On the horizon: major reforms to the UK’s audit market and corporate governance regime A summary and outlook for professional and directors’ Risks
In light of recent high-profile corporate failures, there seems no doubt that significant changes are needed.
On 18 March 2021, the Government published its White Paper, “Restoring trust in audit and corporate governance”, drawing together proposals for reform of the UK audit market, consolidating regulatory oversight of the audit and accountancy professions, and proposing new laws to enshrine clearer and more onerous responsibilities for company directors and stakeholders.
As the White Paper acknowledges, stakeholder and public trust in corporate governance and the audit process has been seriously shaken in recent years by a series of sudden and significant corporate failures which, the White Paper says, have led to major social and economic damage. The White Paper notes the insolvencies of BHS, in 2016, and Carillion, in 2018, as prominent and troubling examples of major UK businesses failing without obvious prior warning. These insolvencies have happened against the backdrop of an audit market which is dominated by the Big Four firms, carrying a heightened risk of conflicts of interest and, certainly, serious concerns about competition and resilience in the statutory audit market. Indeed, the White Paper itself follows three independent reviews of the audit market in 2018, including a report by the Competition & Markets Authority (“CMA”) which found that 100% of companies in the FTSE100 and 97% of those in the FTSE350 were audited by the Big Four firms. Separately, an investigation by the Financial Reporting Council (“FRC”) in 2018 found that 27% of FTSE350 audits required improvements and were sub-standard. Independent reports in 2018 by Sir John Kingman and Sir Donald Brydon respectively also identified the need for significant reform in audit, accountancy and corporate governance. Those findings, together with those of the CMA, are brought together and addressed in the proposals set out in the White Paper. So what are the key proposals?
A new regulator: ARGA
The White Paper proposes to replace the existing FRC oversight body with a new regulator, the Audit Reporting and Governance Authority (“ARGA”). It is anticipated that ARGA will build upon the existing FRC infrastructure, but with enhanced authority and powers to “protect and promote the interests of investors, other users of corporate reporting, and the wider public interest.” It will also have operational objectives relating to audit quality and competition. ARGA will be funded by a statutory levy on market participants.
Significant reforms are proposed in the White Paper relating to the regulation of the audit and accounting professions and the audit process itself. The reforms are intended to address both the concerns as to the quality of the audit process and the more systemic concerns around conflicts of interest and effective market competition, having regard to the dominance of the Big 4 firms in offering accountancy and audit services to all but a small proportion of FTSE100 and FTSE350 companies. The key proposals are as follows:
- A new corporate auditing profession is to be established to operate independently from the professional accountancy bodies. This is intended to address concerns about conflicts of interest where firms are offering corporate clients both accounting and auditing services. The proposal to split the profession also reflects the need to alleviate the burden on existing regulators and ensure that the professions are properly regulated in the key audit disciplines;
- 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 judgments and assessing whether the financial statements give a “true and fair view”;
- New obligations on both auditors and directors relating to the detection and prevention of material fraud.
In order to safeguard the interests of shareholders by increasing audit quality, ARGA is to have powers to set and enforce additional requirements for audit committees in the appointment and oversight of auditors. ARGA would have a new power to appoint an auditor where more serious problems exist with a company’s audits. In addition, it is envisaged that shareholders will have an ability to require directors and auditors to report on specific issues of concern, and there are proposals aimed at achieving better communication between shareholders and directors in some cases.
Addressing concerns about the lack of competition in the market dominated by the Big Four, the White Paper proposes the following reforms:
- ARGA will have regulatory powers and duties intended to increase choice and competition in the FTSE350 audit market, initially through a managed shared audit regime which will introduce opportunities for so called ‘challenger’ audit firms and, potentially, taking a reserve power for a managed market share cap;
- The regulator is proposed to have powers to require operational separation between the audit and non-audit arms of certain firms;
- It will also have the power to monitor the resilience of the audit market and audit firms, and to take enforcement action to address anti-competitive practices and abuse of dominant position within the statutory audit market.
Directors’ accountability and responsibilities
A founding premise of the White Paper is that “responsible behaviour by directors is the fundamental starting point for high quality and reliable corporate governance and reporting. It is particularly vital that we hold the directors of our largest companies to account, both to protect the interests of shareholders in those companies and because loss of trust in those directors and those companies can have far-reaching adverse effects across the UK.” Against that background, reforms to directors’ responsibilities and corporate governance are necessary, says the White Paper, to “sharpen directors’ accountability” because the current framework is inadequate in holding directors to account. Further, there are weaknesses in reporting and accountability in three key areas of management relating to (i) internal controls over financial reporting, (ii) dividend and capital maintenance decisions, and (iii) the steps that directors are taking to consider and strength the company’s future resilience.
The White Paper proposes, first, that the directors should be required to carry out an annual review of the effectiveness of the company’s internal controls and make a statement, as part of the annual report, as to whether they consider the controls to have operated effectively. The statement will need to disclose the benchmark control system used and explain how the directors have assured themselves that it is appropriate to make the statement. There are subsidiary proposals which would entail the auditor also making a statement as to the company’s internal controls. In respect of dividends and capital maintenance, to address the problem of excessive distribution of dividends and inappropriate depletion of capital reserves, the White Paper proposes that companies (and parent companies in a group) should disclose the total amount of reserves that are distributable, and the directors will have to state formally that any proposed dividend is within known distributable reserves. ARGA will have powers in relation to how a company should calculate its distributable reserves.
In addition, the proposals would increase controls and sanctions applicable to defaulting directors, and give ARGA powers of investigation and enforcement against directors of public interest entities. There will also be strengthened “malus and clawback” arrangements which would enable companies to clawback or withhold dividends and remuneration paid to directors guilty of misconduct, a material misstatement of results, failures of internal controls and risk management, reputational damage, or failure to protect the interests of employees and customers. These changes are likely to be reflected in amendments to the UK Corporate Governance Code.
Corporate reporting and resilience
The Government proposes new reporting requirements for directors of public interest entities, requiring an annual Resilience Statement, explaining how directors are assessing the company’s prospects and addressing challenges to the business model over the short, medium and long term. There is expected to be an express requirement for the Resilience Statement to address how the company is meeting the challenges of climate change. Further, under the proposals, directors will be required to publish an Audit and Assurance Policy, describing the directors’ approach, over the ensuing 3-year period, 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. In addition, ARGA will have powers relating to its corporate reporting review work which will enable it to require directors to make changes to company reports and accounts, and to publish its findings and correspondence with directors following a review of any specific company.
In light of the high-profile corporate failures of recent years and, potentially, with more such failures on the horizon in the wake of the pandemic, there seems no doubt that significant changes are needed in the audit market and UK corporate governance regime more generally, addressing the evidence and criticisms identified in the various independent reports published in 2018. Assuming the Government’s proposals are adopted (which by and large seems a pretty safe bet, not least because the audit market has expressed agreement with the need for reform), big changes will be ushered in for accountants, auditors and their regulators. Significant institutional reorganisation will be required both for companies and the relevant accounting and audit professions, most likely carrying a considerable short-term cost.
At least in the early days of the new regime, the reforms will inevitably bring new risks to the accounting and audit professions and, of course, to company directors. Those ‘challenger firms’ which are intended to benefit from the crackdown on anti-competitive practices are likely to face challenges themselves in terms of their operational resilience and ability adequately to resource the requirements of auditing FTSE companies where they have previously had so little opportunity to gain experience. This will bring potentially significant liability risks, and exposures to a wide range of claimants in various classes, as well as exposure to sanction and disciplinary proceedings with a newly-armed and emboldened regulator. The audit profession, particularly challenger firms, and their liability insurers will have much to contemplate. There will also undoubtedly be new and interesting risks for directors and D&O insurers to look out for. The White Paper launched a consultation on the proposed reforms and seeks comments on many of the options identified for future regulation. The consultation closes on 8 July 2021 and, although the Government has said that it does not intend to rush reforms through, we can expect to see the new regime start to crystallise once the results of the consultation are known. For now, we have a pretty good idea of what is likely to be on the horizon and there is time to engage with the White Paper and prepare for the inevitable reforms.
For further guidance on the implications of the new white paper, contact our company law solicitors.