1. Why has the consultation come about?
In recent years, we have seen an increase in major and sudden corporate collapse from the likes of Carillion to BHS and Thomas Cook. This started raising questions from stakeholders, investors and the public about the credibility of statutory audits, internal governance and reporting. In addition, a long-standing question mark has remained over the perceived lack of competition in the audit market and the potential for this to destabilise transparency.
2. What is contained in the consultation?
The consultation paper, released on 18 March 2021, sets out 150 recommendations aimed at improving and strengthening the UK’s audit, corporate reporting and corporate governance systems. It is predominately about increasing transparency to provide investors with certainty and to ensure the stability and good governance of companies.
The consultation paper recognises that corporate failure can happen, but it should rarely be a surprise.
3. What informed the consultation?
To improve the quality of corporate reporting and success, the Government commissioned three independent reviews:
- The Kingman Review of the Financial Reporting Council (FRC)
- The Competition and Markets Authority’s Statutory audit services market study
- The Brydon Review into the quality and effectiveness of audit
Following the reviews, the Government commissioned the consultation looking at new measures in relation to directors, auditors and audit firms, shareholders and the audit regulator.
4. How will it impact businesses?
In addition to likely changes and an associated increase in costs in relation to how companies report on their governance and finances, the Government is proposing to impose further liabilities on directors in relation to audit and reporting, in particular in relation to the detection and prevention of fraud.
5. Who will be caught by the proposals?
The proposals primarily apply to companies that fall within the definition of Public Interest Entities (PIEs). These are public companies listed on regulated markets, credit institutions and insurance undertakings.
6. Is there scope for this to be expanded?
In order to increase public trust in UK businesses, this definition is being reviewed by the Government with a possible extension to include:
- Lloyd’s Syndicates
- AIM listed companies with a market capitalisation over €200m
- Large private companies with either as the first option more than 2,000 employees or a turnover of more than £200m and a balance sheet of more than £2bn, or as a second option companies with both over 500 employees, and a turnover of more than £500m.
7. How will the proposed changes impact directors in relation to fraud?
The consultation recognises that directors are responsible for approving the company’s annual accounts, having satisfied themselves that they give a true and fair view of the company’s financial position and performance. Directors are also responsible for safeguarding the assets of the company and expected to take reasonable steps to prevent and detect any material fraud. This includes:
- Undertaking an appropriate fraud risk assessment and responding appropriately to identified risks
- Promoting an appropriate corporate culture and corporate values
- Ensuring appropriate controls are in place and operating effectively
To improve transparency in respect of the measures directors are taking in relation to fraud, the Government proposes to legislate to require directors of Public Interest Entities to report on the steps they have taken to prevent and detect material fraud.
8. How will the proposed changes impact auditors?
The Government intends to legislate to require auditors of Public Interest Entities, as part of their statutory audit, to report on the work they performed to conclude whether the proposed directors’ statement regarding actions taken to prevent and detect material fraud is factually accurate. This will involve close scrutiny of the measures undertaken by the directors in relation to fraud and a formal opinion on the directors’ assessment of the effectiveness of the internal control systems.
Additionally, auditors for companies that fail to have in place adequate fraud prevention and detection measures will be unable to provide an unqualified opinion.
9. Why is it important for companies to have measures in place to prevent and detect fraud?
Fraud costs UK businesses and individuals more than £137 billion a year. The consequences of being the victim of or having employees/associated individuals investigated for suspected fraud often has disastrous consequences for a business. As a result, a company could suffer significant reputational damage and the threat of law enforcement/regulatory investigations as a consequence of a failure to detect fraud in the early stages. It is therefore imperative that companies have in place adequate measures to prevent and detect fraud.
10. What are the consequences for directors or other individuals who fail to prevent or detect fraud?
There can be significant consequences for individuals, particularly for directors, who sign off on a company's report on the steps taken to prevent and detect fraud, if fraud is later discovered. There are proposals to make key changes relating to directors’ wrongdoing by creating a new audit regulator (ARGA) and giving it the powers to sanction directors’ breaches of statutory duties dealing with corporate reporting and company audits. They are also considering remuneration changes by strengthening malus and clawback mechanisms in the event of directors’ serious misconduct, misstatement of results or error in performance calculations and failures of internal controls and risk management.