Audit consultation: Greater transparency for directors

23 April 2021

The Government's new consultation on strengthening the audit and corporate governance framework proposes significant changes to the way in which large companies are audited, and could also alter the landscape in which directors operate. It has been long-promised but much-delayed, and has gained momentum amid widespread calls for changes to the audit system, and to directors' accountability levels, from politicians, the media, and other representative groups, in light of several high-profile cases.

The consultation sets out a range of potential changes to corporate governance standards, which overall aim to increase directors' accountability, through widening the enforcement actions which can be taken against them.

The consultation's introduction, by Business Secretary Kwasi Kwarteng, states that the review of audit and corporate governance came about "in the wake of large corporate failures that have led to job losses and uncertainty among small businesses and local communities", and that the changes proposed in the consultation will be introduced later in the life of this Parliament, once the disruption from Covid has settled, and once the Government has had sufficient time to consider the responses to the consultation, and develop its findings.  

Changes to directors' duties

One of the higher-profile planks of its programme to reform the audit sector is the Government's plan to replace the Financial Reporting Council with a new body, the Audit, Reporting and Governance Authority (ARGA). ARGA will be granted "the necessary powers to investigate and sanction breaches of corporate reporting and audit-related responsibilities" by directors of 'public interest entities' (that is, listed or large companies, in the main).

Under the consultation proposals, ARGA will be empowered to take civil enforcement action against directors of public interest entities in relation to breaches of their existing duties, as well as new duties introduced in the consultation, for example in relation to internal controls. However, director disqualification proceedings will stay as a responsibility of the Insolvency Service, with ARGA referring cases as needed.

So-called 'rewards for failure' (where directors receive generous remuneration from companies which shortly thereafter are revealed to be in financial distress) will be discouraged via a proposal to strengthen malus and clawback arrangements. It is hoped that this change will mean that payments to directors will be more closely tied to the company's financial performance, in an effort to incentivise prioritisation of long-term profitability.

This will be done through a further consultation on changes to the UK Corporate Governance Code, which will recommend that certain minimum clawback conditions or "trigger points" are included in directors' remuneration arrangements, and that these have a minimum period of application of at least two years after an award is made.

As noted above, directors' responsibility for internal financial controls is also likely to be made more explicit and given more weight, with a new duty to establish and maintain an adequate internal control structure and procedures for financial reporting, and to carry out an annual review of the effectiveness of the company's internal controls over financial reporting.

Resilience Statement

The consultation proposes to strengthen the law on dividends and capital maintenance, including by requiring companies to report on their distributable reserves, and by requiring directors to make a formal statement about the legality and affordability of any proposed dividends. The consultation notes that there have been high-profile examples where companies have paid out significant dividends shortly before issuing profit warnings, and, in some cases, entering insolvency.

Under the proposals, the new Resilience Statement will set out a company's approach to exploring and mitigating risks and uncertainties over the short term (1-2 years), medium term (5 years), and long term (a period to be determined by the company). The Resilience Statement will replace the existing going concern and viability statements, and will in addition build on their contents, by including greater transparency on the potential 'material uncertainties' considered by companies in their going concern assessment, and greater use of scenario testing.

The Government is also looking at requiring further specific disclosures in both the short- and medium-term sections of the Resilience Statement, including threats to liquidity, solvency, and business continuity in response to a major disruptive event (such as a pandemic) which upends normal trading conditions.

A clearer picture for investors and regulators

The aims of the audit consultation are laudable. When a public interest entity enters an insolvency process, the waves of disruption that are caused can have a damaging effect on the business ecosystem as a whole, with some other companies even pushed into insolvency as a knock-on result.

Ensuring that directors of public interest entities put more emphasis on the long-term prospects of their companies, and on 'unknown unknowns' like the Covid pandemic, can only be a good thing. It might encourage directors to be more active in seeking qualified advice at an early enough point to make a difference, while injecting a dose of realism into their projections for their company's future. And, if such an entity does enter an insolvency process, the greater transparency encouraged by the Resilience Statement may prove helpful to insolvency office holders looking to trace the source of its financial problems.

It remains to be seen, however, whether these proposals, which focus mainly on corporate governance integrity at the upper end of the scale, will lead to increased awareness of, and adherence to, director duties and responsibilities across the board - including by directors of small- to medium-sized enterprises.

Impact on insolvency and restructuring

While these reforms will obviously have more of an impact on the audit profession than the insolvency and restructuring profession, they will nonetheless see significant changes to the overall corporate governance framework - within which the latter profession plays an important role.

As the consultation has not yet closed, it is too early to say how the creation of ARGA, the introduction of the new Resilience Statement, and the raft of changes to public interest entity directors' duties, will impact the way in which business is carried out in the UK. However, the prospect of a more rigorous and transparent reporting and regulatory regime should be good news for the economy as a whole.