On 3 December the Government introduced the
Companies (Audit, Investigations and Community Enterprise) Bill to
the House of Lords. The Bill is intended to improve the reliability
of financial reporting and the independence of auditors, and to
strengthen the powers of company investigators. It also includes
the legislative provisions needed to bring into being the new
"Community Interest Company".
Many of the changes in the Bill have been expected
since the publication in July 2002 of the Government's White Paper
on Company Law and since the Government prioritised reform of the
UK's accounting, audit and corporate governance rules in the light
of the Enron and Worldcom scandals.
The Bill must now proceed to a second and third
reading in the House of Lords, and then be scrutinised by the House
of Commons. Under normal circumstances, in order to become law a
Government Bill must complete all its stages in one Session of
Parliament. In the 2001-2 Session all the Bills presented by
the Government were passed in that Session. The current
Session runs until November next year, so it is likely that the
Bill will become law before then.
This article highlights the main changes proposed
in the Bill against the background of recent developments in this
area.
Background
Company Law White Paper
In July 2002 the Government published a White Paper
designed to be part of a complete overhaul of UK Company Law.
Amongst the proposed changes:
- public and large private companies would be required to publish
in their annual report an audited operating and financial review
(OFR), containing an assessment of the company's business,
performance and prospects, as well as its community and
environmental impact and relationships with staff;
- directors of all companies and their subsidiaries would be
required to volunteer to the auditors all information which they
need in order to carry out their audit – with criminal
sanctions attached to a failure to do so;
- the Reporting Review Panel (RRP) should be the successor body
to the Financial Reporting Review Panel, and should have a broader
remit, including power to enforce the rules for public and larger
companies on the form and content of accounts.
Although the Government has not yet set a timetable
to take forward the majority of the reforms in the White Paper, in
July this year the DTI announced that the Government intended to
introduce the OFR through secondary legislation (which will not
require significant Parliamentary time), and that those reforms
which are aimed at preventing 'major corporate failures' would be
introduced "as soon as parliamentary time allows". It is these
reforms that are included in the Bill.
Although the DTI has consulted on the question of
which matters should be deemed sufficiently 'material' to require
inclusion in the OFR, no draft regulations have yet been
published.
For further information on the White Paper see the
LawNow article published on 12 August 2002.
DTI Review of Audit and Accounting
issues
In January 2003 the DTI published two reports on
audit and accounting issues in the UK. In the first, the
Co-ordinating Group on Audit and Accounting Issues (CGAA) made
recommendations for improving auditor independence and
transparency, corporate governance, financial reporting standards
and the monitoring of audit firms.
The second report contained the results of
the DTI's October 2002 consultation on the 'Review of the
Regulatory Regime of the Accounting Profession in the UK' and
recommended that:
- the Financial Reporting Council (FRC) should take on the
functions of the Accountancy Foundation with responsibility for
setting, monitoring and enforcing accounting and audit standards,
and overseeing the major professional accountancy bodies;
- the existing rules on independent regulation and review of
audits should be significantly strengthened. Specifically,
responsibility for setting independence standards for auditors and
for monitoring the audit of listed companies and other significant
entities should be transferred from the professional accountancy
bodies to the independent regulator.
- There should be a risk-based, proactive approach to the
enforcement of accounting standards. In particular, the
Financial Services Authority (FSA) should have a greater role in
identifying the risks to be investigated and the selection of
company accounts for examination. The Inland Revenue should
also help identify 'high-risk' accounts.
From March to June the DTI consulted further on the
legislative changes needed to implement these recommendations, and
the FRC has now taken over from the Accountancy Foundation, as the
second report proposed.
Many of the recommendations in the Reports have
already been implemented in guidance issued by the accounting
bodies and through the incorporation into the new Combined Code on
Corporate Governance of Sir Robert Smith's recommendations on audit
committees. The Bill gives effect to the other recommendations
in both reports.
The Reports are available at http://www.dti.gov.uk/cld/cgaai-final.pdf
and http://www.dti.gov.uk/cld/accountancy-review.pdf ,
this will open a PDF in a new window.
For further information on the Combined Code see
the LawNow article published on 21 August this year.
The Companies (Audit, Investigations and
Community Enterprise) Bill
Many of the reforms proposed in the Bill echo those
introduced in the US by the Sarbanes-Oxley Act of 2002 (SOX), and
represent the Government's response to Enron and Worldcom
scandals.
In particular, the Bill is intended to improve the
reliability of financial reporting and the independence of auditors
by:
- requiring directors to state that they have not withheld any
relevant information from their auditors;
- requiring companies to publish details of non-audit services
provided by their auditors;
- imposing independent auditing standards, monitoring and
disciplinary procedures on the professional accountancy
bodies;
- strengthening the role of the FRRP in enforcing good accounting
and reporting, by giving it new powers to investigate potentially
defective accounts and broadening its remit to include monitoring
accounts or reports required under the UKLA's Listing Rules (such
as interim results); and
- allowing the Inland Revenue to pass information about suspect
accounts to the FRRP.
More detail on these proposals is given in the
'Audit and accounting issues' section below.
Changes are also included in the Bill which are
designed to pave the way for the introduction of the rules on OFRs,
and to strengthen the powers of inspectors appointed by the DTI to
investigate the affairs of companies suspected of operating
improperly.
Disclosure statement by
directors
For all companies whose accounts have been subject
to a statutory audit for that financial year, the directors' report
will have to contain a statement to the effect that, at the time
the report is approved, there is no information which has not been
disclosed to the company's auditors which:
(a) a director of the company is aware
of, or it would be reasonable for a director of the company to
obtain by making enquiries;
(b) the director knows or ought to know
would be relevant for the purposes of the auditors' determination
whether the annual accounts have been properly prepared in
accordance with the requirements of the Companies Act 1985; and
(c) the director knows or ought to know
that the auditors are not aware of.
The Bill proposes that a director 'ought to have
known' something if it would have been known by a reasonably
diligent person having both the knowledge, skill and expertise of
that director, and the knowledge, skill and experience that might
be reasonably expected of a person carrying out the same functions
as that director.
A director who makes such a statement knowing it to
be false, or being reckless as to whether it is false, will be
guilty of a criminal offence unless he can show that he took all
reasonable steps to prevent the report from being approved. The
penalties on indictment are imprisonment for up to two years and/or
an unlimited fine and, on summary conviction, up to twelve months'
imprisonment and/or a fine up to the statutory maximum
(£5,000).
The prospect of having to give such a statement is
designed to encourage directors to ensure that their company has in
place a formal and effective procedure for managers to report to
the board matters which could be relevant to the accounts or the
audit process, and for the accounts to be checked and
double-checked with all the relevant people before they are signed
off.
Sarbanes-Oxley
These provisions are similar to the requirement
imposed by SOX for CEOs and CFOs to certify that financial and
other information contained in quarterly and annual reports filed
with the SEC:
- does not contain any untrue statement of a material fact or
omit to state a material fact necessary in order to ensure that the
contents are not misleading; and
- fairly presents in all material respects the financial
condition, results of operations and cash flows of the company for
the period under review.
The CEO and CFO also have to certify that they
have:
- designed the company's disclosure controls and procedures so as
to ensure that material information is made known to them,
particularly during the period in which the report is being
prepared; and
- disclosed to the company's auditors and to the audit committee
of the board of directors (i) all significant deficiencies in the
design or operation of internal controls which could adversely
affect the company's ability to record, process, summarise and
report financial data; and (ii) any fraud that involves management
or other employees who have a significant role in the company's
internal controls.
An officer who gives a false SOX certification is
guilty of a criminal offence which is punishable by substantial
fines and lengthy terms of imprisonment. Other sanctions (such as
repayment of remuneration) may also follow.
Disclosure of Non-Audit Services
The Bill would give the Secretary of State power to
pass regulations requiring companies to publish more information
about the nature of any services provided to them (or their
associates) by their auditors or their associates (whether in an
audit capacity or otherwise), and the remuneration, expenses and
benefits-in-kind ('remuneration') received or receivable for
such services.
Such disclosure is likely to be made either in
notes to a company's annual accounts, in the directors' report or
in the auditors' report. At present companies that do not qualify
as 'small' or 'medium sized' have to include in a note to their
accounts details of the aggregate remuneration paid to their
auditors in respect of both audit and non-audit services. But
under the new regulations it is anticipated that all or most
companies will have to provide a breakdown of all services provided
and the cost of each component part.
Such services could include bookkeeping services
relating to accounting records or financial statements, financial
information systems design and implementation, appraisal or
valuation services and fairness opinions, actuarial services,
internal audit outsourcing services, management functions or human
resources, broker or dealer, investment adviser, or investment
banking services, and legal and expert services unrelated to the
audit.
Sarbanes-Oxley
The proposal in the Bill does not goes as far as
SOX, which prohibits auditors from providing any such services to
their clients, although tax advice and certain other services can
be provided if the prior approval of the company's audit committee
is obtained and the approval is disclosed in the company's periodic
reports.
ICAEW Guidance for directors
In July this year the ICAEW published Tech 24/03,
which contains guidance for directors of UK companies quoted on a
regulated market as to the form and extent of disclosure in their
annual reports of services provided by auditors. The guidance
states that the annual report should disclose sufficient
information about the services provided, and their cost, to enable
a reader to make an informed judgement as to whether the potential
for conflicts of interest has been satisfactorily addressed by the
auditors and the company. In particular, the company should
break down fees paid to the audit firm in the following categories:
audit, further assurance (such as advice on accounting matters
unrelated to the audit, and due diligence work), tax, and 'other'
services such as financial information technology, internal audit,
valuation and recruitment. Such companies should also give a
narrative statement on the company's policy for ensuring that the
auditor's independence has not been compromised. Tech 24/03 is
available by clicking here.
In May this year the ICAEW also published guidance
for audit committees, which includes guidance on 'Reviewing auditor
independence'. This is available by clicking here.
Auditing Practices Board consultation on
auditor independence
As part of the ongoing process of developing and
updating professional standards for auditors, at the end of
November the Auditing Practices Board issued for public comment
five Exposure Drafts of proposed Ethical Standards dealing with
(amongst other things) 'auditor integrity, objectivity and
independence', 'fees, economic dependence, remuneration and
evaluation policies, litigation, gifts and hospitality', and
'non-audit services provided to audit clients'. When the
Ethical Standards are finalised, any audit of financial statements
will have to be carried out in compliance with them. The
Exposure Drafts can be found by clicking here.
Auditors' rights to
information
Auditors' rights to information under section 389A
of the Companies Act 1985 (which currently allows auditors to
require information and explanations from the relevant company's
directors, managers and company secretary) would be extended to
employees of the company, to any person holding or accountable for
its books, accounts or vouchers, and to any subsidiary undertaking
incorporated in Great Britain (and to the officers, employees,
auditors and persons holding the books of such subsidiary
undertaking). Where a parent company has subsidiary undertakings
which are not incorporated in Great Britain, auditors would be able
to require the parent company to obtain the relevant information
from the same categories of persons at that subsidiary.
Failure to supply information to auditors is not
currently an offence. The Bill would introduce a new section 389(B)
to the Companies Act 1985, under which a failure to comply without
delay with a request for information from the auditors would
constitute a criminal offence. The company and each of its officers
who are in default would be liable to a fine. A failure by a parent
company to take all steps reasonably open to it to obtain the
information or explanations which an auditor has required it to
obtain from subsidiary undertakings which are not incorporated in
Great Britain would also constitute an offence (with a similar
penalty).
There would also be a new offence of providing
false or misleading information or explanations to an auditor where
the auditor requires, or is entitled to require, such information
under the revised section 389. A breach would be punishable by
imprisonment or a fine (or both).
Defective accounts
At present, the FRRP is authorised by the Secretary
of State to enforce the rules which require company accounts to be
prepared in accordance with the Companies Act 1985 and UK GAAP. For
this purpose, the FRRP checks the annual reports of companies that
are incorporated under the Companies Act and, if it believes the
accounts are defective, can apply to court for an order that
revised accounts be prepared.
In future the FRRP's role will be performed by a
FRRP committee known as the Review Panel. The Bill proposes that
the FRRP's role should be enhanced in the following ways:
- The scope of the FRRP's activities should be extended to
include monitoring interim reports and any other periodic reports
required by Listing Rules, in addition to annual reports; and also
to monitoring both the annual and interim reports of entities which
are listed on the Official List but which are not Companies Act
companies (such as overseas companies which have a primary listing
in the UK, and issuers which are not companies but which issue
equities or domestic debt). The FRRP will be expected to inform the
Financial Services Authority of any suspected breaches of the
Rules. This is likely to result in more fines being imposed by the
FSA on listed companies and their directors which publish financial
information that is false or misleading.
- Where it has reason to believe that accounts do not meet the
applicable standards, the FRRP should be given power to compel
companies to divulge relevant information. Currently the FRRP has
no power to force companies to co-operate: it relies on
explanations and documents which are not publicly available being
disclosed voluntarily. The Government believes that, in taking a
more proactive approach, the FRRP will be considering more cases,
and that it is not enough to rely on voluntary co-operation.
- The Inland Revenue should be authorised to pass information to
the FRRP where it believes that accounts may be defective.
OFR
The Secretary of State will be given power to
specify a body to issue standards relating to directors' reports
included in annual reports and accounts (which are not currently
covered by accounting standards). This is intended to pave the
way for the introduction of rules requiring public and very large
private companies to publish an Operating and Financial Review,
which will replace the directors' report.
Company Investigations
A number of changes will be made to the company
investigations regime in order to strengthen the Secretary of
State's powers to investigate the affairs of a company. These
include:
- section 447 of the Companies Act 1985 will be revised to give
DTI investigators power to force a company to produce any documents
and information which they require. This will broaden the existing
powers under section 447;
- a new section 448(A) will introduce a number of protections in
relation to the disclosure of information, by providing immunity
from legal liability for breach of confidence to persons making "a
relevant disclosure";
- inspectors will also get new powers, under new sections 453(A)
and 453(B) to the Companies Act 1985, to require access to and to
remain on premises which they believe are used for the purposes of
the business of the company they are investigating; and
- a failure to comply with a request for documents or information
under the revised section 447, or to co-operate with investigations
under section 453(A), will constitute an offence punishable as if
it were a contempt of court.
Regulation of Auditors
The Companies Act 1989 requires company auditors to
be members of a recognised supervisory body, and to hold a
recognised professional qualification. The five recognised
supervisory bodies (which include the ICAEW and ACCA) are required
to observe certain requirements in carrying out their supervisory
roles. Under the proposals in the Bill, the role of such bodies
would be broadened to include the
- setting of auditing standards relating to professional
integrity and independence,
- the setting of technical standards,
- the monitoring of audits of listed companies (and other
companies whose financial condition is of particular importance),
and
- the investigation and taking of disciplinary action in relation
to public interest cases.
The Bill will also allow certain functions relating
to company auditors and the recognition of supervisory bodies to be
delegated to the Professional Oversight Board for Accountancy
(POBA), which will be set up as part of the Financial Reporting
Council.
Community Interest Companies
Unrelated to the changes described above, the Bill
also sets out the draft legislation required to bring into being
the new Community Interest Company (CIC) proposed by the DTI
earlier this year. The CIC is a new type of company designed for
use by social enterprises or businesses that use their profits for
the benefit of the local community or the wider public (such as in
childcare provision, social housing, leisure and community
transport). CICs are intended to offer an alternative to charities:
they will be subject to a lighter regulatory regime, but will not
have the tax advantages of charities.
The provisions relating to CICs are not covered
further in this article. For further information on the
Government's proposals, see the LawNow article published on 14
April this year.
The full text of the Bill and the Explanatory Notes can be obtained by
clicking on the above links.
Further information on auditor independence can be
found on the ICAEW's website by clicking here.
***************
Reforms to liability of directors and
auditors
On 16 December 2003 the DTI launched a consultation
on amending section 310 of the Companies Act 1985, which imposes
restrictions on the extent to which companies can indemnify or
release their directors and auditors from liability in tort,
contract or otherwise.
The section is notoriously uncertain in scope, and
in June 2001 the Company Law Review Steering Group recommended that
it should be amended to allow auditors - subject to the approval of
the company's shareholders - to limit their liability in contract
to the company or the shareholders in their audit engagement
contract, and that auditors should be expressly permitted to limit
their liability in tort to third parties. In both cases, such
limitations would be presumed reasonable for the purposes of the
Unfair Contract Terms Act 1977 provided they go no further than
certain guidelines to be agreed after public
consultation. Unsurprisingly, audit firms have been lobbying
the Government to introduce such changes.
Nevertheless, the timing of the consultation is
something of a surprise: the White Paper did not deal with the
"difficult question of auditor liability", and instead the
Government stated that it would announce its response to the
question in due course. Subsequent signals from the DTI have
suggested that reform of the section was unlikely to occur for some
time. However, it seems that the Government has responded to
pressure from audit firms, and to the recommendation of Derek
Higgs, that the important issues of directors' and auditors'
liability should be clarified.
The options put forward by the DTI include:
- allowing companies to pay up front the legal costs incurred by
a director in defending himself successfully
- allowing companies to limit the liability of their directors
for negligence
- allowing directors to be indemnified by third parties
- enabling a company to indemnify a director against a reasonable
bona fide deductible under a D & O insurance policy
- allowing auditors to negotiate with their client a limit on
their liability for breach of contract and negligence
- allowing audit firms to cap their liability to clients. The cap
could be calculated by reference to:
-
- a multiple of the audit fee;
- a multiple of total fees paid to the auditor, including any
non-audit services provided;
- a multiple of the auditor's turnover; or
- a fixed rate – for example, one rate could apply to the
Big Four firms and a lower rate or rates to smaller firms
- requiring companies to disclose such arrangements in their
annual report and accounts
- making such arrangements subject to shareholder approval or
ratification.
A system of proportionate liability, whereby the
courts would have to apportion liability between auditors, the
company and its directors, has been considered and rejected.
The consultation closes on 12 March 2004. The
consultation paper can be found at http://www.dti.gov.uk/condocs.htm.