How the corporate governance and audits landscape is changing for directors and auditors

The proposed reforms follow the high-profile collapse of a number of businesses coupled with long-standing concerns about a 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 government's aim is to restore trust in the credibility of directors’ reporting and the statutory audit, and give confidence to all those with an interest in a company’s activities, position and prospects.

Stakeholder and wider public trust in the credibility of directors’ reporting and the statutory audit is essential for a stable market. That trust has been shaken by recent major corporate collapses which have caused serious economic and social damage, leading to the UK government to commission three independent reviews in 2018. The Financial Reporting Council (FRC) has already implemented a number of the recommendations made by the reviews, and this announcement reinforces the message that scrutiny of corporate governance and the audit function will continue to dominate the corporate agenda.

The proposals in context

The Department of Business, Energy and Industrial Strategy (BEIS) has published its consultation, 'Restoring Trust in Audit and Corporate Governance', which aims to "strengthen the UK’s audit and corporate governance framework", to "establish clearer responsibilities for the detection and prevention of fraud, and ensure the audit product and audit profession are fit for the future".

The consultation follows on from three independent reviews commissioned by the UK government: Sir John Kingman’s independent review of the FRC, the Competition and Market Authority (CMA)’s statutory audit services market study, and Sir Donald Brydon’s independent review of the quality and effectiveness of audit:

• In December 2018, the FRC review found that the FRC lacked the necessary powers and clarity of purpose to hold auditors and directors sufficiently to account and recommended that it be replaced by a new body;
• The CMA market study reported in April 2019, concluding that an unhealthy dominance of the statutory audit market for larger companies by a small number of audit firms and called for new measures to increase quality, competition and resilience in the delivery of audit services;
• The Brydon review, published in December 2019, concluded that statutory audit needs to become more informative, and that higher expectations should be placed on both directors and auditors to deliver more useful information to the users of reports.

The government signalled its agreement with these findings in 2020 and undertook to make changes. Focusing on the largest companies "because that is where there is greatest public interest in ensuring that audit and corporate reporting are functioning effectively", and regardless of whether they are admitted to trade on a regulated market, the proposals seek to place the greatest responsibility, and crucially accountability, in the hands of those with the greatest control and oversight, to ensure directors, auditors, shareholders and the audit regulator all play their part.

The proposals in detail

The government makes clear in the consultation that it wants the reforms proposed to be decisive, as previous attempts at incremental reform have been unsuccessful.

In the government's view, this is intended to be a watershed moment. Yet it is complex. The recommendations of three separate and wide-ranging reviews need to be brought together and, as the consultation makes clear, coordinated within a wider regulatory framework for business in the UK, including the market rules set by the Financial Conduct Authority (FCA).

The government commits to avoiding overlap or duplication between the proposed role for the new regulator and the existing scope or powers of the FCA wherever possible, but this requires a deft touch and helps to explain why – together with current uncertainty about the long-term impact of the pandemic – no legislative timetable is set out for these reforms.

Central to the consultation’s proposals is the creation of a new regulator to replace the FRC, which has been criticised for failing to maintain standards and ensure that those at fault are held to account. The Audit, Reporting and Governance Authority (ARGA) will have new statutory objectives and functions and will be funded in part by a statutory levy replacing the existing voluntary levy. The government is also proposing to give the regulator competition powers together with new powers to strengthen its corporate reporting review function, its oversight of audit committees and to enforce the corporate reporting duties of directors.

There are also proposals to increase the responsibility and accountability on directors to drive good corporate governance in key business decisions, through new reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning. These responsibilities will be underpinned by proposals to ensure that the regulator has effective investigation and civil enforcement powers to hold directors to account for breaches of their duties in relation to corporate reporting and audit.

While the impact on directors would be significant if all the proposals find their way into law, the major change will be in reporting rather than – in theory – to directors' responsibilities. There is a ready analogy to the introduction in 2019 of the section 172 statement requiring directors of large companies to report on how they have had regard to the factors set out in section 172(1) of the Companies Act 2006 in complying with that duty – which already applied.

For example, the suggestion that directors confirm in proposing a dividend that the dividend is within known distributable reserves and will not threaten the solvency of the company in the short to medium term, is something that directors must already do. The purpose of making a public statement, as the consultation makes clear, is to focus decision-making and help build external confidence that the dividend and capital maintenance rules are being respected.

What is new is the proposed investigation and enforcement powers for breaches of statutory duties relating to corporate reporting and audit of large companies. At the moment, the FRC has no authority to enforce directors’ duties other than when a director is a member of a professional accountancy body. It is proposed that ARGA should have such a power, justified by, among other things, the utility in providing the new regulator with enforcement powers in relation to each of the main parties involved in reporting and audits. 

A decision on quite what these obligations and powers might be has not yet been made, but BEIS gives the example of an obligation on directors to act with honesty and integrity when carrying out their corporate reporting and audit duties which, if breached, would allow the regulator to take civil action. This would be a major change to the law and to the role of directors, who currently owe their duties to the company they serve.  Although many of the duties of directors are backed up by criminal offences in the Companies Act 2006, it is rare in practice that prosecutions are brought against directors of solvent companies in relation to such offences.

More expected of auditors

The consultation highlights the crucial role played by auditors in providing independent, professional scrutiny of directors’ reporting of their business’s financial position, incentivising improvement. Their opinions on legal and accounting standard compliance and on the efficacy of the accounts are key indicators for the market. However, the consultation notes that whilst those functions are important, they do "not address the increasing expectations of shareholders and other users of company reporting that the audit report should be more forward looking and informative".

The government has concluded that reform is needed "to drive a new auditor mindset and to strengthen the resilience and integrity of the audit market". Central to achieving this is the proposed creation of a new, stand-alone audit profession, independent of professional accountancy bodies. This will be underpinned by new overarching principles to reinforce good audit practice and a new duty on auditors to take a wider range of information into account in reaching audit judgements, in particular whether financial statements give a "true and fair view". Auditors will have a specific responsibility to consider relevant director conduct and wider financial or other information in reaching their judgements.

Dealing with fraud and conflicts of interest

There will also be new obligations on both auditors and directors relating to the detection and prevention of material fraud and to take into account a wider range of information in reaching audit judgements.

Introducing new, regulated standards and reporting that require auditors and directors to take 'reasonable steps to prevent and detect material fraud' will result in significant changes to directors' statements and the audit procedures to substantiate them. Auditors will also be required to assess the effectiveness of a company's relevant controls and the factual accuracy of directors' statements as they related to material fraud. Although these changes are welcomed by investors, financial markets and others who depend on the information UK corporates publish, it will be a significant increase in the expectation and responsibilities of auditors and directors. Not to mention, working with a new regulator tasked to hold those who prepare and assure reports to the highest standards.

The government is also proposing new regulatory measures 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.

An enhanced role for shareholders

The consultation also notes the crucial role played by institutional shareholders in driving excellence in corporate governance. They play a pivotal role in the appointment of directors and auditors and, as primary users of company reports and audit, have a particular interest in their quality and accuracy. Such investors are to be given increased opportunities to engage with companies, with proposed measures including a requirement for companies 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 annual audit plan.

Implications for businesses subject to audit

The increased responsibilities placed on auditors along with the resultant increased scrutiny of their work product will almost certainly translate into increased costs for their clients.

We have already seen an increase in the level of auditor scrutiny on legal and accounting standard compliance and on the efficacy of the accounts. These proposals include new reporting obligations to be introduced on both auditors and directors regarding detecting and preventing fraud, with boards required to set out what controls they have in place and auditors expected to look out for problems.

The proposals aim to make directors more accountable if they have been negligent in their duties, with fines or suspensions in the most serious cases of failings, including "leaving the door open to fraud".

It is suggested that audits will also be able to extend beyond a company’s financial results to look at its wider performance. In particular, this would cover environmental, social and governance reporting, including against key climate targets, to ensure investors and other interested parties are fully informed and can hold companies to account as the UK seeks to eliminate its contribution to climate change by 2050.

Co-written by Chris Richardson and Fiona Cameron of Pinsent Masons.