Restoring trust in audit and corporate governance

On 18 March 2021, the Department for Business, Energy & Industrial Strategy (BEIS) published a consultation paper titled “Restoring Trust in Audit and Corporate Governance”. The White Paper proposes substantial and long-awaited reforms to the UK audit and corporate governance rules, and companies who wish to shape the outcome of the proposals have until 8 July 2021 to respond.

The White Paper follows three independent reviews commissioned by the UK Government in 2018: the Kingsman “Independent Review of the Financial Reporting Council; the Competition and Market Authority’s “Statutory Audit Services Market Study”; and Brydon’s “Independent Review of the Quality and Effectiveness of Audit”.

The proposals set out in the White Paper are part of a wider package of reforms designed to ensure that the UK has a strengthened governance, reporting and audit framework to improve investor and public confidence in the way its largest companies are operated and scrutinised.  However, the proposals in this consultation are a key part of that package, and it is critical that companies understand the potential impact of the proposals on their business, engage with the consultation, and then follow the outcome in order to be ready to comply with the resulting changes. 

Those changes seem likely to be significant, not only in terms of how companies report on their governance and finances, but also to how reports are audited and how the audit market operates more widely.  In addition to the likely increases in compliance costs as a result of these changes, the Government is proposing  to impose further liabilities on directors in relation to audit and reporting, which may well push directors to demand higher salaries before taking on these roles. Finally, the potential risk for more significant and occurring liability for directors resulting out of these far-reaching proposals is likely to drive the premium of D&O insurance up.

The proposals set out in the White Paper set out how:

• companies should report on their governance and finances;
• reports should be audited;
• the audit and audit profession should change;

• a new independent statutory auditor (the Audit, Reporting and Governance Authority (ARGA)) will oversee these areas in place of the Financial Reporting Council which has been criticised for its lack of enforcement power. The new regulator will be equipped with new enforcement and investigatory powers to directly order changes to company’s reports and accounts (without a court order) and, thanks to the extension of the corporate reporting review process, to review governance statements and reports by audit and remuneration committees.

This note focuses on those proposals which impact directors, reporting and governance.

Who will be caught by the proposals?

The Government wants to ensure that the largest companies in the UK which are of public importance are subject to the changes.  The proposals will primarily apply to those companies that fall within the definition of Public Interest Entities (PIEs), which means public companies listed on regulated markets,  credit institutions and insurance undertakings. The Government is consulting on extending this definition to potentially include:

• Lloyd’s Syndicates;
• AIM listed companies with a market capitalisation over €200m; and
• large private companies with either as the first option more than 2,000 employees or a turnover of more than £200m and a balance sheet of more than £2bn, or as a second option companies with both over 500 employees, and a turnover of more than £500m. 

Summary of proposals

The following key proposals are set out in the White Paper.

Directors’ accountability for internal controls, dividends and capital maintenance

• Stronger internal company controls – the proposals seek views on strengthening internal controls frameworks.  The options include strengthening the responsibility and accountability of the CEO/CFO or the board of directors by requiring the inclusion of a statement from them on the effectiveness of the company’s internal controls and risk management procedures (some are referring to this as the Sarbanes Oxley provisions) and options for expanding the role of the external auditor in providing assurance that companies internal controls are effective.
• Dividends and capital maintenance – the proposals include a requirement on companies to report on their distributable reserves and for directors to be required to make a formal statement confirming that the payment of a proposed dividend will not threaten the company’s solvency over the next 2 year period.
• Resilience Statement – the proposals require the inclusion of an annual resilience statement (which builds on the current going concern and viability statements) setting out how directors have assessed the company’s prospects and addressed challenges to its business model over the short (1 year), medium (2 years) and long-term (5 years). 

The proposals recognise that reporting required to comply with the recommendations of the Taskforce on Climate-Related Financial Disclosures may also overlap with the requirements to report for the new Resilience Statement and the Government is looking for views on how these reporting measures may be integrated. 

• Audit and Assurance Policy – the proposals require the publication on an annual basis of an Audit and Assurance Policy which describes as a minimum: 
  • the directors’ approach (over the next three years) to seeking internal and external assurance of the information they report to shareholders beyond the scope of the annual statutory audit;
  • the company’s internal auditing and assurance processes;
  • the company’s policies for tendering for external audit services; and
  • whether, and if so how, shareholder and employees views have been taken into account in the formulation of the policy.

In addition, the proposals suggest that for quoted companies, the Audit and Assurance Policy should be subject to an advisory vote of shareholders.

• Reporting on payment terms – the view is expressed that improved reporting on payment policies and performance would be valuable and views on this proposal are requested by the White Paper.
• Enforcement against company directors – another important goal of this consultation is to remedy the “rewards for failure” corporate culture among executives. As such, the White Paper proposes key changes relating to directors’ wrongdoing (by proposing to give to ARGA the powers to sanction PIEs directors’ breaches of statutory duties dealing with corporate reporting and company audits) and remuneration (by strengthening malus and clawback mechanisms in the event of directors’ serious failures). This new enforcement regime is not intended to replace the existing arrangements for taking action against company directors. 

The Government is also seeking views as to whether directors should be required to meet certain behavioural standards when carrying out their statutory duties relating to corporate reporting and audits. 

Whether or not all of the proposals in the White Paper will be implemented (and in which form) remains to be seen; however it is clear from the general direction of travel that there will be more accountability, more regulation, and with it, increased processes and costs for the relevant companies and directors.  Proactive engagement by affected companies will be critical in shaping the outcome of these proposals.

Authored by Nicola Evans, Julia Marlow, Robert Gardener and Pasan Wijesuriya.