The government, in its consultation document Restoring trust in audit and corporate governance, is consulting on an ambitious package of proposals aimed at improving the UK’s audit, corporate reporting and corporate governance systems.

The proposals are focused on the UK's largest companies, public and private, and aim to restore confidence in the way that these companies are run and scrutinised, following a number of sudden and major corporate collapses. The proposals also address long-term concerns about the lack of competition and resilience in the statutory audit market covering the UK’s largest companies, and a perceived failure of the audit product to meet the growing expectations of its users.

The proposals build on the work of three government-commissioned reviews: Sir John Kingman's Independent Review of the Financial Reporting Council (the FRC Review), the Competition and Market Authority’s Statutory Audit Services Market Study and Sir Donald Brydon’s Independent Review of the Quality and Effectiveness of Audit (the Brydon Review).

In this overview, we focus on the proposals which most directly impact on companies, directors and shareholders.

Entities in scope

Public interest entities (PIEs) are the focus of most of the proposed new regulatory measures relating to audit, corporate reporting and corporate governance. PIEs currently comprise:

• companies whose transferable securities are admitted to trading on a regulated market (e.g. the Main Market of the London Stock Exchange);
• credit institutions; and
• insurance undertakings.

The government proposes to expand this definition to include:

• all large companies, including large private companies; and
• companies on the exchange-regulated AIM market with market capitalisations above €200 million.

For the purposes of identifying what constitutes a large company, the government has identified two alternative approaches. Option 1 comprises companies with either more than 2,000 employees or a turnover of more than £200 million and a balance sheet of more than £2 billion. Option 2 comprises companies with both more than 500 employees and a turnover of more than £500 million. The thresholds used under either option would apply to all companies in their own right. Additionally, in the case of parent companies, the thresholds would be applied to the group headed by that company.

It is estimated that option 1 would mean that approximately 1,960 companies would be brought within the definition of a PIE, whereas option 2 would mean around 1,060 additional companies being caught by the definition.

As well as consulting on which of these options to adopt, the government is also open to views as to whether Lloyds Syndicates, large third sector entities or other types of entity in which there is a strong public interest should be included as PIEs.

Directors’ accountability

Internal controls: Confidence in company reporting depends on the effectiveness of the internal controls and risk management processes that directors put in place and oversee. While acknowledging that the regulatory and other requirements applying to internal control arrangements in UK companies are well established, the FRC Review made the case for a strengthened internal control framework. The consultation, therefore, seeks views on three options to strengthen this framework.

• Option A: Require an explicit directors’ statement about the effectiveness of the internal control and risk management systems.
• Option B: Require auditors to report more fully about their views on the effectiveness of companies’ internal control systems.
• Option C: Require auditors to express a formal opinion on the directors’ assessment of the effectiveness of the internal control systems.

The government's tentative preferred option is to require a directors’ statement about the effectiveness of the internal controls, but leave the decision on whether the statement should be assured by an external auditor to the directors, audit committee and shareholders.

Dividends and capital maintenance: The consultation notes that legal framework for paying dividends is well established and appears generally to have operated effectively to prevent companies paying out excessive and dangerously high levels of dividends.

However, high-profile examples of companies paying out significant dividends shortly before profit warnings and, in some cases, insolvency, have raised questions about the robustness of the framework. Further, many investors are also interested in more information from companies about their approach to allocating surplus capital between the competing demands of returns to shareholders and matters such as long-term investment, pension fund deficits and improving balance sheet resilience. The consultation therefore proposes the following reforms in relation to dividends and capital maintenance. 

• New requirements to disclose distributable reserves: There are currently no explicit requirements under company law or accounting standards for financial statements to disclose the total amount of profits that are distributable. Under the government's proposals, individual companies (or, in the case of a group, the parent company) would disclose in their annual report the total amount of their distributable reserves. In addition, parent companies would be required to estimate and disclose the amount of potential distributable profits across the group that could, in principle, be passed to the parent company for the purpose of paying future dividends to shareholders.
• New directors’ statement about the legality of proposed dividends and the effects on the future solvency of the company: To address criticisms that the current framework is too backward looking and to increase directors’ accountability, there should be a requirement for directors to state that:
  • in proposing the dividend, they have satisfied themselves that it is within known distributable reserves and have had regard to their duties as directors; and
  • payment of the dividend will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years.

The government also invites views on whether the FRC’s successor body, the Audit, Reporting and Governance Authority (ARGA) should have responsibility for defining realised profits and losses, and whether the legal status and enforceability of the definition should be enhanced. (The guidance currently produced by the ICAEW and ICAS has no formal legal status.)

New corporate reporting on resilience, assurance and payment practices

Responding to recommendations in the Brydon Review, the consultation invites views on two proposed new reporting requirements.

• Annual Resilience Statement: This would set out how directors are assessing the company’s prospects and addressing challenges to its business model over the short (one to two years), medium (five years) and long-term (an indefinite period to be determined by the company), including risks posed by climate change. The statement would incorporate and build on the existing going concern and viability statements required of premium listed companies under the UK Corporate Governance Code. The requirement for an annual Resilience Statement would initially apply only to those companies but later be extended to other PIEs.
• Annual Audit and Assurance Policy: This would describe the directors’ approach (over a rolling three-year forward look) to obtaining internal and external assurance regarding the information they report to shareholders. It would provide a proportionate and flexible means for companies to explain whether, and if so how, they are obtaining assurance on any company reporting beyond that which is required by the annual statutory audit. In the case of listed companies, the policy would be subject to an advisory shareholder vote at the time of its publication. The requirement for an annual Audit and Assurance Policy would initially apply only to premium listed companies but later be extended to other PIEs.

The consultation paper also invites views on how company annual reports could include certain minimum reporting on supplier payment policies and practices.

Supervision of corporate reporting

The government proposes to strengthen the regulator’s powers relating to its corporate reporting review work. Key measures proposed include:

• giving ARGA powers to direct changes to company reports and accounts, rather than having to seek a court order, which is the position for the FRC at present; and
• extending the corporate reporting review process to the whole of the annual report and accounts to ensure that ARGA can review areas that are not currently within scope, e.g. corporate governance statements, directors’ remuneration and audit committee reports, and voluntary elements such as the CEO and chairman’s reports.

Enforcement against company directors

Although directors are ultimately responsible for a company’s accounts and reports, and have duties in relation to the auditing of those accounts and reports, the regulator currently has no direct powers to act if those duties are breached.

The government therefore proposes to provide ARGA with the necessary powers to investigate and sanction breaches by PIE directors of their corporate reporting and audit-related responsibilities.  These powers would cover existing Companies Act 2006 duties (e.g. the duties to keep adequate accounting records and approve accounts only if they give a true and fair view) and any relevant new statutory duties.

The proposals also include giving ARGA the power to impose more detailed requirements as to how certain statutory duties relating to corporate reporting and audit are to be met by directors, and potentially requiring directors to meet certain behavioural standards when carrying out their corporate reporting and audit duties.

Separately, the government proposes to strengthen malus and clawback arrangements in directors’ remuneration packages to provide better reassurance against rewards for failure. Initially, it will ask the regulator to consult on changes to the UK Corporate Governance Code. The proposal is that the Code should include provisions which recommend certain minimum clawback conditions or "trigger points" with a minimum period of application of at least two years after an award is made.

Audit purpose and scope

The Brydon Review looked not only at issues around audit performance, but also what audit is for and what should be expected of it. Key changes that the government is proposing in the light of the Brydon Review recommendations include: 

• a new duty on auditors to take a wider range of information into account in reaching audit judgments, in particular whether financial statements give a "true and fair view";
• new overarching principles for auditors, to reinforce good audit practice;
• powers for ARGA to oversee both the auditing of financial statements and the auditing of wider information that companies decide to have audited via the Audit and Assurance Policy process (see above); 
• a new corporate auditing profession to operate independently of the professional accountancy bodies; and
• new reporting obligations on auditors and directors relating to the detection and prevention of material fraud.

Audit committee oversight and engagement with shareholders

There are proposals for ARGA to have powers to impose, monitor and enforce additional requirements on audit committees in relation to the appointment and oversight of auditors, e.g. around monitoring audit quality and consistently demanding challenge and scepticism from auditors. The government envisages that these additional requirements will initially apply only to audit committees of FTSE 350 companies.

There are also proposals for several new measures to encourage and facilitate more meaningful engagement between a company and its shareholders on matters affecting audit quality. These include:

• a formal mechanism by which shareholders of premium listed companies can propose additional matters for emphasis within the scope of the company’s external audit; and
• proposals for better communication to shareholders following the resignation or dismissal of the auditor of a PIE.

Timing and next steps

The consultation is open until 8 July 2021 and the responses to the consultation will inform the draft legislation that government brings before Parliament "when Parliamentary time allows". To balance the need for audit reform with its desire to manage additional requirements on businesses, the government intends to take the following general approach.

• Measures that do not directly impact on businesses (e.g. the establishment of the new regulator) will be brought into effect quickly.
• Measures with significant impacts on those regulated by the new regulator will be commenced quickly, but transition periods and/or phasing may be appropriate to ensure a smooth introduction.
• Measures with significant impacts on wider business are most likely to be considered for later commencement, a transition period and/or phasing. In particular, this is likely to include the proposed extension of the definition of PIEs and the introduction of a stronger internal controls regime.

However, at this stage, there are no hard timelines.