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Article by Hannain Osama
In March 2021, the Department for Business, Energy & Industrial Strategy (BEIS) issued a 200-page long white paper detailing the UK government’s proposals that would lead to new measures for directors, auditors and audit firms, shareholders and the audit regulator. This was to ensure transparency and restore trust in UK’s big businesses and the UK market being an ideal one for investors. The reforms are primarily focused on the largest companies, as that area of the corporate sector is crucial for public interest and requires that audits and reporting are functioning efficiently.
This article includes a background of events that led to the need for a corporate governance overhaul, the proposals initially set out by the UK government, the present status of the audit legislation, as well as the impact of the government’s plans to scale back the reforms on the industry.
In order to understand the legislation, it is vital to know what brought about such an overhaul on a national scale. The talks around the legislation began in 2018, with the collapse of Carillion – a UK construction giant. The Carillon Group filed a £1.3bn claim against KPMG – its former auditors, on behalf of Carillion’s creditors. The construction giant claimed that KPMG breached its contract and duty of care as the firm was not made aware of its true financial position. On the other hand, KPMG stated that it had performed its duties responsibly. In the report issued by Carillion, it was also stated that Deloitte – its internal auditors, and EY – responsible for providing turnaround advice to the giant, also failed to carry out their duties appropriately.1
Carillion’s liquidation shed a light on the shortcomings of the UK’s auditors and regulators, making it necessary to drive change to ensure that the UK businesses and economy continue to thrive. The then BEIS Committee Chair Rachel Reeves commented that the relationship between companies and the Big 4 that fail to report corporate disasters “is a parasitical relationship which sees the auditors prosper, regardless of what happens to the companies, employees and investors who rely on their scrutiny.”
Carillion’s collapse fueled the talks of a corporate overhaul, but it was not the only event that called for such a change. Various similar financial disasters throughout the decades, such as the liquidation of BLC, have also played a role in highlighting the discrepancies that exist in the functioning of audit giants and regulatory authorities.
As highlighted in the background, a change in the UK’s corporate system was necessary to help maintain a healthy economy. In March 2021, the BEIS issued a paper listing proposals that the UK government aims to adopt.2 Salient features of the policy proposals were:
- Increased directors’ obligations in relation to fraud.
- Establishment of ARGA (Audit, Reporting and Governance Authority) – an external auditing body to primarily check the practices of Public Interest Entities (PIEs). The watchdog would have stronger powers than the FRC and a wider scope over the company directors.
- The government intends to widen the scope of companies that count as PIEs to subject more companies to the stringent requirements of ARGA. It was decided that PIEs will be the companies that fulfil the criteria mentioned below. While option 1 would subject 1,960 companies to strict requirements, option 2 would bring 1,060 companies within the scope of PIE.
- Option 1: more than 2,000 employees; or
- a turnover of more than £200 million and a balance sheet of more than £2 billion.
- Option 2: over 500 employees, and
- a turnover of more than £500 million
Present Status of the Audit Legislation
Despite the proposals set out in the past, ministers have scaled back plans for reforms at a scale originally planned. Despite the dire need for the overhaul and popular support from the business community, it has also been reported that the government was planning to shelve the legislation indefinitely, delaying the long-drawn-out plan further.
When the plans were first introduced to overhaul the audit sector, they were different from the present scenario. For instance, initially, the plan was to subject at least 4,000 extra private companies to face additional scrutiny.3 However, according to newer plans, only 600 unlisted companies will be subject to stringent restrictions.
The proposals to hold directors of companies personally liable for proper financial reporting have also been dropped. Instead, the corporate governance code will be amended to add improved provisions that apply only to large public companies. Nonetheless, companies can also opt out of extra scrutiny due to reasonable causes.
The plans for ARGA to hold directors accountable for a breach of their legal duties will stay intact, which means audit companies will not be the only ones held accountable and subject to sanctions.
Impact of Scaling Back the Reforms on the UK Economy
UK businesses and unions have warned against the government’s plans to scale back reforms for the impact this step can have on businesses and the audit sector at large. The UK audit legislation has been compared to the Sarbanes-Oxley Act (SOX) enacted in the US over twenty years ago. This was to achieve the same goals that the UK plans to attain today: increased transparency to incentivise and prove to investors that the capital market is reliable and set the overall economy on the right track.
Fast forward two decades and experts have widely conflicting opinions on the effectiveness of the SOX Act in the US.
While experts claim that the Act improved the audit quality, and provided substantial benefits to investors and the US capital markets, it also increased the cost of doing business and reduced overall productivity. Nonetheless, by establishing the Public Company Accounting Oversight Board, an authority responsible for aligning shareholders’ interests with external auditing bodies, the US succeeded in improving the image of its corporate sector in the eyes of investors. Supervising the quality and integrity of company financial statements has also helped strengthen the corporate governance structure.
The impact of the SOX Act on the US economy reflects the possible implications of the audit legislation on the UK economy as well, provided it is implemented strategically, at the right time, and is not watered down. While the US SOX Act and the audit legislation bill have their differences, it puts forward a lesson for the UK.
Scaling back reforms at a time when the UK needs to prioritise its corporate governance and deal with issues facing the economy could have a devastating impact, such as poor transparency, low investments, and loss of more jobs as large companies go into liquidation. The reforms were put forward in 2018, but to this day, they have not been made part of the substantive law. It has also been reported that the ARGA cannot become operational until 2024.
The audit legislation is an opportunity for the UK to revamp its corporate governance and improve its economy at large. Businesses across the UK have supported the proposals and have emphasised the need for a stronger auditing system for companies. The Better Business Act (BBA) coalition has suggested an amendment to section 172 of the Companies Act to update directors’ duties and align their responsibility to shareholders, to reflect the role of companies and their social and environmental impact.
The proposals initially listed in the white paper, combined with recommendations from the BBA hold the power to overhaul the UK corporate governance for good. However, the government needs to take steps to actively work on enacting the legislation and making it a substantive part of the UK laws for a real impact.