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FRC sets path for audit scrutiny

Proposed changes to governance rules will restore faith in audit committees’ reporting processes, writes Richard Crump

A RAFT OF consultation documents, recently issued by the Financial Reporting Council (FRC), have set greater oversight and reporting standards for company boards, audit committees and auditors.

The regulator is planning to update the UK’s 20-year-old corporate governance code with a host of changes that will encourage more informative reporting by audit committees, and among the processes affected will be that of appointing an external auditor and commenting on their effectiveness.

The updated code will also place a greater onus on auditors to ramp up their communication with audit committees, and increase their reporting levels as part of proposed revisions to International Standards on Auditing.

By forcing auditors and audit committees to be more explicit about their activities in preparing company reports, it is hoped that the greater levels of transparency will restore faith in the reporting process while making it more rigorous than it has been.

Proposed changes include heightening the scrutiny of how annual reports are prepared, with boards required to explain why they consider the report to be “fair, balanced and understandable”; asking the audit committee to add additional oversight; and expecting auditors to report by exception in circumstances where they believe the content of reports does not meet the “fair, balanced and understandable” criterion.

These proposals brought stinging criticism from James Barbour, the Institute of Chartered Accountants of Scotland’s (ICAS) director of technical policy, who said reporting by exception is “outdated” and a “dilution of what is required”: “Reporting by exception … does not place sufficient emphasis on an increasingly important part of corporate reporting.”

In addition to reporting to the board on the front-end, or narrative, section of the report, the audit committee’s section of the annual report will be expanded to include an explanation of its approach to appointing or reappointing auditors.

Timothy Copnell, associate partner and member of the audit committee institute at KMPG, explains that these are areas already considered by audit committees, but “it will better communicate the role of audit committee and restore integrity in business reporting” if the process is made more transparent.

“The FRC’s unstated objective is that a little bit of external disclosure will drive rigour and robustness,” he says.

Prickly issues
It is no surprise that audit committees will be forced to explain why a company did or did not go out to tender – and, if it did not, when a tender was last conducted. The length of audit tenures has become a prickly issue.

FTSE 350 companies are, at best, slow when it comes to switching auditors. According to analysis from the Office of Fair Trading, the average switching rate for FTSE 100 companies is every 43 years and for FTSE 250 companies is every 24 years.

The European Commission (EC) is due to release planned reforms that will enforce mandatory rotation in six-year periods of auditors on companies, while the Dutch parliament is considering the possibility of forcing companies to rotate their auditors every eight years.

“Whether rightly or wrongly, auditors have been open to criticism over the length of audit contracts. Disclosure by audit committees will provide confidence in instances where there is not a change that due process has been gone through,” explains Copnell.

However, the FRC appears to be moving further away from the stance taken by the EC. Its latest proposals, which were already less aggressive than those of the EC, will require FTSE 100 and FTSE 250 companies – rather than the entire listed market, as previously stated – to put their audit out to tender once every ten years.

The FRC said it watered down the proposals because rolling out the change to the whole listed market would have made companies rush out to change their auditor in the same year. In some instances, the change can be deferred by up to five years, the regulator added.

This proposal was received more warmly by Barbour, who agreed that there should be “a period to see how it works before extending its scope”.

By forcing FTSE 350 companies to put their audits out to tender every ten years, but not requiring them to rotate, the FRC has created a halfway house that will appease auditors who believe the frequency of rotation should be placed in the hands of audit committees, rather than regulators.

The FRC also appears to be hedging its bets: while the EC may be in favour of mandatory rotation, this is yet to be ratified by the European Parliament.

As one market source put it: “As with all things Europe, you cannot be sure where this will end up.”

Game changers

The proposed changes to the UK Corporate Governance Code include:

• Requesting FTSE 350 companies to put the external audit contract out to tender at least every ten years;

• Asking boards to explain why they believe their annual reports are fair and balanced;

• Encouraging more meaningful reporting by audit committees;

• Providing more guidance on explanations that should be provided to shareholders when a company chooses not to follow the Code; and

• Embodying provisions that were announced previously, which required boards to report on their gender diversity policies.

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