There have been a number of corporate governance developments since the Autumn of 2018, as well as developments in the narrative aspects of annual reports and accounts. This briefing summarises those developments and looks at some of the future developments in these areas that companies need to start preparing for.
Corporate governance developments
Corporate governance codes
The Wates Corporate Governance Principles for Large Private Companies
In December 2018, the Financial Reporting Council (FRC) published the final version of the Wates Corporate Governance Principles for Large Private Companies (Wates Principles) in light of the requirement, in The Companies (Miscellaneous Reporting) Regulations 2018 (Regulations), for financial years commencing on or after January 1, 2019, for all companies of a significant size that are not currently required to provide a corporate governance statement, to include such a statement in their directors’ report. The Wates Principles are designed to help such companies comply with the Regulations.
The Wates Principles were developed by a coalition established by the FRC and chaired by James Wates CBE. Companies can adopt them as an appropriate framework when making a disclosure about their corporate governance arrangements under the Regulations, following an “apply and explain” approach. Boards are encouraged to apply each Principle by considering them individually within the context of the company’s specific circumstances and then explain, in their own words, how they have addressed them in their governance practices.
The six Principles are
- Purpose and Leadership – An effective board develops and promotes the purpose of a company and ensures that its values, strategy and culture align with that purpose. The guidance states that directors should act with integrity and set the tone from the top and it includes suggestions on how to monitor culture.
- Board Composition - Effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge, with individual directors having sufficient capacity to make a valuable contribution. The size of a board should be guided by the scale and complexity of the company. The guidance suggests companies should consider separating the roles of chair and chief executive and it promotes the benefits of non-executive directors, as well as recommending that boards have a diversity and inclusion policy.
- Director Responsibilities- The board and individual directors should have a clear understanding of their accountability and responsibilities. The board’s policies and procedures should support effective decision-making and independent challenge.
- Opportunity and Risk- A board should promote the long-term sustainable success of the company by identifying opportunities to create and preserve value and establishing oversight for the identification and mitigation of risks. The guidance is split into sections on risk, opportunities and responsibilities and it deals with emerging risk and principal risks.
- Remuneration - A board should promote executive remuneration structures aligned to the long-term sustainable success of a company, taking into account pay and conditions elsewhere in the company. The guidance suggests remuneration should be linked to company strategy, and suggests considering increased transparency in relation to remuneration policies and the possible use of a remuneration committee.
- Stakeholder Relationships and Engagement - Directors should foster effective stakeholder relationships aligned to the company’s purpose. The board is responsible for overseeing meaningful engagement with stakeholders, including the workforce, and having regard to their views when taking decisions. The guidance refers to the FRC’s Guidance on the Strategic Report which refers to methods of engagement with the workforce and it points out different groups that may be stakeholders in certain circumstances.
(FRC: The Wates Corporate Governance Principles for Large Private Companies, 10.12.18)
2018 UK Corporate Governance Code – FAQs
In November 2018, the Financial Reporting Council (FRC) published a list of Frequently Asked Questions (FAQs) on the 2018 UK Corporate Governance Code (Code) published in July 2018 which applies to accounting periods beginning on or after January 1, 2019.
The FAQs include a number of general questions and then specific questions on particular Provisions and terms used in the Code. Questions include the following:
- Why has a 10 year period been set for chairs but non-executive directors?
- How does the Code’s definition of “senior management” fit with the definition in section 414C(8) Companies Act 2006?
- Why does the Code not specifically refer to cyber risks?
The FAQs also note that the FRC intends to update its Guidance on Audit Committees to reflect the Code and that it will be making consequential changes to the Guidance on Risk Management, Internal Controls and Related and Financial Business Reporting. At the same time, it will assess whether further amendments are required in relation to internal controls and the viability statement in light of the completion of the various investigations into the collapse of Carillion.
(FRC, 2018 UK Corporate Governance Code – FAQs, 28.11.18)
QCA Corporate Governance Behaviour Review 2018/19
In November 2018, the Quoted Companies Alliance (QCA) and Hacker Young published the Corporate Governance Behaviour Review 2018/19 (Review).
The Review looks at companies’ disclosures against the QCA Corporate Governance Code (QCA Code) after the instigation of the change to AIM Rule 26 on September 28, 2018. It also looks at the state of disclosures before that time, for comparison. The Review benchmarks the corporate governance disclosures made from a random selection of 50 AIM companies and compares these against the disclosures contained in the revised QCA Code, which was published in April 2018.
A group of institutional investors examined the results at a discussion roundtable and their reflections led to five recommendations for companies to improve their corporate governance disclosures:
- Nail your elevator pitch – Companies should connect their strategy, business model and governance in a simple and straightforward manner, as they would in an elevator pitch.
- Ask for feedback - Engage with shareholders and stakeholders and act on the feedback obtained, communicating effectively how this took place and what results it brought to help achieve the company’s long-term success.
- Know your board’s purpose - Focus on how the board is built and how that is communicated – detail its composition, performance evaluation, succession planning and matters reserved for the board.
- Show how you differ - Communicate clearly where the company’s governance arrangements diverge from common practices – explain to investors why the company’s approach is right for the company.
- Celebrate your company culture - Explain how the company is promoting a sound corporate culture and how that is consistent with its objectives, strategy and business model.
The Review found that, in general, the number of company governance disclosures were significantly higher after the AIM Rule 26 change, particularly those regarding the disclosure of detailed information on independent directors and board performance, as well as corporate culture.
However, some areas still require progress. For example, while 100 per cent of the companies already disclosed the identity of directors, only 4 per cent explained how each director keeps his/her skillset up-to-date – this rose to 32 per cent post-September 2018. Similarly, only 4 per cent included a detailed description of the board evaluation process, and this rose only to 12 per cent post-September 2018. In addition, pre-September 2018, none of the companies in the sample disclosed any information on plans for evolution of their governance framework in line with the company’s plans for growth. After September 2018, this rose to 9 per cent of companies.
(QCA: Corporate Governance Behaviour Review 2018/19, 28.11.18)
Investment Association and Hampton-Alexander Review letter on gender diversity in FTSE 350 companies
In March 2019, the Investment Association and the Hampton-Alexander Review announced that they have written to 69 of the FTSE 350 companies, highlighting concerns relating to gender diversity on their board.
The letter was sent to companies who have no women or just one woman on their board and asks those companies to outline what action they are taking to make progress and ensure they are meeting the Hampton-Alexander targets of 33 per cent of women on their board and leadership team by 2020.
The letter follows the announcement in February that the Investment Association’s voter information service, IVIS, will give its highest warning level (a red-top) to companies who have just a single woman on their board.
(Investment Association and Hampton-Alexander Review: Gender diversity in FTSE 350 companies, 15.03.19)
Hampton-Alexander Review – Improving gender balance in FTSE leadership
In November 2018, the Hampton-Alexander Review published its third report assessing progress against the five key recommendations that it set in 2016, highlighting emerging best practice and current challenges.
The report notes the following
Executive Committee and Direct Reports
The FTSE 100 has seen the number of women on the combined Executive Committee and Direct Reports increase to 27 per cent in 2018, up from 25.2 per cent in 2017. For the FTSE 250, the number of women on their combined Executive Committee and Direct Reports has increased marginally to 24.9 per cent in 2018, up from 24 per cent in 2017.
Women on boards
The number of women on FTSE 100 boards is now 30.2 per cent, up from 27.7 per cent in 2017. Women’s representation on FTSE 250 boards has increased from 22.8 per cent in 2017 to 24.9 per cent in 2018.
The number of all-male boards is now down to five, from 10 in 2017, but 75 companies in the FTSE 350 only have one woman on the board.
The report notes that if progress continues at a similar rate, the FTSE 100 is on track to achieve the 33 per cent target for women on boards by 2020. However, a step change in pace is needed elsewhere with half of all available appointments in the next two years, both board appointments and combined Executive Committee and Director Reports, needing to go to women to achieve the 33 per cent target.
Throughout the report, there are examples of good practice as well as a summary of the barriers to women’s progression in the workplace. The report compares UK progress to that internationally and the role of executive search firms and the investor community is also considered.
(Hampton-Alexander Review, Improving gender balance in FTSE leadership, 13.11.18)
Institutional investor guidelines
PLSA’s Corporate Governance Policy and Voting Guidelines 2019
In January 2019, the Pensions and Lifetime Savings Association (PLSA) published an updated version of its Corporate Governance Policy and Voting Guidelines (2019 Guidelines). The 2019 Guidelines have been updated to mirror the 2018 UK Corporate Governance Code and highlight some of the key developments in UK corporate governance policy and practice.
On the whole, the 2019 Guidelines, which aim to assist pension schemes, asset managers and their proxy voting agents in the interpretation of the 2018 UK Corporate Governance Code and in forming judgements on AGM resolutions, remain unchanged. However, additional guidance has been added throughout and several revisions have been made to the UK Voting Guidelines section.
The revisions include the following
- Section 1: Board leadership and company purpose - Shareholders may want to undertake closer analysis of the narrative used in company statements to assess the company’s approach to workforce and stakeholders, including to assess whether there is evidence of a clear sense of corporate purpose, culture and values, and how those align with the company's strategy.
- Section 2: Division of responsibilities – A company's chief executive should not become chair of the company except in exceptional circumstances and there should be significant engagement with shareholders setting out the reasons for doing so, with clear timeframes indicated, in good time. In addition, shareholders are encouraged to have a clear sense of other demands on directors' time, and of any significant developments which have occurred since a director's appointment that may impact on their ability to commit appropriate time to the company.
Details of other current appointments, including any changes over the previous year, should be set out in the annual report and shareholders should ensure that they have a clear understanding of any existing (or pre-existing) relationship between the independent non-executives and the company that could compromise directors' ability to hold management to account.
- Section 4: Audit, risk and internal control - Shareholders are encouraged to pay close attention to the composition, skills and experience of the audit committee; committee members should have recent and relevant financial experience related to audit, accountancy or investor practitioner expertise, and any committee member's connections with the current or potential auditor should be clearly disclosed.
- Section 5: Remuneration – Investors should continue to express concerns about recent increases in the fixed pay of senior executives (compared to performance-related-pay) and should continue to press companies to clearly explain their rationale for such increases. Remuneration policies should not only be coherent and consistent throughout the organisation, but should be clearly linked to incentivising those behaviours which are consistent with the company's purpose and values.
In relation to the particular voting guidelines, the 2019 Guidelines suggest, in relation to sustainability and climate change, that shareholders may wish to consider supporting relevant climate-related or similar resolutions and key issues to doing so should be the proportionality and achievability of the resolution.
(PLSA: Corporate Governance Policy and Voting Guidelines 2019, 29.01.19)
Investment Association’s issues to consider for 2019 AGMs
In November 2018, the Investment Association wrote to all FTSE 350 remuneration committee chairs highlighting items that investors will focus on at 2019 AGMs. These include the following
- Investor and remuneration committee relations: Investors are concerned that some remuneration committees do not respond to their concerns or are overly considerate of management’s perspective, at the expense of shareholders’ views. In 2018 there were more votes than in previous years against remuneration committee chairs or members where the remuneration committee’s decisions did not met investors’ expectations. Remuneration committees should consider the wider employee pay context when taking executive remuneration decisions.
- Shareholder engagement: Companies should be satisfied they have been sufficiently transparent in their shareholder consultations so that final proposals do not contain surprises and give the full remuneration picture.
- New reporting requirements: While the reporting requirements in the Companies (Miscellaneous Reporting) Regulations 2018 do not come into force until January 1, 2019 so most reporting against them will start in 2020, companies are encouraged to report their CEO pay ratios in 2019 and to use Option A as this method of calculation is considered the most statistically robust.
- Levels of remuneration: Investors will look closely at how increases in remuneration to executive directors are justified and will expect remuneration committees to show restraint in relation to overall quantum.
- Pay for performance: To justify support for remuneration pay-outs, there should be robust transparency on financial and non-financial targets so that the link between pay and performance can be clearly seen.
(Investment Association: Letter to FTSE 350 remuneration committee chairs, 22.11.18)
ISS 2019 Proxy Voting Guidelines updates
In November 2018, Institutional Shareholder Services (ISS) published updates to its UK Proxy Voting Guidelines (ISS Guidelines) for 2019. The updated ISS Guidelines will generally be applied for shareholder meetings held on or after February 1, 2019.
The updates include the following
- Appointment of external auditors: An additional exception has been added to the general policy of ratifying the appointment of the external auditors where the lead audit partner(s) has been linked with a significant auditing controversy. In such a situation, where that lead audit partner(s) is engaged in the audit for other public companies, this track record will be raised by ISS for investor attention, even if no issues of concern have been identified at the subject company.
- Director elections: In listing the extraordinary circumstances where ISS will consider recommending a vote against individual directors, the ISS Guidelines have added the circumstance of egregious actions related to a director’s service on other boards that raise substantial doubt about that individual’s ability to effectively oversee management and to serve the best interests of shareholders at any company. In addition, ISS may now recommend a vote against the re-election of a director if there have been repeated absences (less than 75 per cent attendance) at board and committee meetings that have not been suitably explained and this will apply to all directors, not just those with multiple outside directorships.
- Remuneration policy: Target bonuses should typically be set at no more than 50 per cent of the maximum bonus potential and share awards should be subject to a total vesting and holding period of five years or more in line with the recommendations of the 2018 UK Corporate Governance Code.
- Remuneration report: When there has been a material decline in a company’s share price, the ISS Guidelines recommend that remuneration committees should consider reducing the size of long-term incentive plan awards at the time of grant. In addition, fees payable to non-executive directors should not be excessive relative to similarly sized companies in the same sector.
- Authorisation of issue of equity with and without pre-emptive rights: The current ISS Guidelines state that if a company receives approval to disapply pre-emption rights up to 10 per cent and then is considered to have abused the authority during the year in a manner not in line with the Pre-Emption Group’s Principles, then ISS is likely to recommend a negative vote on share issuance authorities at the following AGM. In the revised ISS Guidelines, the restrictive language “during the year” has been removed so that the company’s practice over multiple years can be considered and it is made clear that an against recommendation could potentially be applied to all share issuance authorities, not only those relating to a disapplication of pre-emption rights.
- Social and environmental issues: It is made explicit that significant controversies, fines, penalties or litigation are considered when ISS evaluates social and environmental shareholder proposals.
(ISS: 2019 UK and Ireland Proxy Voting Guidelines, 6.12.18)
Glass Lewis’s 2019 UK Proxy Paper Guidelines
In November 2018, Glass Lewis published its updated 2019 Proxy Paper Guidelines (Glass Lewis Guidelines).
The changes to the 2018 Glass Lewis Guidelines include the following
- Board and committee responsiveness: Where appropriate, Glass Lewis may hold chairs and members of the relevant committees accountable via a recommendation against their re-election where it is felt that the response to shareholder concerns has fallen below a qualitative threshold.
- Board skills: In analysing election and re-election proposals at FTSE 100 companies, Glass Lewis assess disclosure of directors’ skills. FTSE 100 companies are expected to provide a robust, meaningful assessment of the board’s profile in terms of diversity and skills in line with developing best practice standards.
- Board diversity: Glass Lewis make it clear that they will take into account disclosed gender paygap data and the composition of the executive pipeline when assessing diversity concerns at board level in relation to FTSE 350 companies.
- Environmental and social risk oversight: Glass Lewis have codified their approach to reviewing how boards are overseeing environmental and social issues. They believe that inattention to material environmental and social issues can harm shareholder interests and so should be carefully monitored and managed by companies. For large companies, and in instances where Glass Lewis identify material oversight issues, they will review a company’s overall governance practices and identify which directors or board-level committees have been charged with oversight of environmental and/or social issues. They will also note instances where such oversight has not been clearly defined by companies in their governance documents. They may consider recommending that shareholders vote against members of the board who are responsible for oversight of environmental and social risks in certain circumstances or, in the absence of explicit board oversight of environmental and social issues, Glass Lewis may recommend that shareholders vote against members of the audit and/or risk committee responsible for overseeing risk exposure.
- CEO pay ratio: Glass Lewis note that while they believe the new CEO pay ratio reporting requirement has the potential to provide additional insight when assessing a company’s pay practices, they will not base voting recommendations solely on such ratios in and of themselves.
- Executive remuneration: Glass Lewis make it clear that they will specifically assess the realised pay received by a company’s top executives over at least three years when evaluating the link between pay and company performance.
(Glass Lewis: 2019 UK Proxy Paper Guidelines, 14.11.18)
European Commission’s non-binding guidelines on the standardised presentation of the remuneration report under the Shareholder Rights Directive
In March 2019, the European Commission launched a Consultation seeking feedback on draft Guidelines on the standardised presentation of the remuneration report under the Shareholder Rights’ Directive.
The aim of the Guidelines is to assist companies in disclosing clear, understandable, comprehensive and comparable information on individual directors’ remuneration which meets the requirements of Shareholder Rights’ Directive. The draft Guidelines provide direction on several matters, including the following:
- Companies are required to provide a remuneration report annually to explain how the remuneration policy has been implemented in the most recent financial year under review. The report should follow the structure and order of presentation set out in the Guidelines. If there is nothing to report for a specific section, table or data field, such elements can be omitted from the remuneration report. However, companies are encouraged to explicitly state that they have nothing to report under a certain section or data field.
- The remuneration report should be clear, concise, meaningful and understandable. This should be taken into account when companies assess the need to include additional information not explicitly required in the Shareholder Rights’ Directive.
- Companies should be transparent on the methodology applied and maintain consistency over the reported financial years. Where the methodology has been changed compared with a previous remuneration report, a note would be helpful to explain the change and the effect of this change.
- The remuneration report should be self-standing and contain all the necessary information in one place. Nonetheless, besides the information regarding remuneration awarded or due during the reported financial year, the remuneration report could also include relevant background information via cross-references to published information, when appropriate, in order to avoid unnecessary duplications.
- All the monetary amounts in the remuneration report should be presented gross.
- To the extent applicable, the remuneration report should distinguish between directors with different functions (for example executive/non-executive or supervisory board member, CEO, CFO).
- Ex-post disclosure of performance targets could be provided to help establish the link between the remuneration of directors and the performance of the company.
Responses to the Consultation are requested by March 21, 2019.
(European Commission: Draft guidelines on the standardised presentation of the remuneration report under the Shareholder Rights Directive, 01.03.19)
(European Commission: Consultation on the draft guidelines on the standardised presentation of the remuneration report under the Shareholder Rights Directive, 01.03.19)
GC100 Directors’ Remuneration Reporting Guidance 2018
In December 2018, the GC100 and Investor Group published an updated version of its directors’ remuneration reporting guidance. The second edition, published in August 2016, has been thoroughly reviewed and new material has been added to address the new reporting requirements required by the Companies (Miscellaneous Reporting) Regulations 2018 (2018 Regulations).
Key changes to the 2016 guidance include the following:
- In section 2.2 (Annual Statement) it is made clear that the remuneration committee chair’s annual statement must summarise, for the financial year, any discretion which has been exercised in the award of directors’ remuneration. As a result, a possible new disclosure which should be considered is why the remuneration committee considered it appropriate to exercise discretion in a particular fashion and the impact on the payment of that exercise of discretion.
- Section 3.1 (Single total figure of remuneration) has been amended to provide guidance on the new requirement for companies to disclose, in relation to short-term and long-term incentives, the amount, or an estimate of the amount, of the award that is attributable to share price appreciation and, where discretion has been exercised, how the award was determined and whether discretion has been exercised due to share price appreciation or depreciation.
- A new section 3.9 has been added. This relates to pay ratio information in relation to the total remuneration of the CEO, as required by the 2018 Regulations. The guidance covers companies that are exempt from reporting on pay ratios, means of ensuring consistency in reporting over the 10-year cycle where headcount varies from year to year, the position where there is a change in CEO during a relevant reporting period, the position of the pay ratios table and supporting statements in the remuneration report, the methodology used to calculate the figures, changes in approach across multiple reporting periods and the various disclosure requirements. The guidance notes that where a remuneration committee considers that the ratio is not consistent with pay, reward and progression policies, investors will generally expect the remuneration committee to describe the intended necessary actions that it will take in order to address this issue.
- Section 4.8 (Illustrations of the application of the remuneration policy) has been expanded to include a section on the impact of share price appreciation. Under the 2018 Regulations, companies are required to disclose in their remuneration policy, in relation to long-term incentives and other awards with performance measured over more than one financial year, an indication of the maximum remuneration receivable assuming share price appreciation of 50 per cent during the performance period. The guidance considers where the share price appreciation information should appear and the description of the basis of the calculation of the share price appreciation that must be included.
(GC100 and Investor Group, Directors’ Remuneration Reporting Guidance 2018, 10.12.18)
Investment Association’s Principles of Remuneration 2018
In November 2018, the Investment Association published its updated Principles of Remuneration (Principles). Key changes to the 2017 Principles of Remuneration include the following:
- Executive shareholding requirements: The Principles make it clear that unvested shares not subject to a further performance condition can count towards the shareholding requirement set by the company on a net of tax basis, as can vested shares subject to a holding period and/or clawback (for example, deferred shares awarded under an annual bonus schemes or shares vested from a long-term incentive award which are still in the holding period).
- Post-employment holding periods: These should apply for at least two years at a level equal to the lower of the shareholding requirement immediately prior to departure or the actual shareholding on departure. Structures to maintain post-employment shareholdings (such as nominee accounts or employee ownership trusts) should be stated and these requirements should apply to all new executive directors and for existing executive directors at the earliest opportunity (and by the next remuneration policy vote at a minimum).
- Malus and clawback: Remuneration committees need to establish a substantial list of specific circumstances in which malus and clawback can be used (beyond gross misconduct or misstatement of results) and the Principles set out investors’ expectations of the enforcement processes companies should have in place to implement malus and clawback.
- Use of discretion: The remuneration committee is tasked with ensuring it has sufficient power and processes to enable it to exercise discretion and if discretion is not exercised in a particular year, the remuneration committee chair’s report should confirm this.
- Shareholder consultation: While this needs to focus on major strategic remuneration issues, the final proposals should not contain any surprises for investors, who need the complete picture and sufficient information to make an informed voting decision.
- Base pay: The reasons for any increase in base pay should be fully disclosed, justified and appropriate against awards to the wider workforce.
- Pensions: In meeting the 2018 UK Corporate Governance code requirement for executive directors’ pension provision to be in line with the general approach to the employees as a whole, investors will expect this to be the rate given to the majority of the workforce. New executive directors and directors changing role should receive that rate and the contribution rate for incumbent executive directors should be reduced over time to the level of the contribution given to the majority of the workforce. Compensation should not be awarded for this change.
- Annual bonus: Where financial metrics do not warrant a bonus, investors will scrutinise any payment and its rationale to ensure it is warranted, and dividends accrued on deferred shares should be paid in shares.
- Long-term incentives: Generally the payment of long-term incentive schemes in cash or cash equivalents should only be to settle tax, and dividends accruing on vested shares should be paid in shares.
- Restricted shares: In assessing proposed restricted share schemes, investors will consider the context of the company and the strategic rationale. The Principles set out the views of investors in relation to discretion and underpin, holding period/vesting, the company’s previous approach to remuneration and discounts when assessing restricted share scheme proposals.
- Leaver provisions: Those not meeting the “good leaver” criteria should be treated as “bad leavers”. Deferred bonus and long-term incentive awards should be settled in shares and subject to appropriate performance and holding periods. If an individual is expected to retire (and so be a good leaver), the remuneration committee should have appropriate mitigation clauses in case the director takes on another executive role.
(Investment Association: Principles of Remuneration 2018, 22.11.18)
Proposed revised UK Stewardship Code
In January 2019, the Financial Reporting Council (FRC) published a consultation paper proposing changes to the UK Stewardship Code, together with a draft revised UK Stewardship Code in an Appendix to the consultation paper. The revised Code sets out more rigorous requirements for reporting, focusing on how stewardship activities deliver outcomes against objectives. Reporting will be subject to increased oversight by the FRC to ensure the revised Code is effective in raising the quality of stewardship across the investor community.
The main proposed revisions to the Code include the following:
- Revision of the ‘stewardship’ definition – A new definition of ‘stewardship’ identifies the primary purpose of stewardship as looking after the assets of beneficiaries that have been entrusted to the care of others. At the same time, it broadens the scope of the revised Code to include investment decision-making and investment in assets other than listed equity.
- Purpose, values and culture – Signatories must report on an organisational purpose, strategy, values and culture that enable them to fulfil their stewardship objectives and enable them to fulfil their obligations to their clients or beneficiaries. This focus purposely aligns the revised Code with the 2018 UK Corporate Governance Code and ensures that effective stewardship behaviours are embedded across businesses.
- Integration of stewardship and investment approach – The revised Code sets higher standards for asset owners and managers regarding how they integrate their stewardship responsibilities into their investment processes, including investment decision-making, mandate design and other activities.
- Stewardship beyond listed equity – The revised Code now expects investors to exercise stewardship across a wider range of assets where they have influence and rights, in the UK and globally. Signatories should use the resources, rights and influence available to them to exercise stewardship, no matter how capital is invested.
- Recognising the importance of environmental, social and governance (ESG) issues – The revised Code reflects the significant developments that have taken place in sustainable finance, responsible investment and stewardship since 2012. It makes explicit reference to ESG factors and requires signatories to take into account material ESG factors, including climate change, when fulfilling their stewardship responsibilities.
- Restructuring to align with the UK Corporate Governance Code – The structure of the revised Code mirrors the 2018 UK Corporate Governance Code, with numbered Sections, Principles and Provisions accompanied by supporting Guidance.
- More rigorous reporting requirements – The revised Code sets out more rigorous requirements for reporting, focusing on how stewardship activities deliver outcomes against objectives. Reporting will be subject to increased oversight by the FRC to ensure the revised Code is effective in raising the quality of stewardship across the investor community.
The FRC ask for responses to the consultation on or before March 29, 2019. It is expected that a final version of the UK Stewardship Code will be published in Summer 2019.
(FRC: Proposed revised UK Stewardship Code, 30.01.19)
(FRC: Proposed Revision to the UK Stewardship Code consultation, 30.01.19)
(FRC: Summary of Changes from 2012 UK Stewardship Code, 30.01.19)
Building a regulatory framework for effective stewardship – Discussion paper from the FRC and FCA
In January 2019, the Financial Conduct Authority (FCA) and the Financial Reporting Council (FRC) published a joint discussion paper seeking views on how stewardship can be improved within the existing structure of UK capital markets, acknowledging conventions such as the unitary board and shareholders’ voting rights. The discussion paper examines what effective stewardship should look like, what the minimum expectations should be for financial services firms that invest for clients and beneficiaries, the standards the UK should aspire to and how these could be achieved, as well as the potential public and private benefits of improved stewardship.
The discussion paper notes that at the same time the FRC has issued a consultation paper on a revised UK Stewardship Code and the FCA has published a consultation paper on the implementation of the amended Shareholder Rights Directive. In addition, in considering responses to the discussion paper, account will be taken of the recommendations in Sir John Kingman’s review of the FRC.
The discussion paper requests stakeholder input on certain matters, including:
- The proposed stewardship definition – The discussion paper defines stewardship as the responsible allocation and management of capital across the institutional investment community, to create sustainable value for beneficiaries, the economy and society. Stewardship activities include monitoring assets and service providers, engaging issuers and holding them to account on material issues, and publicly reporting on the outcomes of these activities. The discussion paper asks whether stakeholders agree with the definition of stewardship set out , and if not, requests suggestions for alternative definitions.
- What effective stewardship looks like – The discussion paper suggests that effective stewardship should reflect a clear understanding across the institutional investment community of clients’ and beneficiaries’ financial interests and their investment time horizon. The discussion paper suggests that key attributes of effective stewardship could be a clear purpose, constructive oversight, engagement and challenge, institutional culture and structures that support investment strategies and stewardship activities consistent with clients’ and beneficiaries’ financial interests over their investment time horizon, and disclosure and transparency. Views are sought on the attributes stakeholders consider most important. The discussion paper also asks whether there are any particular areas which stakeholders consider that investors’ effective stewardship should focus on to help improve outcomes for the benefit of beneficiaries, the economy and society.
- Key challenges to effective stewardship – The discussion paper identifies several challenges in achieving effective stewardship, including the complexity of the relationships in the institutional investment community. Views are sought on what stakeholders believe to be the most significant challenges in achieving effective stewardship, particularly on the investment required to embed effective stewardship in investment decision-making.
- The appropriate institutional, geographical and asset class scope of stewardship – The discussion paper requests feedback on how to deal with some specific issues in the design of the regulatory framework, including the institutional, asset-class and geographical scope of the framework. The discussion paper requests feedback on whether there is more that should be done to incentivise international investors and to ensure they recognise the benefits of exercising stewardship, including in respect of their assets in the UK and whether there is a case for regulatory rules to expand the reach of stewardship beyond equities.
- Developments to current and proposed regulations – The discussion paper seeks views on whether there are any areas in which additional regulatory rules, either to improve stewardship quality or prevent poor practice, should be considered rather than relying solely on promoting effective practices through the revised Stewardship Code. In addition, views are sought on whether stakeholders consider that regulatory actions are necessary to address any perceived harms. The discussion paper also asks whether, to support effective stewardship, amendments to other aspects of the regulatory framework that affect how investors and issuers interact, such as the Listing Rules, Prospectus Rules and Disclosure Guidance and Transparency Rules, should be considered.
Reponses to the discussion paper are requested by April 30, 2019. A feedback statement will be published later in the 2019/20 financial year.
(Building a framework for effective stewardship – joint discussion paper, 30.01.19)
Narrative reporting developments
Audit and accounting developments
Independent review of the Financial Reporting Council – Initial consultation on recommendations by BEIS
In March 2019, the Department for Business, Energy and Industrial Strategy published a consultation paper seeking views on certain of the recommendations made by the independent review led by Sir John Kingman of the Financial Reporting Council (FRC). Sir John Kingham published his final report, setting out 83 recommendations, in December 2018 (see further below).
The Government plans to take forward a number of the recommendations made and the consultation paper includes a table setting out its proposed approach to the different recommendations. In some cases, the FRC will move without delay to adopt the improved practices recommended. Some recommendations involve choices in how they should be implemented and these are identified in the consultation paper for discussion and consultation. Other recommendations involve weighty, wider issues and inter-connections which need to be considered, particularly in light of the ongoing study into the statutory audit market being conducted by the Competition and Markets Authority and the review being led by Sir Donald Brydon on audit quality and effectiveness.
The Government’s approach to the Kingman recommendations includes the following:
The new regulator
The Kingman review recommended that the FRC be replaced with an independent statutory regulator, to be called the Audit, Reporting and Governance Authority, accountable to Parliament with a new mandate, new clarity of mission, new leadership and new powers. While this will require primary legislation, the Government intends to establish such a new regulator as soon as Parliamentary time allows. It is taking steps to appoint new leadership at the FRC, which will transition into the Audit, Reporting and Governance Authority once established by legislation. While primary legislation will be needed to give the recommended objective, duties and functions to the new regulator, the FRC has agreed that in the interim it will adopt the new objective, duties and functions as quickly as possible. However, before it does that, comments are requested on the proposed objective which is to protect the users of financial information rather than the providers of that information and on the recommended duties and functions.
Audit expectations and public interest
The Government will consult on proposals to review the UK’s definition of a public interest entity (PIE) later this year.
Corporate reporting reviews
The Kingman review recommended that the new regulator should be given a power to direct changes to accounts rather than having to go to court. The Government intends to bring forward a legislative power to achieve this as soon as Parliamentary time allows.
Wider role on corporate reporting
The Kingman review recommended that the corporate reporting review process should be extended to the entire annual report. The Government supports this and the FRC will take this forward immediately. The Government will also take forward discussions with the Financial Conduct Authority (FCA) and the FRC to consider the case for strengthening qualitative regulation around a wider range of investor information than is covered by the FRC’s existing corporate reporting work. The Government will consult on any proposals which emerge from those discussions in due course.
The Kingman review recommended enhancements to the sanctions regime for audit and for directors. The Government notes that such changes will require primary legislation and will require careful consideration of how any new policies interact with the existing enforcement framework. It will bring forward proposals for consultation on this in due course.
The Kingman review recommended the introduction of a robust market intelligence function to be developed by the new regulator and this is to be taken forward by the FRC immediately. The Kingman review also recommended that the Government introduce a duty of alert for auditors to report viability or other serious concerns. This is to be considered further as the Government wants to ensure that it can act as a meaningful warning and market intelligence tool, rather than a tick-box exercise.
The Kingman review also recommended that the new regulator should be able to commission a skilled person review, paid for by the company, where there are concerns about the corporate governance or corporate reporting at a company. It also recommended that the new regulator should be able to require rapid explanations from companies in serious cases. The Government agrees with this, but points out that this will require primary legislation to implement. In relation to “skilled person reviews”, it will think further about the framework to ensure that it is fit for purpose and fully considers any wider market consequences, while respecting company independence and lessons learned from the similar framework run by the FCA. There will be a further consultation on this framework in due course.
The FRC is to take forward immediately the recommendation that viability statements be reviewed and reformed with a view to making them substantially more effective.
Responses to the consultation are requested by June 11, 2019.
(BEIS: Independent review of the Financial Reporting Council – Initial consultation on recommendations, 11.03.19)
FRC’s consultation on revisions to International Standard on Auditing (ISA) (UK) 570 - Going Concern
In March 2019, the Financial Reporting Council (FRC) launched a consultation on revisions to International Standard on Auditing (ISA) (UK) 570 - Going Concern. The Consultation follows concerns about the quality and rigour of audit and well-publicised corporate failures where the auditor’s report failed to highlight concerns about the prospects of entities which collapsed shortly after as well as findings from recent FRC Enforcement cases. Under the proposed revisions, requirements on UK auditors will be significantly stronger than those required by international standards.
The proposed revisions include:
- Ensuring that auditors make greater effort to more robustly challenge management’s assessment of going concern, thoroughly test the adequacy of the supporting evidence, evaluate the risk of management bias, and make greater use of the viability statement;
- An improved transparency with a new reporting requirement for the auditor to provide a conclusion on whether management’s assessment is appropriate, and to set out the work they have done in this respect; and
- A stand back requirement to consider all of the evidence obtained, whether corroborative or contradictory, when the auditor draws their conclusions on going concern.
Responses to the consultation are requested by 5pm on June 14, 2019.
(FRC: Consultation on revisions to International Standard on Auditing (ISA) (UK) 570 - Going Concern, 04.03.19)
(FRC: Revisions to International Standard on Auditing (ISA) (UK) 570 - Going Concern, 04.03.19)
Position paper on 2016 Ethical and Auditing Standards
In March 2019, the Financial Reporting Council (FRC) published a position paper setting out how Ethical and Auditing Standards will be developed to respond better to the needs of users of audited financial information, following a recent call for feedback. The position paper addresses the issues that will be developed to support a public consultation on the text of revised standards in the summer of 2019, the intention being that the revised standards will apply to audits for financial periods commencing on or after December 15, 2019.
The position paper makes several proposals, including the following:
- There will be a consultation on whether ethical requirements in respect of Public Interest Entity (PIE) audits should apply to other audit engagements which are of significant public interest (even if the entity is not a PIE) and a consultation on a principles-based regime for PIE audits whereby certain audit-related services, closely linked to the audit, can be provided by the auditor. These will likely include those services that were exempt for the purposes of the non-audit services cap, because they are required by law or regulation, and certain other services where there is a clear justification for the auditor to undertake the work. Services not within this category will no longer be able to be provided by the auditor.
- There will be a consultation on an outright prohibition on contingent fee arrangements for all non-audit/additional services.
- There will be a consultation on measures to enhance the authority of the Ethical Partner and the ethics and compliance function within an audit firm, including through strengthening the links with the audit firm’s independent non-executives and governance.
- In consideration of the of the Kingman Review recommendation relating to the definition of a PIE, there will be a consultation on making requirements applicable to PIEs also applicable to other entities of public interest.
The position paper addresses implications for auditors and audited entities if the UK leaves the EU without a withdrawal agreement and no transition period (no-deal scenario). The position paper sets out changes that will be made to the standards to reflect changes to the law, including that PIEs will only be UK-incorporated entities; that the prohibition on the provision of non-audit services will apply globally for periods commencing on or after March 29, 2019, and that non-audit services required by EU law will no longer be exempt for the non-audit services fee cap.
The position paper also highlights how the FRC’s work on the standards responds to certain recommendations made by Sir John Kingman in his independent review of the FRC, how proposals are being developed to support the Competition and Market Authority’s Market Study of the UK Statutory Audit Market; and how revisions made to the international Code of Ethics will be incorporated into the FRC Ethical Standard.
The FRC intends to consult on the revised text in July 2019, and for those standards to apply to the audit of financial periods commencing on or after December 15, 2019.
(FRC: Position Paper on 2016 Ethical and Auditing Standards, 05.03.19)
Independent review of audit - Terms of reference
In February 2019, the Department for Business, Energy & Industrial Strategy (BEIS) published the terms of reference for the independent review into the quality and effectiveness of audit being led by Sir Donald Brydon. The review will engage with a wide range of stakeholder groups in order to fully understand the range of issues facing audit, and ensure constructive challenge.
The review has been commissioned in response to the perceived widening of the “audit expectations gap” - the difference between what users expect from an audit and the reality of what an audit is and what auditors’ responsibilities entail. The review is intended to reconsider the scope of the audit, how far it can and should evolve to meet the needs of users of accounts, what other forms of assurance might need to be developed, and to define and manage any residual expectations gap. The review will also consider how the audit product should be developed to serve the public interest in future, taking account of changing business models, new technology and stronger public expectations.
The terms of reference establish the review’s scope including:
- Understanding the needs and expectations of stakeholders who make use of company audits – Specifically considering the origins and perceptions of the expectations gap, and what can be done to ensure that investors and other stakeholders fully engage with audit and understand its scope and limitations.
- The scope of audit – The terms of reference suggest that the review should consider what information future investors and the users of corporate information are likely to require a company to produce and, in that context, what assurance investors and other users of corporate information will need; and how any extension of that assurance can be achieved at a proportionate cost to corporates.
- How assurance is provided and how that assurance can be made more effective for investors – The review should consider from whom and how the assurance should be provided, the extent to which auditors can and should assess whether underlying information is reliable, the extent to which auditors can and should assess the impact of uncertain future events, and how audit can respond to the opportunities and challenges of new technology and other forms of innovation to increase the assurance and effectiveness of audit.
(BEIS: Independent review of audit - terms of reference, 14.02.19)
Independent review of the FRC – Final report by Sir John Kingman
In December 2018, the Department of Business, Energy and Industrial Strategy (BEIS) published the final report of the independent review of the Financial Reporting Council (FRC) led by Sir John Kingman (Final Report). The purpose of the review was, broadly, to assess the effectiveness of the FRC’s governance and to assess its independence, impact and powers.
The Final Report considers the FRC’s strengths and weaknesses and makes a number of recommendations, including the following:
- The FRC should be replaced as soon as possible with a new independent regulator to be known as the Audit, Reporting and Governance Authority, which should be accountable to Parliament. Its overarching duty should be to promote the interests of consumers of financial information, not producers.
- The Government should review the UK’s definition of a public interest entity (PIE) which comprises UK entities with securities traded on an EEA regulated market, credit institutions and insurance undertakings.
- PIEs and their auditors have to adhere to requirements for auditor rotation, capping the provision of non-audit work and prohibiting some forms of non-audit work. The Final Report notes that some countries have a wider definition of a PIE than the UK and is concerned that the UK’s narrow definition may exclude entities whose audit arrangements are a matter of public interest.
- The corporate reporting review process should extend to the entire annual report, including corporate governance reporting rather than just to the strategic report, directors’ report and annual accounts as is currently the case.
- The Government should work with the Financial Conduct Authority (FCA) and the new regulator to consider whether there should be more regulation around a wider range of investor information (such as earnings release and investor presentations that may include forward-looking information) which is not currently covered by the FRC’s existing corporate reporting work.
- The new regulator should be tasked by the Government to develop detailed proposals for an effective enforcement regime for PIEs that holds a company’s CEO, CFO, chair and audit committee chair (not just those who are members of a professional accountancy body) to account for their duties to prepare and approve true and fair accounts and compliant corporate reports, and to deal openly and honestly with auditors. Relevant requirements or statements of responsibilities in relation to auditing and corporate reporting should also be set out so that directors are individually accountable for their roles.
- The UK’s Stewardship Code should focus on outcomes and effectiveness, not on policy statements.
- The Government should introduce a duty of alert for auditors to report viability or other serious concerns and engage with the auditor where the auditor of a PIE parts company with a client outside the normal rotation cycle.
- The new regulator should have the power to commission a skilled person review, paid for by the company, where, for example, it has significant concerns about the accounting treatment of key areas of audit judgement or where there is evidence of significant investor concern. The new regulator should then have power to require additional assurance on the viability statement or any other aspect of the company’s report and accounts, require an independent boardroom evaluation focussing on areas such as the effectiveness of the audit committee, notify the board of its views of the risks to financial viability and require the board’s formal response or order the removal of the auditor or an immediate retendering.
- In addition, the new regulator should have the power, in the most serious cases, to report to shareholders suggesting that the company’s dividend policy should be reviewed, or that they consider the case for a change of CEO, CFO, chair or audit committee chair or for strengthening the board.
- BEIS should look at whether the framework around internal controls should be strengthened, learning lessons from the operation of the Sarbanes-Oxley regime in the US and viability statements should be reviewed and reformed to make them substantially more effective. If that cannot be done, consideration should be given to abolishing them.
The Final Report notes that although implementing some of the recommendations will require primary legislation, others could be implemented in whole or in part without legislation. The Final Report sets out an interim implementation plan and recommends that the FRC and Government work together to develop that interim implementation plan.
(BEIS: Independent review of the FRC by Sir John Kingman, 18.12.18)
Statutory Audit Services Market Study – Update paper
In December 2018, the Competition and Markets Authority (CMA) published an update paper following the launch of its market study into the statutory audit market in October 2018. In the update paper, the CMA summarises its concerns that the audit market is not currently delivering consistently high quality and it also sets out its views on what is driving these quality concerns. Section 4 of the paper then sets out a proposed package of remedies to address the issues it has found. These are as follows:
Regulatory scrutiny of audit committees – Remedy 1
The CMA proposes that audit committees should be subject to specific regulatory requirements and obligations. It currently believes that this regulation should include:
- A requirement that audit committees report directly to the regulator before, during and after a tender selection process. The regulator would also have the ability to include an observer on all or a sample of audit committees.
- A requirement that audit committees report directly to the regulator throughout the audit engagement.
- The ability for the regulator to issue public reprimands or direct statements to shareholders.
The CMA proposes that this remedy should apply at least to all FTSE 350 audit committees but it welcomes views on whether the remedy should be extended to cover a wider group of companies, such as all public interest entities.
Mandatory joint audit – Remedy 2
The CMA’s provisional view is that joint audits would increase competition without risking audit quality. In terms of design, its initial views are:
- The main aim of the remedy is to reduce the barriers facing challenger firms. The CMA’s preferred way of achieving this would be by mandating that at least one of the audit pair is a challenger firm.
- The remedy should at least apply to FTSE 350 companies, possibly with some limited exceptions where the nature of the company would not sensibly justify a joint audit. Views are sought on whether the remedy should apply to other large companies or whether specific types of company should be excluded.
- Each joint auditor should have to be granted a significant proportion of the audit work. The minimum proportion to be assigned to any joint auditor might vary across FTSE 350 companies and over time to allow challenger firms to build their capacity.
A possible alternative to a mandatory joint audit would involve imposing a market share cap on the Big Four firms so that a given proportion of the market is reserved for challenger firms. Again, this remedy would initially apply at least to FTSE 350 companies but the CMA seeks views on whether it should apply to other large companies that could be in the public interest. However, the CMA prefers mandatory joint audits to a market share cap as a means of breaking down barriers to non-Big Four firms competing successfully for larger audits.
Additional measures to support challenger firms to be considered further – Remedy 3
The CMA favours the prohibition or limits on the length of non-compete clauses as they make it harder for audit partners and staff to switch firms. Partner switching is seen as necessary for challenger firms to build their capacity. The CMA is to investigate this matter further and asks for evidence to support the claim that there are significant and unreasonable barriers to senior staff switching between the claim that there are significant and unreasonable barriers to senior staff switching between firms. The CMA also proposes to look at a number of other measures such as technology sharing as access to technology could, in principle, make challenger firms better able to compete for FTSE 350 audits and so increase auditor choice for companies.
Market resilience – Remedy 4
This remedy would create a market oversight and resilience regime in the event of a likely or actual failure of a large audit firm in the UK. It would ensure that there remains adequate choice of auditors in the market, while maintaining competition and quality both on its own and as part of a package of remedies.
The CMA notes that the remedy warrants further consideration and it asks for views on how an effective resilience regime could be designed to avoid going from the Big Four to the Big Three. It states that the remedy should apply at least to the Big Four. However, it may also be appropriate for some large challenger firms to come within scope if they grow in relative size.
Full structural or operational split between audit and non-audit services – Remedy 5
The CMA does not believe that the current framework for managing non-audit services conflicts is sufficient to focus auditor’s incentives on high quality audits. It considers that one way to address the reality and perception of non-audit service related conflicts would be to structurally separate audit and non-audit services. However, it recognises that there are important practical challenges in creating audit-only firms and so it is considering other variants of this remedy that could be effective, but less costly. For example, one possible solution might be for firms to implement an operational split between the audit and non-audit parts of the firm, with separate profit pools and governance arrangements for audit and non-audit.
Either form of separation, whether it is full structural or an operational split, should apply to at least the Big Four but the CMA seeks views as to whether this remedy should also apply to challenger firms.
Peer review – Remedy 6
The CMA proposes that an important element of the regulator’s toolkit should be a peer reviewer who can identify under-performance as it happens and whose presence may actually stop any under-performance occurring. The peer reviewer should be independent, appointed and paid by the regulator, and owe a duty of care only to the regulator.
The CMA proposes that the regulator should have the ability to determine the scope of the peer review function, perhaps initially targeting this at companies that it considers high risk or which require additional scrutiny.
The CMA notes that at this stage, it is minded not to make a market investigation reference because it sees recommendations to the Government as a more effective route to implementation. Submissions on any of the issues addressed in the update paper are requested by January 21, 2019. The CMA will continue to gather evidence, meet with stakeholders and undertake analysis with a view to refining its proposed remedies and issuing a final report as soon as possible in 2019.
(CMA Statutory Audit Services Market Study – update paper, 18.12.18)
Consultation on guidance for preparers of prospective financial information
In December 2018, the ICAEW published for consultation an Exposure Draft of new guidance for preparers of prospective financial information (PFI). The Exposure Draft updates 2003 guidance, “Prospective Financial Information: Guidance for UK Directors”, and it follows a July 2017 consultation paper which set out a case for updating the 2003 guidance.
As well as updating the 2003 guidance, the Exposure Draft includes general guidance for preparing any PFI, including, on a proportionate basis, any unpublished PFI. It aims to reflect developments since the 2003 guidance was published, such as demands for greater accountability, closer board engagement with management, higher standards of regulation, and investor expectations of cohesion between business strategy, corporate appetite for risk and prospects.
The Exposure Draft is structured as follows:
- Part I – Principles for preparing PFI (which includes primary financial statements, elements, extracts and summaries of such statements and related financial disclosures and/or supporting calculations).
- Part II – General application guidance. This Part identifies procedures that will assist in the preparation of PFI that is relevant, reliable, understandable and comparable.
- Part III – Application note for statements of sufficiency of working capital in capital market transactions. This application note applies to working capital statements included in an investment circular by regulation, and to the supporting underlying PFI which forms the basis for the statement.
- Part IV – Application note for profit forecasts in capital markets transactions and other profits guidance. This application note is primarily intended to assist directors making profit forecast statements for inclusion in an investment circular (where regulation applies to such profit forecast statements), and also those involved in the preparation of such profit forecasts and the supporting unpublished PF).
- Part V – Application note for synergy and stand-alone cost saving statements in capital markets transactions. This application note applies to directors when making statements of anticipated synergies published in a merger and acquisition transaction related UK investment circular, and includes stand-alone cost saving statements published in a bid defence document under the Takeover Code.
Comments on the Exposure Draft are requested by April 30, 2019. Following the consultation process, guidance in the form of a technical release will be published which will replace the 2013 guidance.
(ICAEW: Consultation on guidance for preparers of prospective financial information, December 2018)
IOSCO’s Report on good practices for audit committees in supporting audit quality
In January 2019, the International Organization of Securities Commissions (IOSCO) published a report on the role of audit committees of listed companies in supporting and promoting external audit quality.
The report looks at the role of audit committees and audit quality, as well as at the role of some other key parties in the financial reporting cycle. It also outlines good practices regarding the features an audit committee should have to be more effective in promoting and supporting audit quality. These are as follows
- Features of audit committees that support audit quality: Common features include that at last one member, preferably the chair, should have a good knowledge of financial reporting and/or audit and all members should between them have an appropriate understanding of financial reporting and audit and knowledge of the industry in which the company operates. The chair should have demonstrated leadership qualities, strong communication skills and be knowledgeable about the duties and responsibilities of the position.
- Recommending the appointment of an auditor: Audit committees should develop a recommendation on the selection of auditors independently of management with selection criteria set up front and tenderers assessed against those criteria. The focus should be on audit quality and not fee reduction. Opinion shopping should be avoided and auditor independence should be a key consideration.
- Assessing potential and continuing auditors: In assessing the auditors, and the adequacy and appropriateness of audit resources, audit committees should consider matters such as the auditor’s knowledge of the listed company´s business and industry, the extent of involvement of senior team members in the audit, use of other auditors, use of technical and specialist expertise, the capability accessible by the auditor in different geographical locations, coverage of internal systems and controls, and how the engagement partner and team are accountable within their firm for audit quality.
- What matters should be considered in setting audit fees: Audit committees should consider the extent to which audit fees are consistent with the audit plan and a quality audit.
- Facilitating the audit process: Audit committees should promote quality and timely reporting by seeking explanations and advice on the appropriateness of accounting treatments and estimates, proper books and records, and systems and controls, which can facilitate a quality audit and avoid issues being missed or not adequately addressed due to deadline pressures.
- Assessing auditor independence: Audit committees should review and challenge management’s accounting treatments and estimates, and should not feel encumbered by management to consult with, when considered necessary, an external party (for example and as applicable, a regulator) in carrying out their duties. The audit committee should oversee the development of policies on auditor independence, undertake procedures to satisfy itself on the independence of the auditor and require non-audit services to be subject to its prior approval, and consider other matters affecting auditor independence.
- Communicating with the auditor: Audit committees should have open, timely and meaningful communication with auditors about risks, issues and other matters to assist each of them in performing their respective roles in overseeing the financial reporting process and conducting a quality audit.
- Assessing audit quality: Audit committees should assess audit quality with regard to enquiry, observation and how the auditor addresses findings by audit regulators.
(IOSCO: Report on good practices for audit committees in supporting audit quality, 17.01.19)
Environmental reporting developments
European Commission’s consultation on update of guidelines on non-financial reporting
In February 2019, the European Commission published a consultation paper which supplements its June 2017 non-binding guidelines on non-financial reporting, specifically with regard to the reporting of climate-related information.
The supplement on climate-related reporting is also non-binding and companies can choose alternative approaches to the reporting of climate-related information. Companies are advised to consider using the proposed disclosures in the supplement if either climate-related information is necessary for an understanding of the company’s development, performance and position or if it is necessary for an understanding of the external impacts of the company.
The supplement proposes climate-related disclosures in relation to the business model, policies and due diligence, outcome of policies, risks and risk management and key performance indicators (being the five reporting areas in the Non-Financial Reporting Directive) and suggests that most companies under the scope of that Directive are likely to conclude that climate is a material issue. Those companies that conclude climate is not a material issue are advised to consider making a statement to that effect, explaining how that conclusion has been reached. A number of sector-specific disclosures for banks and insurance companies are proposed in Annex 1.
Comments are requested by March 20, 2019 and the European Commission intends to publish the new supplement in June 2019.
(European Commission: Consultation on update of guidelines on non-financial reporting, 21.02.19)
Environmental Reporting Guidelines - Streamlined energy and carbon reporting guidance published
In January 2019, the Department for Environment, Food and Rural Affairs (EFRA) and the Department for Business, Energy & Industrial Strategy (BEIS) published revised Environmental Reporting Guidelines (Guidelines). The Guidelines are designed to help companies and limited liability partnerships in complying with the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 and the Companies (Directors’ Report) and Limited Liability Partnerships (Energy and Carbon Report) Regulations 2018 (‘the 2018 Regulations’), and to help all organisations with voluntary reporting on a range of environmental matters, including voluntary energy and GHG emissions reporting, and through the use of key performance indicators (KPIs).
Most of the amendments to the Guidelines have been to incorporate guidance for companies to help them comply with their obligations under the new streamlined energy and carbon reporting regime (SECR regime) set out in the 2018 Regulations. The SECR regime applies to quoted companies, unquoted large companies incorporated in the UK, and large LLPs and comes into effect on April 1, 2019 for financial years beginning on or after that date.
The updated Guidelines provide guidance on the steps a company should to take when considering its environmental impacts and which KPIs companies need to report to comply with their legal obligations. It also outlines additional voluntary information that is likely to be useful to qualifying organisations and a wide range of stakeholders.
In addition, the Guidelines highlight the principles for accounting & reporting environmental impacts, including
- Relevance – Companies should ensure that the data collected and reported appropriately reflects the environmental impacts of an organisation and serves the decision-making needs of both internal and external users.
- Accuracy – The Guidelines note that a company should seek to reduce uncertainties in its reported figures where practical and seek to achieve sufficient accuracy to enable users to make decisions with reasonable confidence as to the integrity of the reported information.
- Completeness – Companies should quantify and report on all sources of environmental impact within the reporting boundary that they have defined, and disclose and justify any specific exclusions.
- Transparency – Companies should address all relevant issues in a factual and coherent manner, keeping a record of all assumptions, calculations, and methodologies used. In addition, a company should report on any relevant assumptions and make appropriate references to methodologies and data sources used as this is essential to producing a credible report.
(EFRA and BEIS: Environmental Reporting Guidelines - Streamlined energy and carbon reporting guidance, 31.01.19)
Statement by IOSCO on disclosure of ESG matters by issuers
In January 2019, the International Organization of Securities Commissions (IOSCO) published a statement setting out the importance for issuers of considering the inclusion of environmental, social and governance (ESG) matters when disclosing information material to investors’ decisions.
The statement notes that the disclosure of ESG information in the market has increased in recent years and investors have highlighted that ESG disclosure is necessary to supplement their investment and voting decisions. However, IOSCO has observed that disclosure practices are varied, with the type of information disclosed and the quality of information differing in and between markets. It notes that there are also various disclosure frameworks that issuers can consider on a voluntary basis when disclosing ESG information, including those developed by the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures.
IOSCO encourages issuers to consider the materiality of ESG matters to their business and to assess risks and opportunities in light of their business strategy and risk assessment methodology. When ESG matters are considered to be material, issuers should disclose the impact or potential impact on their financial performance and value creation. In doing so, issuers should give insight into the governance and oversight of ESG-related material risks.
(IOSCO: Statement on disclosure of ESG matters by issuers, 18.1.19)
How to set up effective climate governance on corporate boards – Guiding principles and questions from the World Economic Forum
In January 2019, the World Economic Forum published a report in collaboration with PwC which sets out guiding principles and questions to assist corporate boards in driving climate governance effectively.
The principles built on existing corporate governance frameworks, such as the International Corporate Governance Network’s Global Governance Principles, as well as other climate risk and resilience guidelines such as the recommendations of the Financial Stability Board’s Task Force on Climate Related Financial Disclosures. Each principle is accompanied by a set of guiding questions to help a company identify and fill potential gaps in its current approach to governing climate. The principles are designed to increase directors’ climate awareness, embed climate considerations into board structures and processes, and improve navigation of the risks and opportunities that climate change poses to business.
The eight guiding principles for effective climate governance on corporate boards are as follows
- Principle 1 – Climate accountability on boards: the board is ultimately accountable to shareholders for the long-term stewardship of the company so the board should be accountable for the company’s long-term resilience with respect to potential shifts in the business landscape that may result from climate change.
- Principle 2 – Command of the (climate) subject: the board should ensure that its composition is sufficiently diverse in knowledge, skills, experience and background to effectively debate and take decisions informed by an awareness and understanding of climate-related threats and opportunities.
- Principle 3 – Board structure: the board should determine the most effective way to integrate climate considerations into its structure and committees.
- Principle 4 – Material risk and opportunity assessment: the board should ensure that management assesses the short, medium and long-term materiality of climate-related risks and opportunities for the company on an ongoing basis.
- Principle 5 – Strategic and organisational integration: the board should ensure that climate systematically informs strategic investment planning and decision-making processes and is embedded into the management of risk and opportunities across the organisation.
- Principle 6 – Incentivisation: the board should ensure that executive incentives are aligned to promote the long-term prosperity of the company. The board should consider including climate-related targets and indicators in their executive incentive schemes where appropriate.
- Principle 7 – Reporting and disclosure: the board should ensure that material climate-related risks, opportunities and strategic decisions are consistently and transparently disclosed to all stakeholders.
- Principle 8 – Exchange: the board should maintain regular exchanges and dialogues with peers, policy-makers, investors and other stakeholders to encourage the sharing of methodologies and to stay informed about the latest climate-relevant risks, regulatory requirements etc.
(World Economic Forum: How to set up effective climate governance on corporate boards – Guiding principles and questions, 17.01.19)
Environment Agency - Business planning for climate change
In November 2018, the Environment Agency published a press release encouraging businesses to prepare for climate change. The press release follows the Environment Agency’s report "Climate change impacts and adaption".
Following the recently published UKCP18 projections, the Environment Agency notes that a worryingly low number of FTSE boards are disclosing the strategic risks to their shareholders brought about by the physical impacts of climate change. The Environment Agency emphasises that boards cannot continue to see extreme weather events, such as floods and heatwaves, as purely operational and encourages them to put aside capital expenditure for resilience measures to ensure business continuity. The Environment Agency has encouraged businesses to prepare and adapt, and suggests that governments, business, and communities work collaboratively in order to mitigate the impacts of climate change.
(Environment Agency: Business planning for climate change press release, 26.11.18)
Home Office guidance on publishing an annual modern slavery statement
In March 2019, the Home Office published guidance for organisations on publishing an annual modern slavery statement under section 54 of the Modern Slavery Act 2015. The guidance is intended to assist organisations in identifying when they need to publish an annual modern slavery statement, highlights how to demonstrate compliance with the minimum legal requirements, and sets out best practice guidance on producing a statement.
The guidance states that an organisation is required to publish an annual statement if:
- it is a ‘body corporate’ or a partnership, wherever incorporated or formed;
- it carries on a business, or part of a business, in the UK;
- it supplies goods or services; and
- it has an annual turnover of £36 million or more.
In order for an organisation to meet and demonstrate the minimum legal requirements relating to the annual modern slavery statement, it must update its modern slavery statement every year, publish the modern slavery statement on its UK website, seek approval from the board of directors (or equivalent management body) and get a signature from a director (or equivalent) or designated member (for LLPs). Statements must describe the main actions taken by an organisation during the financial year to deal with modern slavery risks in its supply chains and business. In order to address all relevant matters, the guidance recommends that organisations cover:
- organisation structure and supply chains;
- policies in relation to slavery and human trafficking;
- due diligence processes;
- risk assessment and management;
- key performance indicators to measure effectiveness of steps being taken; and
- training on modern slavery and trafficking.
The guidance also highlights that the detail and quality of information included under each of these six areas should improve in successive annual statements and should demonstrate how the organisation is acting transparently and disclosing information about any modern slavery risks the organisation has identified and what actions it has taken in response to them, targeting the organisation’s actions where they can have the most impact by prioritising its risks and how it is making year-on-year progress to address those risks and improve outcomes for workers in its business and supply chains.
(Home Office: Guidance on publishing an annual modern slavery statement, 12.03.19)
Financial Reporting Lab reports
Artificial Intelligence and corporate reporting – How does it measure up?
In January 2019, the Financial Reporting Council’s (FRC) Financial Reporting Lab (Lab) published a report, "Artificial intelligence and corporate reporting: How does it measure up?", which considers artificial intelligence and its role in the future of corporate reporting.
The report is the third in a series of technology deep-dive reports exploring how different technologies might impact corporate reporting production, distribution and consumption. It follows from the Lab’s report on blockchain and corporate reporting published in June 2018. It also highlights key decisions and considerations that boards and others need to think about when using artificial intelligence (AI).
The nature of corporate reporting and reporting process challenges
The report highlights the potential uses of AI in corporate reporting and addresses some of the challenges faced across the various stages:
- Production – The report suggests that corporate reporting and underlying accounting processes could be made less complex and time consuming by using AI to help solve problems in the production of accounting and reports. A significant proportion of the work of a typical back-office finance function is the routine recording, managing, matching and processing of transactional and other information and the report suggests that AI can provide an alternative to the outsourcing of such activities. AI could enhance efficiency by replacing mechanistic human processing of underlying transactions and transforming that data into accounting and management information, ultimately feeding into annual reports.
- Distribution – Both internal and external auditors obtain comfort over a consolidated annual report, specific entity report, balances or process by undertaking testing. Testing is undertaken on a sample basis, however, as it is impractical to review all transactions, due to the limitation of the human team. AI combined with data analytics tools might allow 100 percent of certain balances to be rechecked or recomputed and connections to external data sources such as bank or investment feeds could also match and confirm transactions. The report suggests that AI could be used to help provide assurance on compliance with rules, both internally and externally, in an efficient and effective way. AI could efficiently and effectively support auditors and boards in the internal and external validation processes needed to ensure that annual reports are credible and compliant. AI can support auditors and boards in getting comfort over the data internal to the company that makes up the annual report. AI can support auditors, boards and regulators in getting comfort over annual reports using data external to the company. However, the report points out that while AI will play a role in both internal and external audit processes in the future, the overall complexity and uniqueness of each business requires a human and AI approach for the foreseeable future.
- Consumption - The report notes that many investment organisations and their data providers already use AI to enhance the effectiveness of investment analysis by extracting meaning and value not only from company reporting but also from various sources of alternative data.
Corporate reporting actions and questions
The report emphasises that the quality of company financial and accounting data is critical to the development of AI in corporate reporting, and advises that if AI is to be used to improve the efficiency and effectiveness of companies’ financial processes then they need data that is of sufficient quality and quantity and is relevant to financial decision making.
The report suggests a number of key considerations for companies considering AI-based accounting and finance systems, including: the source of data used to train systems and how quality and lack of bias is ensured; what controls and processes need to be changed or modified to reflect the new system; and, where significant to the company’s operations, how the risks associated with the use of AI and data are being managed and disclosed.
The report acknowledges that the opportunities for achieving efficiencies require a rethinking of processes with AI in mind, and highlights the need to embed the expertise of AI directly into governance, finance, the board, advisers and regulators through training and development. Boards are advised to consider how they are going to meet the challenges that AI brings either through including AI focused individuals in the boardroom, or through wider training.
(FRC: Artificial Intelligence and corporate reporting report – How does it measure up?, 21.01.19)
FRC: Business Reporting of Intangibles - Realistic proposals discussion paper
In February 2019, the Financial Reporting Council (FRC) published a discussion paper ‘Business Reporting of Intangibles: Realistic proposals’. The discussion paper aims to explore reasons why many intangibles are not fully reflected in financial statements and to develop practical proposals for improving business reporting of intangibles.
The discussion paper considers the case for radical change to the accounting for intangible assets and the likelihood of such change being made in the near future, and seeks stakeholder reviews on matters including:
- Intangibles as assets – The discussion paper suggests that an intangible should be recognised at cost only where the costs to be incurred on development of an intangible asset can be estimated at the time when a project to develop an intangible is undertaken, and the economic benefits to be derived from the intangible can be specified when the costs are first incurred. The discussion paper also suggests that for many intangibles the measurement uncertainty of fair value is so great as to call into question whether it could provide a representationally faithful depiction and proposes that requirements of existing accounting standards should be reviewed in light of these conclusions.
- Disclosure of expenditure on intangibles – The discussion paper proposes that there is a case for specific disclosure requirements of the amount and nature of investments in unrecognised intangibles that are treated as an expense in the period and that these should be clearly differentiated from expenses that unambiguously relate to the period.
- Narrative reporting and intangibles – The discussion paper further suggests that a company’s management should select the intangibles that are discussed in narrative reporting, by reference to those that are most relevant to the entity’s business model, and proposes that narrative reporting should include metrics relating to intangibles.
The discussion paper also suggests ways in which the business reporting process could improve the reporting of intangibles. Responses to the discussion paper are requested by April 30, 2019.
(FRC: Business Reporting of Intangibles - Realistic proposals discussion paper, 06.02.19)
FRC: Audit quality thematic review – Other information in the annual report
In December 2018, the Financial Reporting Council (FRC) published its “Audit quality thematic review – Other information in the annual report” (Audit Review).
The Audit Review highlights that work on the information in the front end of company reports outside the financial statements does not consistently meet the requirements of Auditing Standards. Inconsistency in the extent and quality of the work in part reflects the non-prescriptive requirements in the Audit Standards. In addition, firms’ guidance to their auditors in some cases lacks prescription, which has led to changing approaches being taken to work, even by different audit teams within the same firm.
Although the FRC has identified some areas of good practices, the Audit Review notes that too frequently insufficient work was performed to support the statements made by auditors in respect of the other information in their audit reports. If it is materially inaccurate, other information can undermine the credibility of the audited financial statements or may inappropriately influence the decisions of users of the annual report. To improve the quality and consistency of their work on other information, the FRC expects auditors to:
- Undertake more targeted procedures, based upon more prescriptive guidance from audit firms;
- Place greater emphasis on their review of key non-financial information;
- Increase their scepticism and pay more attention to the completeness of information, particularly in relation to principal risk disclosures and their linkage to viability statements;
- Require boards to prepare, on a timely basis, appropriate documentation to support key areas of other information such as the viability statement; and
- Ensure staff with appropriate experience and knowledge to identify potential material misstatements and inconsistencies are assigned to review the other information.
(FRC: Audit quality thematic review – Other information in the annual report, 6.12.18)
FRC: IFRS 9 – Thematic Review
In November 2018, the Financial Reporting Council (FRC) published a report summarising the key findings of a thematic review it has conducted in relation to IFRS 9 “Financial Instruments” which became effective on January 1, 2018. The thematic review considered disclosures in 2018 interim accounts of banking entities relating to the implementation of IFRS 9 since it is the banking sector that is most significantly affected by IFRS 9.
The FRC noted certain good examples of disclosure and it has highlighted some of these in the thematic review. However, the thematic review also identified a number of areas where disclosure could be improved, and some areas where no disclosure had been provided at all. While the FRC accepts that interim disclosure requirements are less extensive than those for full-year accounts, it does feel that some companies, particularly smaller banks, did not sufficiently explain the impact of adopting IFRS 9 and it hopes companies will provide more comprehensive disclosure in their upcoming annual reports and accounts.
The report notes that in particular, the following disclosures could be improved:
- Transitional disclosures analysing the principal differences between IAS 39 and IFRS 9;
- Qualitative and quantitative disclosure made by the smaller banks regarding determination of significant increases in credit risk, including linkage to internal credit rating;
- Disclosure of estimation uncertainty, in particular quantification of sensitivities of expected credit losses to changes in assumptions; and
- Discussion of the business model in assessing the classification of financial assets.
(FRC, IFRS 9, Thematic Review: Review of interim disclosures in the first year of application, 05.11.18)
IFRS 15 – Thematic Review
In November 2018, the Financial Reporting Council (FRC) published a thematic review of interim disclosures about the implementation of IFRS 15 “Revenue from Contracts with Customers” which became effective on January 1, 2018.
The report notes that for some industries (such as telecommunications, aerospace and defence and software), the initial impact of applying IFRS 15 is particularly significant and so the purpose of the thematic review is to assess the adequacy of interim disclosures of a sample of companies in high-impact industries in the first year of adoption with the aim of producing useful guidance for companies when considering the completeness of their upcoming year-end disclosures.
The FRC feels that some companies did not sufficiently explain the impact of adopting IFRS 15 and it notes that the following disclosures in particular could be improved:
- Information about transition adjustments recognised, and linking these to changes in accounting policies;
- Clearer explanation of the changes made to accounting policies, including the reasons for the changes and the judgements made by management in arriving at the new policies;
- Information about performance obligations, including judgements made in determining these and the timing of their satisfaction (i.e. when control transfers to the customer); and
- The impact on the balance sheet, including disclosure of accounting policies for new items such as contract assets and contract liabilities.
The report notes that the best disclosures were those that were specific to the company and provided additional detail for the benefit of providing a relevant robust explanation of the impact of IFRS 15. The report highlights some good examples of disclosure and the FRC will expect companies to use these examples to benchmark the quality of their own disclosures in their upcoming annual reports and accounts.
(FRC, IFRS 15 Thematic Review: Review of interim disclosures in the first year of application, 05.11.18)
Government’s response to BEIS Committee report on gender pay gap reporting
In January 2019, the House of Commons Business, Energy and Industrial Strategy (BEIS Committee) published the Government’s response to the report on gender pay gap reporting published by the BEIS Committee in August 2018 (BEIS Report).
The Government addresses some of the recommendations in the BEIS Report, including the following
- The BEIS report recommended that the Government reviews the gender pay gap reporting requirements with a view to aligning them with other business reporting requirements but the Government notes that there is no other common reporting requirement that logically aligns with gender pay gap reporting, so the focus has been on balancing transparency of data with flexibility for employers.
- The BEIS report recommended that organisations should be required to provide some narrative reporting with their gender pay statistics and an action plan setting out how pay gaps are being and will be addressed. While the Government considers an action plan crucial to closing gender pay gaps (and guidance on the kinds of actions employers can take has been published), it deliberately did not make publishing an action plan mandatory as this might result in a prescriptive format with limited value to employers and employees.
- The BEIS Report recommended that the qualifying threshold be reduced from 250 to 50 employees. The Government is concerned that data from smaller organisations could be unreliable and the requirement too burdensome, but will consult on the feasibility if there is sufficient appetite for lowering the threshold in future reporting years.
- The BEIS Report recommended that in revising the UK Stewardship Code, the Financial Reporting Council (FRC) include reference to ensuring that gender diversity is properly reflected throughout the company, notably at board level. The Government states that the FRC will consider ow a revised Stewardship Code can support and challenge investors to improve diversity and succession planning in UK listed companies.
(BEIS: Government’s response to BEIS Committee report on gender pay gap reporting, 17.01.19)