On September 29, 2015 the Financial Reporting Council (FRC) published a consultation paper providing and requesting responses to proposed amendments to the UK Corporate Governance Code (the Code), the FRC’s Guidance on Audit Committees, Auditing Standards and Ethical Standards for Auditors. The consultation was prepared in response to Regulation EU/537/2014 (the Statutory Audit Regulation) which covers specific requirements regarding statutory audits of public interest entities, and Directive 2014/56/EU (the Statutory Audit Directive) which covers the statutory audit of annual accounts and consolidated accounts. Both will apply with effect from June 17, 2016.
The UK Corporate Governance Code
The FRC proposes minimal changes to the Code to align it with the Statutory Audit Directive and to limit the regulatory burden. The proposed changes are as follows:
- The requirement in Code Provision C.3.1 for the board to “satisfy itself that at least one member of the audit committee has recent and relevant financial experience” has been amended to reflect the wording in Article 39 of the Statutory Audit Directive that at least one member has “competence in accounting and/or auditing”. Additionally, this Provision now includes reference to the requirement in Article 39 that the audit committee as a whole should have competence relevant to the sector in which the company operates.
- Having reviewed Code Provision C.3.2, the FRC considers that the requirements in Article 39 are satisfied, particularly the audit committee’s responsibility for the appointment of the external auditor, and the management of the external audit process and its effectiveness.
- The FRC is satisfied that Code Provision C.3.8 covers Article 39 Sections 6 (e) and (f) which require the audit committee to, among other things, monitor the integrity of the company’s financial statements.
- The FRC refers to the Competition and Markets Authority’s (CMA) 2013 report and subsequent Orders relating to the audit services market where the CMA identified adverse effects on competition including a lack of switching of auditors and auditors being too close to management. In order to address this the report identified seven remedies, of which the FRC addresses three in the consultation paper:
- Remedy 1 required FTSE 350 companies to put their audit engagement out to competitive tender at least every ten years. This requirement has been superseded to an extent by the Statutory Audit Regulation and Statutory Audit Directive. As the Code includes a similar requirement, which is now considered redundant, Code Provision C.3.7 has been amended to remove this reference. However, Code Provision C.3.8 is being amended to add a requirement that shareholders are informed about future audit tendering plans and a footnote about the retendering rules is being included.
- Remedy 4 related to increasing shareholder engagement on audit matters through changes to both the Code and the UK Stewardship Code. The FRC considers that sufficient coverage is already given to this topic in both the Code and the Stewardship Code and that it is not appropriate for the Code to place emphasis on a particular topic over any other.
- Remedy 4 also included a recommendation to introduce an advisory vote for shareholders to indicate their satisfaction with the audit committee’s annual report,. However, the FRC considers that shareholders already have sufficient rights to express their opinion on the audit committee report either by the annual re-election of the directors, which includes the audit committee chairman, or by tabling a specific shareholder resolution.
- Remedy 5 made suggestions to increase audit committee oversight of the external audit. The FRC considers it unnecessary to amend the Code as it already contains provisions for the audit committee’s oversight of the external auditor that are consistent with the Order, however it does address additional requirements in its discussion on the revised Guidance on Audit Committees.
Guidance on Audit Committees
The FRC proposes several changes to its Guidance on Audit Committees to take account of proposed amendments to the Code. The principal changes relate to:
- Statutory Audit Regulation and Statutory Audit Directive. The main amendments involve changes to take into account the requirements of the Statutory Audit Regulation and Statutory Audit Directive. This includes expanding on changes relevant to the composition of the audit committee covering sectoral competence; removal of the references to audit retendering; changes covering the new rules around the prohibition of non-audit services; and consequential changes reflecting amendments to the Ethical and Auditing Standards for Auditors.
- Recommendations of the CMA. The FRC addresses Remedies 1, 5, and 6 as outlined in CMA’s 2013 report, in the proposed changes to the Guidance:
- Remedy 1 required FTSE 350 companies to put their audit engagement out to competitive tender at least every ten years. To address this remedy the FRC has removed references to audit retendering in the Guidance as these have been overtaken, however the Code and Guidance have been amended to provide that shareholders should be informed about future audit tendering plans.
- In Remedy 5 the CMA recommended that the Code align with the Order relating to an audit committee’s oversight of the external auditor and the provision of non-audit services. The FRC does not wish to override the ‘comply or explain’ nature of the Code by requiring certain items, but has included suggested clarifications in the Guidance.
- Remedy 6 recommended the disclosure of the FRC’s Audit Quality Review (AQR) team inspection findings in audit committee reports and the Guidance has been amended to include this kind of reporting.
- Audit Quality Review and Corporate Reporting Review transparency.
- Guidance has been included requiring the audit committee to discuss with their auditors the findings of the FRC's AQR team (if such a review has been undertaken). The audit committee should consider whether any findings are significant and, if so, make disclosures about those findings and the action they and the auditors plan to take.
- The nature and extent of interaction (if any) with the FRC's Corporate Reporting Review (CRR) team should be disclosed in the audit committee section of the annual report. Since changing its policy in 2014, which included encouraging boards to refer voluntarily to their exchanges with the CRR team in their reports, the FRC's Conduct Committee has found that relatively few audit committees have provided clear disclosure of the nature and extent of interaction with the CRR team. As a result, the FRC will continue to monitor how audit committees report the outcomes of CRR reviews (and AQR team reviews) in their annual reports.
- Ensuring consistency and minimising overlap. The Guidance has been amended to reduce duplication with elements of the Code. The Guidance should be read in conjunction with section C.3 of the Code.
- Internal Audit. The section on internal audit has been updated to reflect recent reviews of best practice in this area. A number of the elements around internal audit were already included in the Guidance, but they have been expanded upon to provide an indication of best practice.
Ethical Standards for Auditors
The FRC proposes to replace existing Ethical Standards for Auditors (other than the Standard for small entities) with a single consolidated standard that includes changes to reflect the FRC's approach to member state options, as set out in the Statutory Audit Regulation and the Statutory Audit Directive.
In particular, the FRC suggests neither extending the EU's blacklist of prohibited non-audit services for public interest entities nor creating a white list of permitted non-audit services. The FRC does not wish to impose a lower cap for non-audit fees than is set out in the Statutory Audit Regulation, although it would seek to make changes relating to the calculation of that cap.
The FRC recommends a maximum period of five years for an audit partner engagement, but would retain flexibility to extend that period in exceptional circumstances. It would also retain its existing definition of a 'listed entity', despite it being wider than the EU definition.
The FRC intends to reverse its position on auditing standards on the form and content of the auditor's report by adopting ISA 700 and ISA 701, making additions specific to UK audits.
Furthermore, the FRC suggests amendments to the Auditing Standards including an obligation for auditors to keep audit working papers for a period of six years from the date of the auditor's report, changes reflecting the UK's implementation of the Accounting Directive and, especially, an option for small companies to file abridged accounts that do not require the filing of a special auditor's report.
The consultation closes on December 11, 2015.
(FRC, Enhancing Confidence in Audit: proposed Revisions to the Ethical Standards, UK Corporate Governance Code and Guidance on Audit Committees, 29.09.15)