August 13, 2022

UK Audit and Corporate Governance Reform: Better Financial Reporting Ahead

Recent years have seen high-profile scandals like BHS and Carillion, raising serious questions about the role of governance and auditing in the collapse of these companies. The public outcry was met with government promises of an overhaul of auditing rules and the meeting room. On May 31, 2022, the Government published “Restoring Trust in Audit and Corporate Governance”, setting out its main proposals in this area, the main one being to expand the network of “public interest entities” ( EIP) – large companies of public importance – increase regulation. In this briefing, we focus on the main recommended measures.

What a greatWill private companies be affected?

The new PIE definition will bring within the scope large private companies or LLPs with 750 or more employees (on a global basis) and an annual turnover of at least £750 million (the 750:750 threshold ). Companies whose shares are traded on AIM or other multilateral trading systems will be considered PIEs if they meet the 750:750 threshold (but not if they are smaller). It is estimated that 600 companies will be included in the PIE category.

What is the practical effect of being a PIE?

Companies will be subject to stricter regulatory scrutiny in areas such as corporate reporting, payment of dividends and audit requirements. The reforms propose the creation of a new regulatory body, the Audit, Reporting and Governance Authority (ARGA) which will succeed the Financial Reporting Council. ARGA will be entrusted with a dual purpose: to protect and promote the interests of investors, other users of corporate reporting and the broader public interest, as well as to promote effective competition in the market for audit work. accounts.

What will this mean for EIP managers?

They will have greater responsibility for reporting on the effectiveness of a company’s internal controls and fraud prevention measures. The FRC will be asked to include in the UK Corporate Governance Code an explicit statement from the directors about the company’s internal controls and their effectiveness. Along with the new Code provisions, the regulator will be asked to work with companies, investors and auditors on guidance on issues such as acceptable standards and benchmarks. However, proposals that would have gone much further and required directors to be personally responsible for internal controls over financial reporting (like the Sarbanes-Oxley Act in the United States) have been dropped.

If the UK Corporate Governance Code is the main vehicle for reform, does this mean that private companies are not affected?

No, large private companies are concerned if they reach the threshold to be PIEs. The government recognizes that using the Code as a vehicle for reform is the proven approach to strengthening corporate governance, providing a “comply or explain” approach to improving transparency and accountability to investors. Although it currently only applies to blue chip listed companies, it has a wider influence on other codes and principles of good practice developed for other types of companies. These include the QCA Corporate Governance Code and the Wates Principles for Large Private Companies.

The law on dividends and maintenance of capital is accentuated

Paying a dividend leaves a company with fewer assets to meet its obligations to creditors, and company law imposes strict rules on dividends payable only out of profits. But companies such as Carillion were found to have racked up large debts and sold assets in order to continue paying dividends to shareholders, in apparent defiance of company law rules on capital maintenance. The new regulator, the ARGA, will be responsible for issuing guidance on a clear definition of “realized” profit and loss so that administrators have a clear idea of ​​the level of distributable reserves. There will be new rules requiring IPPs reaching the 750:750 threshold to disclose their distributable reserves (for UK groups this will relate to the parent company) and explain the board’s long-term approach to the amount and the calendar of returns to shareholders . The directors of PIEs will also be required to make an express statement confirming the legality of the proposed dividends and those already paid. There was a proposal for there to be mandatory disclosure of a group’s ability to pay dividends, taking into account any reserves that might be distributed within the group to the parent company, but this was rejected as a legal requirement.

Will corporate reporting also be strengthened?

Yes, a number of changes are proposed for EIPs reaching the 750:750 threshold. A new statutory statement on resilience will be introduced, setting out the directors’ approach to managing risk and building resilience in the short, medium and long term. The government intends to legislate for companies to report on issues they consider to be a significant challenge to resilience in the short to medium term, explaining how they have assessed materiality. In addition, PIEs will have to publish an audit and assurance policy every three years, defining their internal audit and assurance process. This will not be subject to a shareholder advisory vote (contrary to the white paper proposal), but it will be mandatory for companies to indicate in the audit and assurance policy how the opinions of shareholders and employees have been taken into account.

How will EIP administrators be held accountable for these new rules?

The government intends to give the new regulator, ARGA, the power to enforce the statutory obligations of PIE trustees in corporate reporting and auditing. It is promised that the new civil enforcement regime will be targeted, proportionate and transparent, and that administrators will only be liable for what can reasonably be expected of someone in their position. All PIEs are subject to the new administrator enforcement regime. Note that if a subsidiary meets the 750:750 threshold, this will bring its parent company into the fold, so both parent and subsidiary directors will be subject to the new enforcement regime. A parent company will also be a PIE if it is incorporated in the UK and its consolidated accounts comply with the new threshold, even if the parent company does not meet the definition of PIE as such.

Hourly

We do not yet have a specific timetable for the reforms, but the government has indicated that the changes will be implemented according to timetables which will give the companies affected time to plan and prepare. The timeline is likely to span several years, with changes being implemented through a mix of primary and secondary legislation and amendments to the UK Corporate Governance Code.