Financial Reporting Council and Corporate Governance Review

The Financial Reporting Council UK (FRC) Replaced

A series of comprehensive reviews of both UK Corporate Governance and the related review of audit spell major changes for governance at all companies and organisations in the UK.

On 18 December 18 2018, the committee chaired by Sir John Kingman published its Review of the Financial Reporting Council (FRC) – the authority responsible for corporate governance and audit in the UK. The report recommended that the FRC be closed down and replaced by a new authority with increased powers. Business Secretary Greg Clark confirmed in December that the Government would implement 48 of the review’s 83 recommendations immediately, including abolishing the FRC and replacing it with a new independent authority called the Audit, Reporting and Governance Authority (ARGA). The other 35 Kingman Review recommendations will be subject to consultation before being instituted.

Separately, the Competition & Market Authority (CMA) published its Update Paper on its review of the audit sector. The CMA report proposes legislation to split audit from consulting services; introduce measures to substantially increase the accountability of those chairing audit committees in firms, and impose a ‘joint audit’ regime giving firms outside the four dominant providers a role in auditing the UK’s biggest companies.

In addition, Sir Donald Brydon, outgoing London Stock Exchange Group Chair, is leading a separate investigation of audit practices, also at the behest of the Government – this report is still in progress.

Finally, the Parliamentary Committee on Business, Energy and Industrial Strategy (BEIS) published a report also calling for the breakup of the ‘Big Four’ audit firms in the UK into smaller units, dividing consulting from audit.

Taken individually, the reforms proposed in each document are far reaching. However, their combined impact would reshape the face of corporate governance and financial reporting, along with its regulation, warns the London-based law firm 4 New Square Chambers.

Kingman Reform: A Proactive Take on Corporate Governance

The Kingman reforms take corporate governance authority from reactive to proactive.

“The overall approach to enforcement is to encourage a robust approach from the regulator, greater transparency and accountability and a broadening out of the current regime, together with its lower hurdle for sanction, to cover more businesses, more work streams and a broader view of audits,” comments the London-based law firm Taylor Wessing in a recent note.

Clearly, the most important reform made by the Kingman Review is the replacement of the FRC with the ARGA – this will take place in full as soon as the Government can place it on the Parliamentary agenda.

The new authority will be funded with a levy on accounting firms and provided with an increased budget. It will also have full statutory authority. Its mandate will specifically call for an expanded role in sounding the alarm when companies are at risk – it will be expected to blow the whistle when companies are no longer viable or if there are concerns about imminent failure. Viability statements, which companies are obliged to make as part of audits, will either be reformed for improved effectiveness or simply abolished.

The Stewardship Code and the Kingsman Review

The Stewardship Code, a corporate governance code for institutional investors, is also likely to be abolished. The review called the Stewardship Code “ineffective” and called for its replacement with a code that “focused on outcomes and effectiveness.”

It will also drive improvements in corporate financial reporting and audit quality. “There is a proposal under consideration  to expand the amount of reporting required, beyond annual reports and quarterly statements. Greater internal company controls will be required: The Government, recognising that this is a detailed and complex issue, will consult (in due course) on strengthening the framework around internal company controls learning from the operation of the Sarbanes Oxley regime in the United States,” says a recent note from the London office of Baker McKenzie.

The Kingman Review criticises the FRC for lagging in enforcement. While the FRC can level very severe fines, the investigations into non-compliance have dragged out for a very long time. The review calls for a more robust approach, and for a clear separation between audit firms and the Authority – Kingman notes a certain “consensus” between the two at the FRC that is insalubrious.

The review calls for vigorous reform of the hiring processes at the Authority. “The current process is criticised for having staff with a perceived lack of seniority and experience when compared with the US authority Public Company Accounting Oversight Board staff, and who are therefore unable properly to challenge and engage firms on complex matters of judgement,” points out Taylor Wessing.

“The review recommends that the new authority strengthen its resourcing, and to develop a pool of so-called ‘grey panthers’ (being former or retired senior executives and experts) to boost capacity and deploy expertise at short notice. Increasing expertise in this manner seems to us a helpful development. Having that experience available at the ARGA would also be helpful in assessing audit work in the enforcement context,” explains Taylor Wessing.

Corporate Governance Review and Considerations for Boards of Directors

All of these changes mean increased rigour in reviewing corporate governance at the major public and private companies.

“A new and bulked-up regulator will inevitably find more work for itself and may feel the need to be more aggressive in order to justify its existence (and show mettle to its own stakeholders). This is particularly likely given Kingman’s criticism of the FRC’s approach. In addition, the volume and variety of regulatory action and disputes will also increase,” says 4 New Square Chambers.

“The proposed enlargement of the scope of the ARGA’s involvement in corporate reporting is dramatic. If the ARGA is to fulfil the aim of being more forward-looking and pre-emptive then new disputes are likely to arise between it, auditors, companies and company officers.”

“If the ARGA can impose a range of sanctions on firms tendering for audit work short of de-registration, then one would expect it to be more likely to be prepared generally to impose a sanction, with less concern about a sanction being disproportionate,” predicts the law firm.

Explanations for non-compliance will be judged more harshly. The quality of internal controls will be reviewed in greater detail.

When there are doubts about viability, the ARGA will be able to commission a “skilled person review,” paid for by the company, in which a suitable individual inspects a firm. This will also pressure boards into greater care about compliance and risk management.

The regulator should have the power to make recommendations to a company’s shareholders that they take action such as cutting dividends or firing senior staff, in “serious cases” where “the severity of the facts” merits an intervention.

The board may lose the ability to choose its own auditor. A plan under discussion is to have the ARGA both appoint auditors for specific corporate audits, and also to review the remuneration structure of the auditors.

Financial reporting will be carefully reviewed, and individual audit quality inspection reports, including gradings, are to be published in full. This means that the media may be able to seize on aspects of the reporting.

The Government will make the legislative changes necessary to make the FRC/ARGA responsible for reviewing the entire annual report, including the corporate governance section. As an interim step, the FRC will review the whole of a company’s annual report and write to companies pointing out where reporting is clearly deficient.

• Boards should watch out for increased reporting requirements if plans to create new reporting are fulfilled.
• Boards should also consider that the investment community has hailed the Kingman Report. The chairman of the Local Authority Pension Fund Forum, which represents 80 local government pension schemes, has called on the government to conduct a swift clear-out of the UK audit regulator’s senior ranks and shut it down as quickly as possible – and the ARGA should start up as soon as possible. Chris Cummings, Chief Executive of the UK Investment Association, said his organisation“welcomes the clarity of responsibilities the proposed new regulatory body would bring, and that investors were strongly supportive of the recommendation that corporate and audit quality reviews be published.”
• UK board members should consider how these regulatory changes will affect their relationships with investors, and perhaps show a real inclination to make the changes happen.

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