The reforms will place renewed scrutiny on boards, audit committees and their work—and it’s essential that boards review the key issues.
This article was first published in Board Agenda and features comment from Mazars audit and governance reform experts.
After years of waiting, auditors and boards were presented in March with the government’s proposals for reforming audit, the audit market, audit regulation and audit committees. In a document spanning 230 pages, ministers outline a slew of reform plans leaving company directors with much to digest and consider.
The reforms will place renewed scrutiny on auditors, but also boards, audit committees and their work. There is, therefore, little time to waste in gaining a sound understanding of where the reforms are likely to go, according to Anthony Carey, a partner and head of board practice at Mazars, the professional services firm.
“It’s essential boards and, in particular, audit committees should review where they stand in relation to the key issues covered by the proposals. It’s good business and it’s good business done now rather than later,” he says.
The proposals come after a number of corporate scandals—including the collapse of department store BHS in 2016, and the insolvency of construction firm Carillion in 2018. They also follow parliamentary investigation and three major reviews that placed the regulation of auditors, the audit market and the content of audits under a microscope.
Oversight of annual reports
The headline plans include the creation of a new regulator with strengthened powers and responsibilities (the Audit Reporting and Governance Authority, or ARGA), a ”managed shared audit” regime, and a mandatory operational split between audit and non-audit services at the largest accountancy firms.
However, the proposals range across a host of audit-related issues. One notable suggestion in the works is a change in the regulatory approach to annual reports. The new regulator will no longer limit its oversight primarily to the financial statements but will take a look at the entire document. “Allowing regulators to look at the whole report, in particular with the growing importance of sustainability, seems sensible,” says Carey.
Another practical step is the replacement of the current “viability statement” and the introduction of a “resilience statement” in which boards and management look five years ahead instead of the usual three currently. The government says viability statements have “not proved as effective as originally hoped” while investors have observed that a three-year review may fail to cover a full business cycle.
While reporting responsibilities are set to broaden significantly under the proposals, one notable proposed area for change surrounds dividend decision-making and payments. Companies will be required to disclose their total distributable reserves, including disclosure of an estimation of dividend paying capacity for groups, and provide a statement from the directors attesting that any proposed dividend is both lawful and affordable without threatening the solvency of a company for the following two years.
According to Jessica Howard, a director in the accounting technical services team at Mazars, providing such dividend disclosure and statements could be a big adjustment for some boards.
“Boards need to ensure they have very sound forecasts that go out for 24 months, and have carried out adequate scenario analyses, as this will form the basis of the new confirmation statement” she says. “They will not only need reliable numbers for the forecasts but they will also need to understand all the underlying inputs and assumptions on which to base their decision-making. Additionally, boards will need to have a more detailed grasp on the legalities behind what constitutes the company’s distributable reserves in order to support their confirmations.”
Internal controls statement
Internal controls are another major area of development. After much public speculation the government says boards should be required to make a statement on the “effectiveness” of a company’s internal controls framework as regards reporting controls. This preferred measure falls short of a process similar to the US, which requires the external auditor to express a formal opinion on key directors’ assessment of the effectiveness of internal control systems on reporting controls
Matt Dalton, head of risk consulting at Mazars, observes that the government held back from going that far and has made the internal controls statement a collective responsibility of boards. Going down the US route may “turn off” people from becoming directors in the UK, says Dalton.
At the moment the UK Corporate Governance Code that applies to premium listed companies already asks boards to “oversee” a company’s internal controls framework. But it does require attention.
“Our view,” says Dalton, “is that any new proposal needs to build on the current expectations of the code in a proportionate way. This is about boards and audit committees determining what they need in terms of controls and assurance, which may come from internal audit, to be able to give an ‘effectiveness’ statement. They will need to build an integrated controls framework that is robust and sustainable.
Audit committee standards
Audit committees come in for special attention in the government’s proposals. Indeed, there is a drive at the heart of the proposals to strengthen scrutiny of audit committee members, give them new responsibilities, even impose new penalties for going astray. This stems, at least in part, from a Competition and Markets Authority review, which concludes there are “significant variations” in the performance of audit committees in delivering on their duties.
The government proposes giving ARGA powers to implement and monitor new standards for audit committees and their work supervising audits. They also plan new powers for the watchdog to demand information from audit committees, place an observer at meetings, even discipline underperforming committees with “public notices” or “direct statements to shareholders”.
Anthony Carey says the government has indicated penalties should be the “exception rather than rule”. But there are concerns about the unintended consequences for audit committees. Carey says there is a risk they could increasingly draw directors with financial qualifications rather than from more diverse backgrounds and shift the balance of the board and its committee taken together in favour of “accountability” over “enterprise”. The “professionalisation” of audit committee membership may even be inevitable, under the current proposals, according to Carey.
However, as things stand there remains many decisions for the new regulator to resolve.
“The important element,” says Carey, “is how the system is going to work in practice. “Inevitably you have to give the regulator powers to act when there are serious breaches of the law or what’s seen as good governance.
“But an absolutely critical element is the culture of the regulator and how it applies those powers.”
The audit proposals represent a vast piece of work to rebuild faith in UK audit and auditors. Though the government plans appear to have solidified to some extent they remain under consultation with some way to go. But it is clear boards should be preparing now, not least because the government also proposes making many more companies subject to audit regulation than is currently the case.
As Anthony Carey says: “Undertaking a review now of where you are on these issues is good business, not just to be ready for fresh regulation but because a thorough review will never be time wasted.”