BEIS consultation: Restoring trust in audit and corporate governance – Focusing on the proposals for corporate reporting (part 1)

The proposals set out in the Government’s Department for Business, Energy & Industrial Strategy (“BEIS”) consultation Restoring trust in audit and corporate governance unquestionably has a primary focus on audit reform, however there are some substantial aspects in relation to corporate reporting that have been proposed. Specifically, to progress directors’ accountability in relation to dividends and capital maintenance and to introduce new reporting requirements surrounding companies publishing an annual Resilience Statement and enhancing reporting on supplier payment practices. Currently, there are no specific proposals on publishing a new Public Interest Statement.

The proposals will have a hugely significant impact for UK companies, particularly directors of companies, and the audit industry as a whole. In this first Mind the Gaap blog article covering the Government’s consultation, we focus simply on what the proposals are that impact corporate reporting.

We will be publishing more articles over the coming months taking you through the proposals in more detail and looking at what the implications will mean for companies and directors, so watch this space.

Overview of the proposals

The Government’s consultation sets out a raft of proposals that introduce new measures in relation to directors, auditors and audit firms, shareholders and the audit regulator – a holistic approach, with the aim to ensure that there is meaningful and lasting change. The proposals focus on the largest UK companies because this is where it is considered the greatest public interest lies and hence the need to ensure the audit and corporate reporting functions in these organisations are working effectively.

The proposals broadly cover the following 6 key areas:

1. Reforming audit, including purpose, scope, and competition, choice and resilience in the audit market.
2. Creating a new strengthened regulator – the Audit, Reporting and Governance Authority (“ARGA”) – and enhancing its responsibilities, including the supervision of audit quality and corporate reporting.
3. Improving audit committee oversight and engagement with shareholders.
4. Developing enforcement powers against directors.
5. Advancing directors’ accountability for internal controls, dividends and capital maintenance.
6. Introducing new corporate reporting requirements

Scope

One of the key aspects of the proposals is scope – who do these proposals apply to? Different elements of the proposed measures are being suggested to apply to different companies, mainly in relation to their size and status, but a key proposal is to expand the definition of a ‘public interest entity’.

Definition of a public interest entity (“PIE”)

The proposals look to extend the existing UK’s definition of a PIE (i.e. entities whose transferable securities are admitted to trading on a regulated market; credit institutions; or insurance undertakings), so that it includes large companies meeting certain limits, even if those companies are not admitted to trading on a regulated market. This would therefore include, for example, large private companies (depending upon their size such as number of employees and or turnover/balance sheet thresholds) and companies on AIM with a market capitalisation above €200m, and also potentially Lloyd’s Syndicates and third party entities (such as universities, charities and housing associations) that exceed a certain size threshold.

What are the proposals for corporate reporting?

The changes proposed for corporate reporting centre around those affecting directors. This is because the current framework is deemed to be “inadequate in holding directors of [our largest] companies to account in the rare but serious case that they neglect their reporting responsibilities”.  Under section 172 of the Companies Act 2006, directors have statutory duties to promote the success of their company and various duties in relation to the preparation of the company’s accounts and reports, and hence, as the consultation makes clear, it is vital that directors of the largest companies are held to account, both to protect the interests of shareholders and because the loss of trust in directors can have far-reaching adverse effects across the UK.

The consultation therefore focuses on two areas that are applicable to corporate reporting:

1. Improving director accountability and reporting surrounding dividends and capital maintenance; and
2. Improving reporting surrounding companies’ resilience, supplier payment practices and public interest obligations.

Dividends and capital maintenance

The Government’s proposals consolidate and build on the recommendations made in the 2018 consultation on Insolvency and Corporate Governance, the Brydon Review and the BEIS Committee’s response on the Future of Audit inquiry in 2019. The proposals for progressing directors’ accountability in relation to dividends and capital maintenance stem from 3 main areas within the current legal framework. It is important to note that the Government’s proposals look to strengthen the weaknesses in the existing framework in “a proportionate way” as opposed to a “more radical reform” that looks to replace the existing framework; this therefore meaning that the current underlying legal requirements are not proposed to change, which may be seen by some as a non-preferred approach.

The 3 main areas of weakness for change are as follows:

1. There is currently no fixed definition of realised profits and losses within company law

Section 830 of the Companies Act states: “A company’s profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made”, and section 853 states: “References to “realised profits” and “realised losses”, in relation to a company’s accounts, are to such profits or losses of the company as fall to be treated as realised in accordance with principles generally accepted at the time when the accounts are prepared, with respect to the determination for accounting purposes of realised profits or losses.”

The requirements within company law are therefore principle-based (i.e. not detailed), leave open the possibility that generally accepted practice may change (which of course, rightly-so, they have over time), yet do not consider the complication that accounting differences exist between IFRS and UK GAAP (so there will be different implications depending upon the accounting framework applied). As a result, the ICAEW and ICAS produced a Technical Release – the latest version being TECH 02/17BL Guidance on realised and distributable profits under the Companies Act 2006 – with the purpose of identifying, interpreting and applying the principles relating to the determination of realised profits and losses for the purposes of making distributions under the Companies Act. This technical guidance is therefore used by the accountancy profession as the main tool for interpreting and applying the legal requirements; but it does not have any formal legal status.

What does the consultation propose?

• Assign responsibility for defining realised profits and losses to ARGA and enhance the legal status and enforceability of the definition – The proposals consider giving the new regulator, the Audit, Reporting and Governance Authority (“ARGA”), who is to replace the FRC, stronger responsibilities for defining what should be treated as realised profits and losses for the purposes of section 853 of the Companies Act 2006. This could mean either: (a) giving ARGA a duty to prepare guidance on what should be treated as realised profits and losses and then this guidance having authoritative status in company law; or (b) giving ARGA powers to make binding rules as to the meaning on realised profits and losses with which preparers would have to comply. Either way, ultimately this means that the responsibility for providing the guidance would reside with the new regulator and, therefore, the requirements within the guidance would be enforceable.
• Additionally, in practice the proposals mean that ARGA would be able to use the existing ICAEW/ICAS Technical Release guidance simply as it currently stands, or as a basis to change and enhance, or not at all. However, whatever route is chosen, the new regulator would be required to undertake a full consultation from first principles, including with investors, creditors and other users of accounts before finalising the guidance or rules.

2. There is currently a lack of transparency and required disclosures surrounding distributable reserves

There are currently no legal or accounting requirements that mandate companies to disclose their profits that are available for distribution i.e. their distributable reserves, within the accounts and reports. The Companies Act requires that only profits available for distribution, which are accumulated realised profits less accumulated realised losses, may be proposed as a dividend, however the accounting requirements do not have any concept of what are realised profits or losses for this purpose. The basis for determining if a profit is ‘realised’ is not necessarily straight forward – from a high-level perspective, it is, interalia, based on whether the transaction comprises of cash, is readily convertible into cash, releases or settles a liability in whole or in part, or relates to an expected settlement of a receivable. Hence the retained earnings reserve, as presented with companies’ balance sheets (or statements of finance position), does not, in the majority of cases, equate to the company’s profits that are able to be distributed as a dividend. Accordingly, shareholders and other stakeholders rely on the company’s directors that dividends are being paid out of sufficient distributable reserves and that the remaining reserves are adequate to maintain the company’s future capital and investment plans over the short, medium and long-term.       

What does the consultation propose?

• New requirement to disclose distributable reserves in the financial statements – The proposals set out a new disclosure requirement for individual companies (or in the case of a group, the parent company only) to disclose the total amount of distributable reserves within their financial statements; this disclosure would therefore then be subject to audit. The disclosure would help shareholders and other stakeholders identify the headroom between the company’s proposed dividend and the distributable reserves available.

• New requirement to disclose estimates of a group’s dividend-paying capacity – The proposals set out a further new disclosure requirement for parent companies of groups (in addition to the disclosure requirement above) to disclose an estimate of the amount of potential distributable profits across the group that could, in principle, be passed to the parent for the purpose of paying future dividends to the parent company’s shareholders. Narrative disclosure would also be required to be provided to explain any major constraints on the ability of a subsidiary to pay its distributable reserves to the parent; this disclosure would again be subject to audit. The consultation does not provide clear reporting requirements at this stage, but indicates that it would expect the new regulator, ARGA, to consider issuing guidance on the most effective ways of meeting the new reporting requirement, as well as potentially advising companies on how they can best report on their dividend and capital allocation policies (see below).

Who are the proposals applicable to? It is proposed that these new disclosure requirements would become applicable to only publicly listed companies (i.e. those on the LSE) and AIM companies, rather than being applicable to companies covered by the new wider definition of a ‘public interest entity’. This therefore would exclude large private companies meeting certain size thresholds (see above).

3. The current focus on dividends and capital maintenance is backward looking

When determining whether a dividend can be declared, a director is required to base the decision on the ‘relevant accounts’; these being the last annual accounts that were circulated to shareholders, or interim accounts made up to a more recent date if the proposed dividend cannot be justified by reference to the last annual accounts. Accordingly, and understandably, this approach reflects a company’s past performance as the basis for making the distribution. It does not, therefore, specifically require a director to consider, and evidence, the impact of the proposed dividend on the future performance and financial requirements of the company; albeit the directors must, under section 172 of the Companies Act, consider the likely long term consequences of the decision to declare a dividend, as part of their general fiduciary duties to promote the success of the company.

What does the consultation propose?

• New directors’ statement about the legality of proposed dividends and the effects on the future solvency of the company – The proposals set out a new requirement for directors to make statement confirming that:
• (i) In proposing the dividend, the directors have: (a) satisfied themselves that the dividend is within the known distributable reserves; and (b) have had regard to their general duties under section 172(1) of the Companies Act 2006 (including the need to have regard to the likely consequences of any decision on the long term) and their wider common law and fiduciary duties; and
• (ii) It is the directors’ reasonable expectation that payment of the dividend will not threaten the solvency of the company over the next two years in the light of the risk analysis undertaken and the directors’ knowledge of the company’s position at the date the dividend in proposed. Where relevant, directors should also confirm that the dividend is consistent with the Resilience Statement (see below).
• This proposed new ‘compliance and solvency’ statement would be a significant step to make directors’ more accountable for dividend decisions, both in relation to compliance with the law and over the future solvency of the company.  The proposals therefore explain that mandating directors to make this explicit statement would provide an improved focus for directors’ decision-making and help to build confidence that the legal requirements surrounding lawful dividends and capital maintenance are being complied with.

Who are the proposals applicable to? It is proposed that this new disclosure requirements would become applicable to only publicly listed and AIM companies, however the consultation also questions whether it should extend to PIEs and large private companies (as the requirements on dividends apply to all companies and are interest to creditor as well as shareholders).   

• Improved information for investors about company distribution policies – The proposals do not set out a new narrative reporting requirement for companies to disclose their distribution and capital allocation policies. This is because the Government believes that the existing requirements within section 172(1) of the Companies Act 2006 and the best practice guidance issued by the FRC’s Reporting Lab: Disclosure of dividends – policy and practice and the Investment Association: Shareholder votes on dividend distributions on UK listed companies – The case for a Distribution Policy, along with the new proposed quantitative requirements (as discussed above) will be sufficient. Furthermore, by not mandating any further narrative reporting requirements will allow companies the flexibility to develop their own narrative reporting approaches that meet the needs of their investors and other stakeholders.

Corporate reporting on a Resilience Statement, Supplier Payment Practices and a Public Interest Statement

The Government’s proposals principally consolidate and build on the recommendations made in the Brydon Review and centre around companies needing to do more in relation to demonstrating a company’s resilience, being transparent about a company’s supplier payment policies and practices, and explaining how directors’ view a company’s public interest obligations.

The 3 corporate reporting areas are as follows:

1. A new reporting requirement to publish an annual Resilience Statement

The proposals introduce a new reporting requirement to publish an annual Resilience Statement that addresses business resilience over the short, medium and long-term. The new requirement therefore builds upon the existing going concern and viability statements. The three sections of the statement are proposed to comprise of:

• A short-term section – this section would incorporate a company’s existing going concern statement, and include disclosure of material uncertainties no longer judged to be material after the use of significant judgement and/or mitigating action (that are required to be disclosed under paragraph 22 of IAS 1 Presentation of Financial Statements (“IAS 1”)). The aim being that the encompassing disclosure within the Resilience Statement could potentially drive better compliance and more informative reporting.  The proposals do not specify a period that this assessment should cover, however for compliance with the going concern requirements within paragraph 26 of IAS 1, the assessment period would need to be at least, but not limited to, twelve months from the end of the reporting period.

• A medium-term section – this section would incorporate the existing viability statement requirements to provide an assessment of the company’s prospects and resilience, and to address matters that may threaten the company’s ability to continue in operation and meet its financial liabilities as they fall due. The proposals specify that this assessment should be five years and that it must include at least two stress testing scenarios.

• For both the short-term and medium-term sections, the proposals would also mandate some specific areas/issues that should be included by all companies as a minimum, albeit the proposals do also accept that that companies would have the flexibility to report on other matters that are relevant and material to their individual business. These specific matters might include: threats to liquidity, solvency and business continuity in response to a major disruptive event (such as a pandemic) which disrupts normal trading conditions; supply chain resilience and any other areas of significant business dependency (e.g. on particular markets, products or services); digital security risks (including both external cyber security threats, and the risk of major data breaches arising from internal lapses); the business investment needs of the company to remain productive and viable; the sustainability of the company’s dividend and wider distribution policy; and climate change risk. Companies would additionally be given the flexibility for these matters to be addressed in either the short-term section or the medium-term section, depending upon their businesses’ circumstances.

• A long-term section – this section would not be prescribed, but instead would need to set out what the directors of the company consider to be the main long-term challenges to the company and its business model, and how these are being addressed, for instance this might include the impact of long-term changes in demographics, technology, consumer preferences and other long-term trends impacting the company’s business model.

The consultation does not, however, set out prescribed proposals for how companies should address the impact of climate change within the Resilience Statement. Instead, it poses a question as to whether the Resilience Statement should, in whole or in part, look to address the impact of climate change on a company’s business model and financial planning, and hence whether it could provide a means for companies to provide disclosures consistent with the recommendations of the Taskforce on Climate-related Financial Disclosures (“TCFD”).

Who are the proposals applicable to? It is proposed that this new reporting requirement would become applicable to all PIEs, however there would be a phasing-in approach that starts with premium listed companies, and then moves to all other PIEs within two years. Recently listed companies would, however, be out of scope.

2. New reporting requirement to provide enhanced disclosures surrounding Supplier Payment Practices

The proposals introduce a new reporting requirement that seeks to improve supplier payment reporting to shareholders by making disclosures more accessible within the annual report and by making it easier to understand payment practices at a group level, rather than only at an individual subsidiary level. Notably, the proposals leverage off the existing requirements of the Payment Practices Reporting Duty (“PPRD”) that have been applicable to all large companies since 2017 (large company being defined as exceeding the size thresholds for qualifying as a medium-sized company under section 465 of the Companies Act 2006).

The proposals consider requiring companies to provide, in their annual report, a summary of how the company (or group in the case of a parent company) has performed with regard to supplier payments over the previous reporting year, and to comment on how this compares to the year before that. The proposed minimum reporting content to be provided by a company (or at a group level in the case of parent companies) would be:

• the company’s supplier payments policy, including its standard payment terms and shortest and longest standard payment period;
• the percentage of the company’s supplier payments that met its standard terms and, where this figure is less than 80%, an explanation of why this occurred and what actions the company plans to take to improve its payments record; and
• where such an explanation was required in the previous year’s annual report, an update in the following year’s report on the actions that were taken to improve the payments record and any additional steps proposed.

Who are the proposals applicable to? It is proposed that the new reporting requirement would become applicable to either: (a) PIEs that are large companies (i.e. those who are already required to report under the PPRD requirements; or (b) PIEs with more than 500 employees (i.e. those who are already required to provide a non-financial information statement).

3. No new requirement for a Public Interest Statement

At this stage of the consultation, no new requirement has been proposed for a Public Interest Statement to be introduced – as a reminder the Brydon Review proposed that companies should be required to report on what they perceive to be their responsibilities to the public interest in additional to their statutory and other regulatory obligations.

Instead the consultation is mindful of the FRC’s discussion paper, published in October 2020, on the Future of Corporate Reporting that includes discussions on how a public interest report might be established, and hence comments received in relation to this consultation and the FRC’s discussion paper will help shape the Government’s further consideration in this area.

When will the proposals become effective?

The comment period ends on 8 July 2021. As yet, there is no clear time frame for when the various aspects of the proposed changes may come into effect.

Instead the proposals discuss a different approach depending upon the individual measure to be brought it, for instance measures could be brought into force on a specific date or over a phased period. However, in order to balance urgency of some of the measures, such as the audit reform, whilst managing those measures that impact businesses, the Government’s overall general approach is to:

• Quickly bring into effect those measures that do not directly impact on businesses, such as those relating to establishing the new regulator, ARGA;
• Quickly commence those measures that have a significant impact on those regulated by the new regulator (i.e. audit firms), but with a transition period and/or a phasing-in approach; and
• Have a later commencement for measures that have a significant impact on wider businesses, along with a transition period and/or a phasing-in approach.

For the proposals in respect of dividends and capital maintenance and the new corporate reporting requirements, there will likely be a phasing-in approach, for example applying the new requirements to premium listed companies and then, over time, to other companies falling within the scope.