UK governance after Brexit

By Stephen Haddrill – Chief Executive Officer of the Financial Reporting Council

The UK’s corporate governance framework is respected globally and has helped attract significant investment in UK businesses. Twenty-five years on from the inception of the UK Corporate Governance Code, and with changing expectations from shareholders and other stakeholders, it was time to have a major review to ensure that it remains fit for purpose.

There are many reasons why international investors favour UK companies, including, of course, the knowledge that the ‘comply or explain’ basis of our corporate governance code delivers better governance practices and enables informed engagement between companies and investors. The Financial Reporting Council (FRC) has supported companies in this in several ways:

• We provided additional guidance in the financial crisis to support auditors in their audit of management’s assessment of going concern and guidance on factors to consider where liquidity may be an issue
• We provided guidance on going concern for directors of listed companies, which set out disclosures by directors and for auditors
• We set up an inquiry, led by Lord Sharman, to identify lessons for companies and auditors addressing going concern and liquidity risks
• We have developed revised auditing standards, including additional requirements to drive more stringent, higher quality audit work
• We developed the concept of extended auditor reporting, providing a way for more of the auditors’ insight on an entity to be shared with the users of financial statements by sharing the auditors’ assessment of risk and materiality. Alongside that we introduced audit committee reporting and, more recently, developed material to support audit committees in making an assessment of the quality of the audit they receive

Public trust in business

The political events over the last year or so, accompanied by the Brexit referendum, have ushered in a new political and economic narrative and a degree of uncertainty about the future. Alongside this and following some high-profile cases of misconduct, public confidence in business has been damaged, leading to a perception that business is not delivering for all.

Codes put forward principles for best practice that make bad behaviour less likely to occur; and public reporting can make it harder to conceal such behaviour. But, by itself, a code does not prevent inappropriate behaviour, strategies or decisions. Only people, particularly the leaders within a business, can do that.

To establish an appropriate governance structure, a board must define the purpose of the company and what type of behaviours it wishes to promote in order to deliver
its business strategy. It involves establishing a company-specific corporate culture, asking questions and making choices: how to align values and purpose to the company’s strategy; how to integrate new leaders into that culture, particularly at times of a merger or acquisition; how to maintain a healthy governance under pressure; how to decide whether different parts of the business should operate different cultures; and how actively to communicate values, purpose and behaviours in order for shareholders to engage in constructive discussion.

A robust culture is also rooted in diversity and succession planning. A board must determine the balance of skills, background and experience required by the senior executives and non-executive directors.

Boards must champion the benefits of a diverse workforce, including senior management. They must determine the balance of skills, background and experience necessary for both executive and non-executive directors to achieve success. Effective succession planning is crucial to achieving an effective board. Succession plans should recognise the value of recruiting talent from a wide pool. A diverse board avoids the dangers of group think and encourages wide-ranging ideas and views.

Boards should take time to consider and understand how diversity and effective succession plans will achieve the strategy and promote success and value. In the revised code – the consultation on which closed in February – succession planning and the promotion of diversity are key elements within its principles and provisions. As such, it will encourage boards and investors to engage in considering how these matters benefit the company.

Audit quality

Corporate governance isn’t the only important element in promoting Britain as ‘open for business’ after Brexit; ensuring the highest audit quality is also paramount. It remains essential that a company audit is trusted by the users of financial statements. It should provide reasonable assurance on the public reporting of financial performance of a business. Auditors should examine the strategic report and the annual report to ensure that it provides clarity and accuracy in its reporting.

The UK Corporate Governance Code has, since 2012, expected the audit committee to appoint the auditor; retender the audit at least every 10 years; ensure auditor independence; and assess audit effectiveness.

In 2016, following the EU Audit Regulation and Directive, the FRC became the competent authority for audit in the UK with responsibility for the oversight of UK statutory audit, ensuring audit regulatory tasks are carried out effectively.

The directive requires auditor rotation for public interest entities, meaning an audit firm can serve no more than two terms of 10 years, and limiting the provision of non-audit services, as well as prohibiting auditors from providing certain additional functions, such as tax, valuation and legal services. The FRC now requires extended auditor reporting, which provides greater transparency over the judgments an auditor makes and the work they do. We also require public reporting by audit committees, so they can demonstrate how they have challenged the auditor on the quality of their work.

At the same time, auditors should consider and be prepared to challenge directors’ assessments of the long-term health of a company. Since 2014, boards have been expected, through the UK Corporate Governance Code to include a viability statement in their strategic report, to provide an improved, broader assessment of long-term solvency and liquidity.

Companies should also state whether they consider it appropriate to adopt the going concern basis of accounting and identify any material uncertainties as to their ability to continue to do so. They should assess their principal risks and explain how they are being managed or mitigated and they should monitor and review annually the effectiveness of their risk management and internal control systems.

The UK’s audit quality inspection regime is a world leader. The FRC has inspected audits for the last 12 years to maintain a focus on continuous improvement on the quality of firms’ audit work. It is also the most transparent regime in the world, publishing reports on individual firms’ audit quality. The FRC also undertakes thematic reviews on specific issues to maintain a focus on audit quality. Recent reviews have found that firms can do more to support the roll-out of data analytic techniques and materiality.

Large firms are improving the effectiveness and efficiency of audit through the transformative use of technology, which should prompt further competition on quality. This raises concerns, though, about smaller firms’ ability to compete; what the role of an auditor is and should be; and how regulators and standard-setters will be able to match the pace of change.

The FRC continues to track innovation and developments in audit in order to promote high-quality corporate governance for stakeholders and society as a whole. Strong innovation and continuous improvement will help ensure that the UK remains a prime capital market as we face a post-EU-exit environment.

About the Author:

Stephen Haddrill has been the Chief Executive Officer and Director of Financial Reporting Council Ltd since November 2009. Haddrill served as Director General at Association of British Insurers (ABI) from May 2005 to November 2009. Previously, he served as Director General at Fair Markets Group at the Department of Trade and Industry (DTI) since January 2002, where he was responsible for the development of the framework within which business operates.