The Financial Reporting Council (FRC) has published a consultation paper (the Paper) detailing revisions to the UK Corporate Governance Code (the Code) and its accompanying guidance on Audit Committees (the Guidance). The Paper outlines, among other changes, proposed revisions to Section C of the Code, which relates to “accountability”, and it seeks views on any transitional arrangements that may be required when the implementation of the revised Code and Guidance begins on or after 1 October 2012.  

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Background

The Code applies to all premium listed companies with a financial year ending on or after 29 June 2010. It is a codification of best practice in corporate governance that offers guidance to interested parties on how a company should be run: its direction, performance and accountability. The Code replaced the Combined Code on Corporate Governance that was retired following an extensive review of its effectiveness carried out by the FRC during 2009 and 2010. 

In December 2011, the FRC announced that it would consult on changes to the Code and the Guidance with a view to issuing a revised edition that would apply to reporting periods beginning on or after 1 October 2012. Accordingly, the FRC published a report entitled Effective Company Stewardship: Next Steps in September 2011 (the Report) which set out policies concerning, inter alia, the annual report, the audit committee and external audit.

The Paper seeks views on the proposed changes to the Code that the FRC deems necessary in order to implement the policies set out in the Report.

Key Changes:  Proposed Revisions to Section C of the Code

Fair and Balanced Annual Report

The FRC proposes to extend the remit of the audit committee to include consideration of the whole annual report, including the narrative report. Currently, the remit of the audit committee extends to the financial report only.

The purpose of this is for the audit committee to consider whether the annual report, when viewed as a whole, is fair, balanced and understandable and whether it provides stakeholders with adequate information to assess the performance, business model and strategy of the company. Under the proposals, the audit committee will be required to report to the board on these issues and the board will be required subsequently to publish the audit committee’s assessment in the annual report.

In the Report, the FRC had indicated that the audit committee should advise on whether the annual report provides adequate information to assess the company’s “performance and prospects”. However, concerns were raised that inclusion of the term “prospects” may be wrongly construed as requiring companies to provide forecasts of future financial performance. This wording has therefore been removed from the current proposal.

In particular, the FRC seeks views on whether the proposed wording in the draft Code achieves the desired effect of encouraging boards to pay more attention to the disclosures in the business review and on their business model and strategy. If it does not achieve this effect, the Paper also asks for suggestions on how the wording might be improved.

More Meaningful Reporting by Audit Committees

The FRC also proposes the inclusion of a new section of the annual report that details the work the audit committee has undertaken in discharging its responsibilities. Currently the Code contains no such requirement.

Under the new section, the audit committee would be required to report to the board, as well as independently in the annual report, on areas such as any key judgements made, assessment of the effectiveness of the external audit, and the approach taken in appointing or reappointing the external auditor. The aim of the proposal is to encourage more meaningful reporting on the part of the audit committee, which would extend to consideration of significant issues and how these were addressed, plus the approaches taken in the appointment or reappointment of any external auditor and explanations of how auditor objectivity and independence is safeguarded.

In particular, with regard to the appointment or reappointment of the external auditor, the FRC proposes to include a requirement to disclose the length of tenure of the current audit firm, as well as the length of time elapsed since any last tender. Currently, such requirements are only included in the Guidance, which does not impose any obligation on a company or its audit committee. In 2011, the FRC carried out a monitoring exercise that found only one third of companies currently disclose such information, a figure the FRC believes to be far too low. Including the requirement as a recommendation within the Code would make it subject to the “comply or explain” principle and place a further obligation on the audit committee.

For this reason, the FRC considers it appropriate to make the current proposals and seeks views on whether the right balance has been struck between changes to the Code, which has a “comply or explain” obligation, and changes to the Guidance, which does not.

Audit Contracts to Be Put Out to Tender Every Ten Years

The FRC proposes to introduce in the Code a requirement that companies put the external audit contract out to tender every 10 years, or reappoint the current auditor subject to a “comply or explain” requirement. There is currently no such requirement in the Code.

Careful management during the introduction of regular tendering will need to be introduced as, owing to the volume of companies that have not gone out to tender in the past 10 years, if all were to do so, the market may be overwhelmed. This could result in the “big four” accounting firms being favoured as a result of their greater resources. Accordingly, the FRC has amended its original proposal and intends that the provisions be phased in gradually, with the requirement being placed only on FTSE 350 companies in the first instance.

The FRC has assessed the timing of future tenders so as not to disrupt the existing audit partner cycle and to take into consideration the length of time since the company last put the audit contract out to tender. Where there has been a tender process in or after 2000, the FRC proposes that as part of any transitional arrangements, the company may defer the tender process for up to a further five years. This means a significant number of companies could defer the tendering process until to 2018.

In particular, the FRC seeks views on whether the proposed transitional arrangements provide a workable structure and whether there are any alternative arrangements that should be considered. They welcome the submission of any data that outlines the frequency and pattern of tendering in FTSE 350 companies to aid in the assessment of the transitional provisions.

Quality of Explanations

The FRC recognises the continuing importance of the “comply or explain” principle that is integral to the Code. Companies must provide meaningful explanations where they choose to deviate from the recommendations of the Code, so shareholders can understand the reasoning behind any decisions taken and judge whether they are satisfied with the approach adopted.

In February 2012, the FRC published a paper entitled What Constitutes an Explanation under Comply or Explain? that identified a number of features of a meaningful explanation necessary to conform with the requirements of the “comply or explain” policy. These include setting out the context and historical background, providing a convincing rationale for the action taken and initiating mitigating action to address any additional risk.

The FRC proposes to include these features in the introductory section of the Code as a form of background and guidance to aid companies’ understanding of  what is expected of them in fulfilling the requirements of the “comply or explain” policy. The Guidance will also provide a benchmark against which shareholders might assess any explanations provided.

The FRC seeks views on the extent to which an explanation of meaningful features inserted in to the introduction to the Code would be helpful and, if so, whether the proposed addition correctly identifies such features.

Follow-Up Action

The FRC invites all responses to the proposals set out in the Paper to be submitted by 13 July 2012. Subject to the outcome of these, the proposed changes will apply to financial years beginning on or after 1 October 2012.

A copy of the Paper can be viewed here

Isobel Lloyd Davis, a trainee solicitor in London, also contributed to this article.