Ringing the changes

The second article of two looking at the government’s proposed plan to strengthen trust in audit, corporate reporting and corporate governance systems – while it’s clear that something needs to change, it’s less clear what that is.

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.

As I said in my article last month, 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 last month’s article, I considered the changes that we can expect relating to the definition of PIEs, the proposed ‘tiered approach’, directors’ accountability for internal controls, dividends and capital maintenance, the new resilience statement, the audit and assurance policy, reporting on payment practices and public interest, and the supervision of corporate reporting. This month, I will look at the remaining issues in the government response.

Company directors

The new regulator, ARGA, will be given powers to enforce PIE directors’ statutory duties relating to corporate reporting and audit, although the government is clear that ‘the new civil enforcement regime will be targeted, proportionate and transparent, and directors will only be accountable for what could reasonably be expected of a person in their position.’

It is possible that, ‘in exceptional circumstances’, such powers might ‘also be applied to a non-PIE’s directors, if doing so was justified by the public interest.’ Currently, the FRC only has power to take action against a director for misconduct if they happen to be a member of one of the professional accounting bodies so, although this is a significant extension of regulatory power, it seems proportionate.

Clawback and malus provisions in directors’ remuneration arrangements

The government remains concerned about ‘rewards for failure’ and will ask the FRC to ‘consult on how the existing malus and clawback provisions in the UK Corporate Governance Code can be developed to be more transparent and rigorous, and yet flexible to meet individual business needs.’ The original white paper invited views on a proposed list of minimum conditions for malus and clawback provisions to which remuneration committees could be asked to adhere, on a comply or explain basis, through the Code. In light of feedback, including that from the Institute, the government has accepted that there are risks in prescribing a one-size-fits-all approach for every remuneration committee to follow and that it is important for remuneration committees to retain flexibility to design and enforce their own malus and clawback polices so that they can be tailored to a company’s specific circumstances. Our chief concern was that any further tightening of clawback and malus would make becoming a director of a listed company an unattractive choice for potential directors. This particularly applied to the proposed condition for ‘reputational damage’. It is entirely possible that reputational damage may arise from decisions or actions that were, at the time, completely reasonable and the condition should contain a safe harbour for such cases.

Audit purpose and scope

The government supports the Brydon Review’s vision for the long-term scope and purpose of audit. This goes beyond the scope of the financial statements in order to become more informative for audit users but will not seek to establish a new professional body or regulatory oversight of a new ‘corporate auditing’ framework at this stage. The decision on whether to develop a non-binding purpose statement for audit, and its content, will be for ARGA. This is a little disappointing as one of our consistent arguments has been that the ‘expectation gap’ – the significant difference between the political, press and public expectation of the role of audit and what an auditor would perceive it to be as defined in the audit engagement letter – is one of the key challenges to be resolved. Our second issue was the ‘delivery gap’ – the poor quality of audits as assessed by the FRC. The government has taken the view that auditor mindset and behaviour can be most effectively influenced and changed through changes to audit standards, additional guidance and enforcement by the new, stronger regulator, rather than through additional legislation. This will be another task for ARGA.

Tackling fraud

Following consultation, the government intends to proceed with a new requirement for directors to report on the steps that they have taken to prevent and detect fraud.

Audit committee oversight and engagement with shareholders

The government intends to take forward the white paper proposals to give ARGA powers to set new minimum requirements for audit committees. These will relate to the appointment and oversight of auditors as well as powers to monitor compliance with the new requirements, but the decision has been made not to pursue Sir John Kingman’s proposal that ARGA should be able to appoint the auditor in limited circumstances nor will ARGA be able to place an observer on an audit committee.

Finally, the government is taking forward a series of proposals to empower shareholders to engage more meaningfully with audits and matters affecting audit quality, including asking ARGA to include appropriate provisions in the audit committee requirements and make appropriate amendments to the Stewardship Code. It will also introduce legislation to improve the information provided by auditors about their reason(s) for ceasing to hold office.

Competition, choice and resilience in the audit market

This was one of the more contentious areas of the consultation. For the Institute, the third key issue in the audit market was the ‘capacity gap’ – the lack of confidence on the part of companies, investors and some regulators in the capacity of smaller auditors to deliver high-quality audits of large or complex organisations. We argued that the regulator should publish an assessment of the quality of audits undertaken by challenger firms.

The government has decided to proceed with a package of measures to increase choice and improve resilience in the audit market and to enhance professional scepticism. These include: legislation to require UK-incorporated FTSE 350 companies to appoint a challenger as sole group auditor or, alternatively, appoint a challenger firm to conduct a meaningful proportion of its subsidiary audits within a shared audit (a ‘managed shared audit’); granting powers to ARGA to operate a ‘market share cap’, either in the event of a significant firm collapse or in the event that further intervention is required once managed shared audit has had an opportunity to take effect; and granting powers to ARGA to require an ‘operational separation’ of the largest firms and to monitor the health of audit firms, including sufficient powers to address concerns around an audit firm’s resilience.

Supervision of audit quality

The government will enable ARGA to reclaim the approval of statutory auditors of PIEs from the current RSBs and ARGA will also be asked to consult stakeholders to identify ways to increase the usefulness of information published on AQR findings and enhance the AQR process. The government is therefore retracting the 2016 Ministerial Direction that currently directs the FRC to delegate all those tasks which the law permits to be delegated to the RSBs, other than in certain circumstances.

A strengthened regulator

ARGA will have roles and powers clearly defined in statute and will be empowered to exercise its expert judgement to further its objectives. It will be funded through a statutory levy and appropriate mechanisms will be put in place in the event that decisions taken by the regulator are challenged. Our one concern in this area was that ARGA should not be standard setter, regulator, prosecutor, judge, jury and executioner. The government has agreed that it is unrealistic to expect that those who are subject to regulation and potential enforcement action will always agree with decisions taken by ARGA and so there will be a right to challenge those decisions and have those challenges heard by an independent and impartial third party.

Additional changes to the regulator’s responsibilities

The FRC’s current regulatory functions in relation to auditors are largely underpinned by legislation, but in the case of accountants, they are dependent on voluntary arrangements between the FRC and professional accountancy bodies. Such arrangements restrict the regulator’s effectiveness. The government will therefore introduce a new statutory regime to cover all relevant professional accountancy bodies – not only the chartered bodies – with a statutory enforcement regime for accountants, limited to members of the chartered professional accountancy bodies and to cases where wrongdoing gives rise to public interest concerns. ARGA will also be given statutory powers to oversee and regulate the actuarial profession, focused primarily on individuals, by reference to actuarial activities of public interest.

ARGA will also be tasked with carrying out a review of the regulatory framework for effective stewardship including the operation of the Stewardship Code, probably in 2023. The review will assess whether the Code is creating a market for effective stewardship and the need for any further regulation in this area.

The government also believes that ARGA is best placed to take on the role of system leader for the local government audit framework because, in the current local audit framework, the FRC is the only organisation which undertakes the core functions in relation to the quality framework needed by a system leader, as well as being an existing regulator.

The gestation period of this bill as it goes through the committee process will be fascinating. The Institute will continue to engage with BEIS and others as the final bill is developed – if you would like to be part of our working groups as this progresses, please let us know by contacting policy@cgi.org.uk

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

Search CGI