectiveness of the company’s internal controls and the basis for that assessment.’ We can also expect to see ‘guidance covering the identification of acceptable standards or benchmarks, definitional issues, and the circumstances where external assurance would be appropriate.’

This seems an appropriate and proportionate response. Although there was some support in the press for a UK version of the US Sarbanes-Oxley legislation, the government reports that 80% of responses to the consultation were opposed to making assurance mandatory, and they have taken on board our, and others’, concern that ‘the introduction of US-style internal control regulation would adversely affect the UK’s attractiveness as a prime location for business because it would increase costs for preparers.’ It seems, however, clear that we have not seen the end of this debate, and this may be an area of contention in the discussion of the draft bill.

Dividend payments and, in particular, the issue of distributable reserves, have been a contentious issue for some time, with an unedifying public argument between QCs as to whether or not the law requires that a figure for distributable reserves be included in the accounts. It will in future. The government also proposes to give the new ARGA ‘responsibility for defining realised profits in line with prevailing, generally accepted principles. A power for ARGA to issue statutory guidance was strongly preferred over a rule-making power.’ Directors will also be required ‘to make an explicit statement confirming that a dividend is legal and that paying it would not be expected to jeopardise the solvency of the business over the next two years.’

Resilience Statement

The government consultation proposed the introduction of a new statutory Resilience Statement and a new statutory Audit and Assurance Policy (AAP). The feedback statement is clear that both proposals will be carried forward, although in a slightly revised form in the light of consultation responses.

The Resilience Statement will require ‘companies to report on matters that they consider a material challenge to resilience over the short and medium term, together with an explanation of how they have arrived at this judgement of materiality.’ As we suggested, the Resilience Statement will replace the current requirement for a Viability Statement and also, subject to further consultation, a Going Concern Statement.

The government also ‘intends to replace the five-year mandatory assessment period previously proposed for the combined short and medium term sections of the Resilience Statement, with an obligation on companies to choose and explain the length of the assessment period for the medium-term section,’ but has reduced the requirement for reverse stress tests from two to one.

Finally, we mooted in our consultation response that the requirement for reporting to look further ahead, ‘combined with the proposals to increase the liability of directors, will result in greater caution in reporting, particularly for companies exposed to US regulation where there is already significant resistance from the companies’ US legal advisers to reporting, especially of risks or future speculation, that would be regarded as a basic expectation in the UK.’ We therefore argued that the government should provide a ‘safe harbour’ for statements made in good faith. They have confirmed that the Resilience Statement will form part of the Strategic Report and, as such, will benefit from the existing ‘safe harbour’ provision in Section 463 of the Companies Act 2006 unless ‘they knew the information was untrue or misleading (or were reckless as to whether it was so) or if they dishonestly concealed a material fact.’

Audit and Assurance Policy

PIEs will be required to publish an Audit and Assurance Policy which sets out a company’s approach to assuring the quality of the information it reports to shareholders beyond that contained in the financial statements. In the light of consultation feedback, this will be required every three years and will not be subject to an advisory shareholder vote.

Reporting on payment practices and public interest

The government is now planning to consult on whether the existing Reporting on Payment Practices and Performance Regulations 2017 should be amended, and that consultation will take account of responses to the white paper.

Consultation responses supported the government view that the suggested public interest statement was not required.

Supervision of corporate reporting

The feedback statement confirms the government’s intention to strengthen ARGA’s corporate reporting review powers as proposed in the consultation. ARGA will have ‘powers to direct changes to company reports and accounts, rather than having to seek a court order, along with powers to publish summary findings following a review. The government also intends to ensure that the regulator’s new power to require or commission an expert review will be available to support its corporate reporting review work. In addition, the government will extend the regulator’s powers to cover the entire contents of the annual report and accounts so that it can review areas that are not currently within scope, such as corporate governance statements and directors’ remuneration and audit committee reports as well as voluntary elements such as the CEO’s and chairman’s [sic] reports.’

The one area where, in response to feedback, the government has decided not to implement the consultation proposals is that of ARGA being able to offer a pre-clearance service for novel or contentious matters connected with accounting standards. This would involve a prior determination by the regulator that an accounting treatment that a company proposed to adopt would be compliant with the relevant accounting standards and it was felt that the challenges such a service would create are incompatible with the role of the regulator.

We strongly support the government’s proposals for strengthening the regulator, as set out in this chapter and elsewhere in the consultation document, but have to remind the government – as we have done in previous consultation responses – that the regulator’s objective to ‘promote brevity and comprehensibility in company reporting’ does not sit well with the government’s tendency in recent years to produce a stream of new reporting requirements; in some cases, it might be argued, in response to small but vociferous lobbies.

Next month, I will look at the remaining legislative proposals, including those dealing with company directors; audit purpose and scope; audit committee oversight and engagement with shareholders; competition, choice and resilience in the audit market; supervision of audit quality; a strengthened regulator; and additional changes to the regulator’s responsibilities.

Peter Swabey FCG
Policy & Research Director, The Chartered Governance Institute UK & Ireland

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