Government white paper: Restoring trust in audit and corporate governance

Yesterday, the government published its long-anticipated white paper on restoring trust in audit and corporate governance. The government's aim is clear: it wants to improve the quality, accuracy and reliability of the information published by the largest companies.

Precipitated by various corporate failures - Carillion, Thomas Cook, BHS and Patisserie Valerie chief among them, together with long-standing concerns about the lack of competition and resilience in the statutory audit market, the proposals take forward most of the recommendations of the three government-commissioned independent reviews: the Review of the Financial Reporting Council (FRC) led by Sir John Kingman KCB, the Competition & Markets Authority's (CMA) Statutory audit services markets study, and the Review of the Quality and Effectiveness of Audit by Sir Donald Brydon CBE.

The consultation contains significant, far-reaching and, in some cases, controversial reforms in its 233 pages as well as 98 consultation questions. Reflecting this, the normal period in which responses can be submitted has been extended to 16 weeks and will close on 8 July 2021. 

The government also published an impact assessment, a summary of stakeholder responses to the government’s initial consultation on the recommendations of the CMA’s Market Study, and a summary of how each of the 150-plus recommendations of the three reviews is addressed either by the White Paper or through action by the FRC.

Headline proposals include:

Directors' accountability for internal control, dividends and capital maintenance

• Strengthening disclosure and attestation requirements relating to dividends and capital maintenance to ensure that when distributions are made they do not put a company into financial difficulty. Companies should disclose the total amount of distributable reserves and directors should be required to state that any proposed dividend is within known distributable reserves and that it will not, in their opinion, threaten the company's solvency over the next two years.
• Requiring directors to carry out an annual review of the effectiveness of internal controls and to make a statement as to that effectiveness as part of their annual report, with that statement potentially being subject to audit.
• Seeking views on proposals to give the new regulator (see below) new powers in relation to how companies should calculate their distributable reserves.

Corporate reporting on resilience, assurance and payment practices for Public Interest Entities (PIEs)

• Mandating an annual Resilience Statement which sets out how directors assess the company's prospects and are addressing challenges to its business over the short, medium and long-term, including risks posed by climate change. This would "incorporate and build on" existing going concern assessments and viability statements.
• Requiring publication of an Audit and Assurance Policy, describing the directors' approach (over a rolling three year "forward look") 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.
• Seeking views on how annual reports could include information on supplier payment policies and practices.

Strengthening the supervision of corporate reporting

• Providing the replacement for the FRC, the Audit, Reporting and Governance Authority (ARGA), with powers to direct changes to company accounts without the need to seek a court order to do so (as is the case currently).
• Extending the scope of ARGA's reviews to the entirety of the annual report, thus taking in corporate governance statements and directors' remuneration and audit committee reports, as well as voluntary elements such as the CEO and chair's reports.

Strengthening enforcement powers against directors

• Providing ARGA with additional investigative and enforcement powers in relation to breaches of statutory duties relating to corporate reporting and audit by directors of PIEs.
• Strengthening "malus and clawback" arrangements within executive directors' remuneration arrangements to counter the potential for rewarding failure.

Audit purpose and scope - closing the audit expectations gap

• Creating new overarching principles for auditors to reinforce good practice, while requiring them to take into account a wider range of information in reaching audit opinions, in particular whether financial statements give a "true and fair view".
• Imposing new obligations on both auditors and directors relating to the detection and prevention of material fraud.

Audit committee oversight and shareholder engagement

• Providing ARGA with powers to set and enforce additional requirements for audit committees of FTSE 350 companies as regards the appointment and oversight of auditors.
• Enabling quoted company shareholders to propose additional matters for emphasis within the scope of a company's external audit.
• Requiring better communication with shareholders following the resignation or dismissal of the auditor of a PIE.

Improving competition, choice and resilience within the audit market

• Creating a "managed shared audit regime", falling short of a full joint audit, in the FTSE 350 market to increase choice and competition. If this does not work, firms could have the number of audits they undertake in this bracket capped.
• Mandating operational, as opposed to structural, separation between the audit and non-audit arms of certain auditors.
• Constituting ARGA, making it accountable to Parliament and providing it with significant additional powers of regulatory oversight, while also making it responsible for approving the statutory auditors of PIEs.

Scope and timing

Acknowledging the urgency of audit reform but also the need to manage additional requirements on businesses, the government intends a staggered approach to implementation. Measures which do not have a direct impact on companies will be brought into effect more quickly, such as the constitution of ARGA. Measures with a significant impact on businesses will be phased in, with many likely to be subject to transitional arrangements. Larger companies, particularly those with a premium listing, are likely to be subject to new requirements before others, although consideration could also be given to excluding emerging growth companies from some of the new measures for a period of time after an Initial Public Offering to ensure that they do not present a deterrent to seeking a listing.

Many of the proposals centre on PIEs - currently, credit institutions, insurance undertakings, and those with securities admitted to regulated markets, such as the main market of the London Stock Exchange. To ensure that the most economically significant entities in the UK are caught, the government is proposing an extension to the scope of this key definition to include the very largest private companies (one option sets the bar as low as those companies with more than 500 employees and a turnover of more than £500m) and AIM companies above a specified level of market capitalisation (€200m).

Timing for the introduction of the reforms is necessarily opaque: "when Parliamentary time allows".

These are very significant reforms. Each will need to be carefully considered both individually and in the round, especially to ensure that there are no unintended consequences and that the benefits outweigh the costs. Whether they restore trust in business and audit, and give investors the confidence to invest in the UK which the government is hoping for, remains to be seen.