March 24, 2021 Restoring Trust in Audit and Corporate Governance

The Department for Business, Energy and Industrial Strategy has published a substantial Command Paper with the loaded title ‘Restoring Trust in Audit and Corporate Governance’.

Below, Elemental summarises why the government feels trust has been lost and the proposal put forward to restore it.

Corporate failures

The government acknowledges that reliable corporate reporting is vital to well-functioning financial markets, business investment and growth. Three things that will be sorely needed in the wake of the pandemic.

Corporate failures can happen but, if reporting and the audit process has been robust, they should not be a surprise. However, following several high-profile collapses including BHS in 2016 and Carillion in 2018, public trust in the credibility of directors’ reporting and the statutory audit has been shaken.

In addition, the Financial Reporting Council (FRC) has found that up to a third of audits carried out by the seven largest audit firms in recent years are in need of improvement or significant improvement.

There is clearly a problem.

The government accepts the findings of three recent reviews (Sir John Kingman’s Independent Review of the FRC, 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).

Fundamental reform of the framework underpinning audit and corporate reporting is needed to address the weaknesses and lack of accountability that the three reviews highlighted.

The consultation focuses on the largest companies and demands that directors, auditors, shareholders and the audit regulator each play their part.

Directors

Directors are ultimately responsible for a company’s accounts and reports. Responsible behaviour by directors is identified within the consultation as the starting point for high quality and reliable corporate governance and reporting.

The consultation notes that accountability of directors is lacking and needs to be improved. The FRC does not have any powers to enforce directors’ duties. The consultation contains proposals for new reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning.

There are also proposals to ensure that the regulator has effective investigation and civil enforcement powers to hold to account directors of large businesses which are of public importance for breaches of their duties in relation to corporate reporting and audit.

Audit, Auditors and Audit Firms

The government notes that the recent findings of the FRC have brought into serious question whether the statutory audit is performing the public interest function expected of it. A lack of both evolution and competition are cited as two major issues.

The Government is clear that reform is needed to drive a new auditor mindset and to strengthen the resilience and integrity of the audit market. It proposes the creation of a new, stand-alone audit profession, underpinned by a common purpose and principles – including a clear public interest focus – and with a reach across all forms of corporate reporting, not just the financial statements.

New regulatory measures are also proposed to increase competition and reduce the potential for conflicts of interest, by providing new opportunities for challenger audit firms and new requirements for audit firms to separate their audit and non-audit practices.

Shareholders

As the primary users of company reporting and audit, shareholders should have a strong interest in its quality, accuracy and reliability because it provides a basis for informed investment decisions and the efficient allocation of investment capital across the economy. Shareholders, especially institutional investors, also have a stewardship role. This is identified within the consultation as a problem area, i.e. audit not being prioritised as an area of stewardship priority.

The consultation proposes that companies be required to set out their approach to audit through publication of an audit and assurance policy on which there would be an advisory shareholder vote. Shareholders would also have a formal opportunity to propose to the audit committee areas of emphasis to be considered within the auditor’s annual audit plan.

The Audit Regulator

The FRC is being succeeded by the Audit, Reporting and Governance Authority (ARGA). The consultation document sets out the steps that the Government proposes to take to give ARGA the formal duties, functions and powers it needs to be fully effective.

The Government’s proposals include; welcome competition powers and new powers to strengthen the ARGA’s corporate reporting review function, its oversight of audit committees and to enforce the corporate reporting duties of directors.

Overall, the consultation is detailed and wide-ranging. Directors, shareholders, and auditors should all prepare themselves for what will undoubtedly be significant reforms off the back of the Command Paper.

How Elemental Can Help

The consultation is open until 8 July and responses can be submitted here.

For more information on Elemental’s corporate governance services and tax & accountancy services or to speak to one of our experts, please get in touch.