In an article in the April edition of Governance & Compliance, I wrote about the government’s consultation on Restoring trust in audit and corporate governance. As I said in that earlier article, this is one of the most significant consultations in the governance arena for some time and I am grateful to all those members who joined our roundtables to share their views. In total, more than fifty members helped us with this response, so thank you all very much. In this article, and in another next month (as there is a limit on how much we can expect members to read about audit !) I will share the feedback that we received and – as we did not all agree on everything – the positions that we reached on the issues raised.
Regular readers of G&C will know that we have adopted a consistent position on the future of audit which we have repeated in all the recent reviews of the audit market and its regulation – Sir John Kingman’s review of the Financial Reporting Council (FRC), which reported in December 2018; the BEIS Committee’s report on the future of audit and the Competition and Market Authority(CMA)’s Market Study of the audit market, both in April 2019; and Sir Donald Brydon’s review of the quality and effectiveness of audit, which reported in December 2019. This is that there are three key issues that need to be addressed in order to improve audit quality: the expectation gap, the delivery gap and what we have termed ‘the Challenger challenge’. We reiterated those in our response. We also made the point that, in our view, there is a greater need to restore trust in audit than in corporate governance; the UK enjoys an international reputation for high-quality governance and trust is not as fractured as some may suggest.
As strong supporters of the UK corporate governance model of ‘comply or explain’, which allows companies to put in place the most effective governance arrangements for their particular circumstances, we cautioned against diluting or, in some cases, removing this flexibility. We are concerned that a number of the proposals set out in the consultation document will replace provisions of the UK Corporate Governance Code with set rules. This, combined with the increasing number of internal management processes that are being put to a shareholder vote at the AGM, risks eroding the UK’s system of Corporate Governance. There are already many mechanisms by which investors can signal dissatisfaction with the way in which their appointees – the directors – manage the company, not least the ability to vote against those directors at a general meeting every year. Advisory votes, which have little real impact, simply create an opportunity for those investors who wish to do so to ‘virtue signal’ by voting ‘against’, without actually doing anything meaningful like voting against the responsible director or directors personally.
Finally, we emphasised the critical importance of the competitiveness of the UK market. Our members with international businesses, particularly those with large US interests, are already reporting difficulties in both executive and non-executive recruitment, with the UK being perceived as over-regulated, especially in relation to remuneration, and unattractive to business and it is important that the UK retain its international competitiveness.
Public Interest Entities
The question of which organisations should fall with the definition of a Public Interest Entity (PIE) was fraught for many reasons, not least the desire of many organisations – and their representative bodies - currently outside the scope to avoid being drawn within it. We took the view that the definition should be strictly applied– organisations that meet the criteria should be in, otherwise they should be out. We were not convinced by arguments that certain large organisations should be exempt because they were charities, educational bodes, quoted on AIM etc. The one exemption that we did support was for subsidiary companies of an entity that would, itself, be within scope, as to treat such subsidiaries as PIEs in their own right would merely serve to create additional reporting at a level where it serves little useful purpose. We argued that, for consistency with other reporting requirements, the chosen definition should reflect the test used to identify those large companies which are already required to include a corporate governance statement in their directors’ report under the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), Schedule 7, paragraphs 21 to 30. We also argued that, it is inappropriate to use market capitalisation as a threshold for categorisation as a PIE. A company’s market capitalisation is constantly changing and is affected by many factors, some of which are external to the company, including market expectations, the performance of competitors and, in some regrettable cases, market manipulation by speculators.
Finally, we made the point that, whatever threshold is chosen, there should be an additional requirement that all organisations within scope have a properly qualified company secretary or governance professional. Granted, there is nothing to stop any organisation having a company secretary or governance professional should it choose to do so but, with the additional focus being placed on governance and reporting, we believe that the statutory obligation should be widened to cover the additional organisations being brought into scope as PIEs.
Another significant area for potential change was around proposals for the development of a UK version of the US Sarbanes Oxley regime. We saw no case for this. The current internal control frameworks generally work well and we see no advantage in adding layers of additional requirements except in a very few specific areas where existing requirements might be strengthened to increase effectiveness. We discussed this issue in our roundtable session with Lord Callanan and, whilst it was good to understand that it is not the Government’s intention to replicate the US regime, our members were able to share their experience of that regime that it creates a cottage industry, prioritising process over results, with considerable additional cost for the company, particularly in the form of accountancy and advisory services. We cautioned against the risk of regulatory creep.
That said, the Government’s initial preferred option, as set out in the consultation document, is generally a reasonable and proportionate approach. In particular, we supported the proposal that all directors should be required to acknowledge their responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting, rather than merely the executive directors, because we believe that the concept of the unitary board, with collective responsibility, is critically important. We argued that carrying out a review of the internal control framework on an annual basis would not necessarily be helpful, because twelve months is insufficient time to assess the effectiveness of any new or amended internal control framework. We also argued that companies’ internal control frameworks should not become subject to yet another shareholder vote at the annual general meeting and made the same points with regard to the proposal for a vote on the company’s Audit and Assurance Policy. We do not believe the increasing number of matters being put to a shareholder vote is supported by shareholders generally, or that many shareholders are well placed in terms of resource or expertise to understand the details of a company’s internal management processes.
We saw little real value in the proposed distributable profit reporting requirements, but we know that it is a matter of keen interest to some investors and, given that a company must prepare this information for the board before they can recommend a dividend payment, the marginal cost of reporting distributable profit should be negligible.
New Corporate Reporting
Enhanced reporting was a key focus in the consultation. We were not convinced by the argument that the proposed Resilience Statement is necessary, although were pleased to see that the intention seems to be that it replace the Going Concern and Viability Statements rather than being in addition to them – an additional statement would merely be repetitive.
Our chief concern was the expectation that the medium-term section of the Resilience Statement will require companies to look forward over a period of five years, with the long-term section looking even further ahead. It is our members’ experience that reporting tends to become less useful when companies are required to make statements on matters more than three years into the future as reporting tends to become more ‘boiler plate’ with fewer details and with less information specific to the company. This, 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 argued that the Government should provide in legislation for a ‘safe harbour’ for statements made in good faith and that companies cannot and should not be expected to look into a crystal ball that will predict all eventualities. For example, how many companies two or three years ago might reasonably be expected to have foreseen the impact on their businesses of the COVID-19 pandemic.
Audit Purpose and Scope
Generally we supported the Government’s proposals for the future of the audit profession and a clarification of the purpose and scope of audit. We disagree with the Brydon review’s position that the ‘expectations gap’ and ‘delivery gap’ are “a distraction”; on the contrary, we see them as fundamental to the underlying issue that the Brydon review rightly identifies: “Either audit is helping to reinforce deserved confidence in business or it is not”. In the interests of closing the ‘expectations gap’, we believe that a new definition of the purpose of audit should be adopted by the regulator. Unsurprisingly, we agree that a professional body always drives up the quality of a profession.
Next month I will report back on our responses on supervision of corporate reporting, directors and audit quality, Audit Committee oversight and engagement with shareholders , and competition, choice and resilience in the audit market.