The Government has just published a Consultation Paper discussing implementation of the 83 recommendations for reform put forward in The Independent Review of the Financial Reporting Council, led by Sir John Kingman (the "Kingman Review"). In this Consultation Paper, the Government sets out its timetable for implementing the reforms, and also seeks initial feedback on some of its proposals to conduct follow up consultations. The Consultation is due to close on 11 June 2019. We set out a summary of the Government's action plans in respect of some of the more significant Kingman Review recommendations below.
The key recommendation in the Kingman Review is the proposal to replace the Financial Reporting Council (the "FRC") with a new independent statutory regulator with stronger powers (the "Audit, Reporting and Governance Authority", or "ARGA").1 The Business Secretary, Greg Clark, confirmed in December that the Government will be taking this recommendation forward, and the Consultation clarifies that this will be done as soon as Parliamentary time allows for the necessary legislation.
The Government's approach to the other recommendations can be split into three categories: (i) those that will be actioned immediately; (ii) those where significant policy choices should first be addressed via consultation (though no legislative change is necessary); and (iii) those that will require consultation and legislative change and which will be influenced by other ongoing reviews (including the CMA's Statutory Audit Services Market Study, the Brydon Review into the quality and effectiveness of the UK audit market and the BEIS Committee Inquiry on the "Future of Audit").
Immediate action by the FRC
The Consultation Paper confirms that the FRC will immediately:
- introduce a robust market intelligence function - the FRC will immediately take forward the recommendation to introduce a robust market intelligence function to identify emerging risks at market and company levels at an early stage;
- embark on a review of whether viability statements are fit for purpose - the FRC will review and, if possible, reform the viability statement requirements in the 2018 Corporate Governance Code ("2018 Code") to make them more effective, for example by bringing them within the scope of audit. If they cannot be made more effective, they will consider whether they should be abolished;
- extend its review to cover the entire annual report, including corporate governance reporting - ultimately, 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; and
- action the recommendation to be more sparing and disciplined in promulgating guidance and discussion documents.
In addition, the FRC has already launched a consultation on a revised Stewardship Code in which it has invited responses on whether the proposed revisions help to address the concerns identified in the Kingman Review, including in respect of investment outcomes and effectiveness. The FRC consultation also seeks views on whether new powers are needed to address and promote compliance with the Stewardship Code.
Future Government consultations
The Consultation Paper confirms that the Government will consult, in due course, on the following:
- the definition of PIE - later this year the Government will consult on the definition of Public Interest Entity ("PIE")2 to see whether this should be expanded to cover a broader range of entities whose audit arrangements are a matter of public interest, for example major private companies. If taken forward, this could have a significant impact, subjecting many more companies to the current rules regarding mandatory auditor rotation and possibly to some of the more significant Kingman recommendations where these are aimed at PIEs only;
- proposed changes to the enforcement regime against directors - the Government will reflect on the following recommendations (which will require primary legislation and careful consideration of how any new policies interact with the existing enforcement framework) and bring forward full proposals for consultation:
- that the Government, working with the FRC/ARGA, should develop detailed proposals for an effective enforcement regime in relation to PIEs that holds relevant directors to account for their duties to prepare and approve true and fair accounts and compliant corporate reports, and to deal openly and honestly with auditors. The Kingman Review recommended that this should apply to a company's CEO, CFO, chair, and audit committee chair; and
- that the FRC/ARGA should ensure that a consistent approach is taken in enforcement action against auditors, accountants, and responsible non-member directors (i.e., directors who are not also members of a professional accountancy body) by putting in place schemes that are equivalent to the Audit Enforcement Procedure (or AEP);3
- introducing a duty of alert for auditors - the Government will consult on proposals that it should introduce a duty of alert for auditors to report on viability or other serious concerns, but warns that this will need careful consideration to ensure that this is a meaningful warning and market intelligence tool, and not just a tick box exercise which auditors feel obliged to use to reduce liability;
- increasing the powers of the FRC/ARGA in the cases of serious concern about a company's financial position, including the ability to commission a skilled person review in certain cases. In the most serious cases, it may include a power to suggest to shareholders that the dividend policy is reviewed, or board members replaced - the Government will work with the FRC in the short term to deliver the ambition (set out in the Kingman Review) to increase the powers of the FRC/ARGA in cases of serious concern. In the longer term, the Government will consult on the following proposals, which would require primary legislation to implement and need careful consideration to ensure that they are fit for purpose and fully consider any wider market consequences, whilst respecting company independence, and lessons learned from the similar framework run by the FCA:
- where serious company level risks are identified, the FRC/ARGA should have the power to require rapid explanations from the company;
- in certain cases, the FRC/ARGA should have the power to commission a skilled person review ("SPR"), paid for by the company, which may be published if the FRC/ARGA deems it is in the public interest to do so;
- depending on the findings of the SPR, the FRC/ARGA should be given the power to require the company to provide additional comfort on the viability statement or other aspects of the annual report; and
- in the most serious cases, it may be appropriate for the FRC/ARGA to have the power to issue a report to shareholders suggesting that the dividend policy is reviewed, or that they consider the case for changing the CEO, CFO, chair, audit committee chair, or otherwise strengthen the board of directors;
- the pros and cons of greater internal company controls - 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; and
- any proposals which emerge from discussions (with the FCA and the FRC) considering whether to strengthen reporting oversight and qualitative regulation around a wider range of investor information than the annual report and accounts - the Government, the FCA and the FRC will collectively consider, looking at the US and Netherlands as examples, whether to strengthen reporting oversight and qualitative regulation around a wider range of investor information than the annual report and accounts (i.e., earnings releases, investor presentations and other investor communications). The Government will consult on any proposals which emerge from those discussions in due course.
Impact on companies now and in the future?
In the short term, most listed companies will welcome the news that the FRC is going to review its viability statement requirements and stop issuing the vast quantities of guidance and commentary that we have seen over the last few years. The news that the FRC is going to start reviewing and commenting on the corporate governance section of annual reports is likely to be less welcome, particularly as it comes at a time when companies are already under pressure to revamp their corporate governance behaviours (and disclosures) in response to the 2018 Code. This Consultation provides a timely reminder of the importance of planning ahead, and using the rest of 2019 to get ready for the publication of the first 2018 Code compliant annual reports in 2020. In the longer term, along with the various other reviews that are ongoing, it illustrates that the Government is committed to overhauling the current audit and reporting framework, and audit committees, in particular, should be aware that it is now a question of when, not if, significant changes are made.
1 Recommendation 1, which is then supplemented by Recommendations 2 to 14.
2 The current UK definition comprises a UK incorporated traded, banking or insurance company with more than 500 employees. A traded company means a company with any transferable securities (equity or debt) admitted to trading on an EEA regulated market, such as the London Stock Exchange's Main Market.
3 See paragraphs 2.64 to 2.66 of the Kingman Review (starting on page 41) for further on the Audit Enforcement Procedure