Effective Company Stewardship - frc.org.uk

EffectiveCompanyStewardshipEnhancing CorporateReporting and Audit

Financial Reporting Council

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Effective Stewardship

This paper considers how the effectiveness of thestewardship role of Boards and Audit Committeescan be enhanced through corporate reporting andaudit. We welcome responses from all ourstakeholders and particularly seek the views ofinstitutional investors and directors withstewardship obligations. This paper does not focuson the crisis in financial services. Instead, it looksforward and covers companies in all sectors.

The deadline for responses is: 31 March 2011.

Responses should be sent to:Stephen HaddrillChief ExecutiveFinancial Reporting Council5th Floor, Aldwych House71-91 AldwychLondonWC2B 4HN

e-mail: [email protected]

The FRC would like to thank all those who havecontributed ideas to this discussion paper, inparticular members of the advisory group whichwas established in July 2010 to provide advice onthe issues covered in this paper. The ideas andrecommendations contained in the paper are thoseof the FRC.

What happens next?

The FRC will evaluate the responses to thisdiscussion paper and hold a stakeholderconference on the key issues emerging from theconsultation. We will also pilot a number of theinitiatives proposed in the discussion paper. Whererelevant, we will consult further (including aregulatory impact assessment) on specificproposals that we decide should be taken forward.

INDEX

CHAPTER ONE:

INTRODUCTION 44

CHAPTER TWO:

KEY RECOMMENDATIONS 66

CHAPTER THREE:

NARRATIVE REPORTING 77

CHAPTER FOUR:

ASSURING INTEGRITY 1122

CHAPTER FIVE:

FOSTERING QUALITY

IMPROVEMENTS 1199

CHAPTER SIX:

THE LEGISLATIVE AND COST

IMPLICATIONS OF THE FRC's

PROPOSALS 2211

CHAPTER ONE:INTRODUCTION

The modern company, formed in theVictorian era and developed since, givesBoards of directors the stewardshipresponsibility for investors’ money. It hasenabled enterprises to raise debt andequity and a vibrant capital market todevelop. However, the financial crisis andglobal recession placed unprecedentedstress on companies and it is timely to askwhether the worst financial crisis in eightyyears has exposed any shortcomingsacross all large companies, not just infinancial services.

Many argue that the crisis demonstratesthe need for reform. Others point out thatcompanies in the non-financial sectorscame through the global recession betterthan expected given its speed and depth.Furthermore, the UK equity marketexcelled in funding companies torecapitalise and weather the storm.

What is stewardship? • Investors delegate control to Boards

and receive reports about how thatcontrol is exercised. They expect theBoard to provide strategic direction; toensure its executives implement thatstrategy; and to report openly andhonestly so that they can assess theprogress being made.

• Investors’ trust in the Board isunderpinned by the UK CorporateGovernance Code the aim of which is'to facilitate effective, entrepreneurialand prudent management that candeliver the long-term success of thecompany'.

• Whilst Board directors are theprincipal stewards of investors’interests, many individual investorsand pensioners also often expect fundmanagers to act on their behalf andare reliant on them being active asstewards of their investments.

This system is dependent on the provisionof robust and reliable information bycompanies to investors and on auditassurance of that information.

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The UK Government, the EU and others are alreadyconsidering how the risk of such a crisis occurring in thefuture can be reduced and whether there are lessonsthat can be learned of general application. TheDepartment for Business, Innovation and Skills hasconsulted on the re-introduction of an Operating andFinancial Review (OFR) and on how to develop a long-term focus for corporate Britain. This paper is the FRC’scontribution to these debates, focused on reportingand audit.

The FRC has already undertaken enquiries into thelessons to be learned about governance from thefinancial crisis. As a result, it revised the UK CorporateGovernance Code (the “Code”) and issued theStewardship Code for Institutional Shareholders. It hasalso issued guidance to auditors on assessing whethera business is a going concern, on audit firms’governance and on auditor independence.

However, lessons go wider. The financial crisishighlighted the importance of the identification, analysisand management of risk. That is not only true in financialservices. Companies in all sectors still get into troublebecause of failures in this respect. Our aim is to reducethe likelihood that the message will be forgotten – as ithas been after past crises – by increasing transparencyin the way that directors report on their activities,including their management of risk.

We want to see the example set by the best incorporate reporting adopted across the market so thatAnnual Reports, including audited financial information,deliver greater value to investors and serve the publicinterest better.

Our aim is to see:

• Higher quality narrative reporting, particularly onbusiness strategy and risk management;

• More widespread recognition of the importance ofAudit Committees and, therefore, greateremphasis on their contribution to the integrity offinancial reporting;

• Greater transparency of the way that AuditCommittees discharge their responsibilities inrelation to the integrity of the Annual Report,including oversight of the external auditors;

• More information about the audit process, both forAudit Committees and for investors, and abroadening of the scope of the auditor'sresponsibilities; and

• More accessible Annual Reports through the useof technology.

As these proposals are developed, the FRC will consulton whether they should apply to all listed companies,to those in the FTSE 350, or to some other grouping(such as those having systemic significance).

The proposals build on existing foundations and arenot, in our view, over-prescriptive, but on that wewelcome views. They also take account of theundesirability, in the context of promoting economicprosperity, of building a regulatory framework thateliminates the risk of failure.

Effective Company Stewardship Enhancing Corporate Reporting and Audit

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CHAPTER TWO:KEY

1. Directors should take full responsibilityfor ensuring that an Annual Report,viewed as a whole, provides a fair andbalanced report on their stewardship ofthe business.

2. Directors should describe in more detailthe steps that they take to ensure:

• the reliability of the information onwhich the management of acompany, and therefore directors’stewardship of the company, isbased; and

• transparency about the activities ofthe business and any associatedrisks.

3. The growing strength of AuditCommittees in holding management andauditors to account should be reinforcedby greater transparency through:

• fuller reports by Audit Committeesexplaining, in particular, how theydischarged their responsibilities forthe integrity of the Annual Reportand other aspects of their remit(such as their oversight of theexternal audit process andappointment of external auditors);and

• an expanded audit report that:

•• includes a separate new sectionon the completeness andreasonableness of the AuditCommittee report; and

•• identifies any matters in the AnnualReport that the auditors believe areincorrect or inconsistent with theinformation contained in the financialstatements or obtained in the courseof their audit.

4. Companies should take advantage oftechnological developments to increasethe accessibility of the Annual Reportand its components.

5. There should be greater investorinvolvement in the process by whichauditors are appointed.

6. The FRC’s responsibilities should bedeveloped to enable it to support andoversee the effective implementation ofits proposals.

7. The FRC should establish a marketparticipants group to advise it on marketdevelopments and internationalinitiatives in the area of corporatereporting and the role of assurance andon promoting best practice.

RECOMMENDATIONS

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1 See, for example, the Regulated Information Service ('RIS') operated by the Financial Services Authority to support the requirements of the

Listing Rules and other regulations.

CHAPTER THREE:NARRATIVE REPORTING

Key Points:-

• The Annual Report shouldcommunicate high quality and relevantnarrative and financial information tothe market.

• Directors should take full responsibilityfor ensuring that an Annual Report,viewed as a whole, provides a fair andbalanced report on their stewardship ofthe business.

• Directors should describe in more detailthe steps that they take to ensure:

•• the reliability of the information onwhich the management of acompany, and therefore thedirectors’ stewardship, is based; and

•• transparency about the activities ofthe business and any associatedrisks.

• Companies should take advantage oftechnological developments to increasethe accessibility of the annual reportand its components.

At a time when business and the provision of finance isbecoming increasingly complex and globalised,investors and capital markets require reliable in-depthinformation about the business of a company, itsstrategy, the risks to its success and the ways in whichit manages those risks.

Most of this information cannot be defined in accountingstandards and reduced to individual numbers. Forwardlooking information about how markets are expected todevelop and the consequent strategy can only becommunicated in a narrative manner.

Companies are required by law to prepare AnnualReports, including audited accounts, and these arethe mechanism by which management report on thestewardship of the company and its assets to investorsand other users. Annual Reports then provide theunderpinning to other communications by companies– such as interim management statements, marketsensitive information, and investor presentations. Giventhe important role that they play in the corporatereporting framework, it is essential that Annual Reportsare relevant and present an accurate, coherent andbalanced picture of the business and its prospects.

The manner in which information is provided is not theonly consideration. The requirements of securitiesregulators ensure that investors are provided withmarket sensitive information speedily1. An informedinvestor should not, therefore, be surprised by anyinformation contained in the published Annual Reportsand accounts of listed companies.

The Annual Report should communicatehigh quality and relevant narrative andfinancial information to the market.

Significant changes have taken place in recent yearsin narrative reporting as companies have respondedto the introduction of the Business Review requirementsof the Companies Act 2006, Corporate Governance

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disclosures required by the Code and pressures fromstakeholders to extend the commentary onenvironmental matters.

Some companies have produced Annual Reportscontaining exemplary narrative reporting. However, thisis far from universal and best practice has not becomethe norm. Indeed, too many Annual Reports do notcover all of the necessary topics sufficiently well toconstitute an adequate report on the Board'sstewardship of the company.

The FRC recently concluded that it was necessary tointroduce a new disclosure requirement into the Codebecause companies have provided inadequateexplanations of business models and strategy. TheFinancial Reporting Review Panel (FRRP) has raisedthe adequacy of disclosures relating to principal risksand uncertainties with a number of companies andseen deficiencies in descriptions of a company’sbusiness model. Concerns have also been raised aboutthe reporting of environmental matters and of howcapital is managed.

2 It is notable that, whilst all companies formally complied with this reporting requirement, it was the area where they did so in the least

informative manner.

The Accounting Standards Board (ASB) found poor information in a number of areas relating to the requirements of theCompanies Act 2006:

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Business description 6 52

Strategy 8 44

Principal risks2 0 66

Performance and position 4 20

Trends and factors 6 56

Corporate Social Responsibility 12 34

Contractual and other arrangements 12 52

Financial KPIs 6 34

Non-financial KPIs 32 20

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This overview, which is supported by other studies3, shows thatcompanies in general need to improve the quality and relevanceof their narrative reporting, whilst also decreasing its length anduse of legalistic ‘boilerplate’ disclosures.

The FRC believes that:

• Regulation, combined with guidance and compliancemonitoring, must promote the production of Annual Reportsand accounts that contain information that is relevant toinvestors and other users, rather than allowing or encouragingboilerplate.

• Companies should provide information in a user-friendly andaccessible manner4. To achieve this, statutory and regulatoryrequirements need to be amended to permit:

•• companies to decide how and where they provideparticular information; and

•• the Annual Report and accounts to be posted on acompany's website, rather than produced in print.

3 Recent studies have commented on the ever increasing content of Annual Reports and accounts.

• Deloitte recently reported [Swimming in words: Surveying narrative reporting in Annual Reports] that Annual Reports and accounts

for listed companies are 41% longer than in 2005 and, on average run to over 100 pages.

• The structure of the Annual Report and accounts has also raised concern. Having been created in piecemeal steps by a wide range

of bodies, there are overlapping requirements to provide narrative and numerical amounts in different parts of an annual report, and

barriers to how companies can present items in a logical sequence. As some of the requirements are not aligned perfectly, this leads

to inconsistent information being reported in two or more areas of the annual report and accounts. The result is confusing to

investors and undermines confidence in the reliability of the overall document.

• Black Sun commented [Black Sun Rethinking Reporting: Annual analysis of FTSE Corporate Reporting Trends, 2009] that over 40%

of companies fail to identify any non-financial KPIs and that whilst the quantity of corporate social responsibility narrative may have

increased, the quality of that material is questionable particularly as most do not demonstrate how it is an integral part of their

business. They also observe that the majority of risk reporting is a list of boilerplate disclosures which do not provide a meaningful

discussion of potential impacts or mitigation strategies and that most companies still approach the way they communicate on

governance as a box ticking exercise. Deloitte [Right to the End: Surveying financial statements in annual reports] found that

descriptions of principal risks are too generic, that there is a lack of detail on trends and factors, and that there are too many KPIs

and no explanation of the link between strategy and objectives.

4 The following sequence might better facilitate a dialogue with investors and stakeholders:

• Vision and objectives

• Market opportunity and position relative to market

• Business model

• Strategy for achieving objectives

• Required resources including people and other forms of capital

• Principal risks and uncertainties

• Performance against key performance indicators

• Financial position and historical financial and other performance

• Governance and remuneration arrangements

• CSR matters could be addressed within the above topics or dealt with separately.


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5 Lessons learned include the risks of borrowing short and lending long (in the 1970s secondary banking crisis), the loss of risk control

caused by 'slicing and dicing' in the pursuit of intermediary costs (which led to the Lloyds of London insurance market collapse in the late

1980s); and the market losses arising from unrealistic and unsupported business projections (the ‘Dot Com’ crash in the early 2000s).

Directors should take full responsibility forensuring that an Annual Report, viewed asa whole, provides a fair and balancedreport on their stewardship of thebusiness.

The narrative report, like the financial statements, shouldreflect a Board's considered view of the informationthat investors and other users of Annual Reports need.It should not be promotional in nature, a fault seen insome narrative reporting.

To achieve this, the FRC believes that an Annual Reportshould explain, in a manner that is clear andunderstandable to users, the company's business,strategy and prospects and the risks and uncertaintiesinvolved in the course being pursued. Directors shouldbe responsible for ensuring that each element of anAnnual Report, as well as the Annual Report inaggregate, should meet the test of being balanced and fair.

In order that such a regime can be responsive tochanging regulatory and market developments, aframework should be established through a NarrativeReporting Standard issued by the ASB, rather thanthrough regulation. Such a Code could set out theprinciples governing the preparation of Annual Reports(including narrative reports) and establish theresponsibility of directors for ensuring that AnnualReports are balanced and fair. The role of the auditor inrelation to this material is addressed in chapter four.

Directors should describe the steps thatthey take to ensure the reliability of theinformation on which the management of acompany, and therefore directors’stewardship of the company, is based andtransparency about the activities of thebusiness and any associated risks.

A recurring theme in post crisis analysis has been theimportance of how risk is identified and managed. It isstriking that the importance given to managing risktends to track the state of the economic environment– in difficult times, the risks that companies face occupysenior management and the Board; whilst in goodtimes, the pursuit of growth takes centre stage, often,as we have seen, without an equivalent considerationof the risks involved. Nor are all the lessons of previouseconomic crises learned so that the errors of onegeneration are avoided by the next.5

It is not possible for senior management of largercompanies to have personal knowledge of all theactivities of their business, including the risks arisingfrom those activities. An information gap will alwaysexist between those actually handling particularbusiness activities and their directors. To address this,directors need systems that will ensure that they aregiven enough relevant information about the businessto understand the risks it runs and how these risks arechanging. Only then will they be able to discharge theirstewardship responsibilities to shareholders.

This is the foundation on which delegated managementis built and so, if users are to have confidence in thedirectors’ stewardship, companies should explain thesteps that they take to ensure the reliability of theinformation on which the management of a company,and therefore directors’ stewardship of the company, isbased. Any such explanation should include matterssuch as:


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• the principles on which the internal reportingregime, particularly in relation to the principal risksarising from the company's activities, is based;

• the steps taken to establish a clear framework ofmanagement and reporting, under which specificindividuals have responsibility for particular aspectsof the company's activities;

• the role of internal audit;

• the extent and frequency with which theeffectiveness of the system is tested; and

• the effectiveness of the external assurancearrangements.

The challenge is to provide that explanation in a waythat is accessible to users and efficient in terms of thecost and burden on companies6.

Companies should take advantage oftechnological developments to increasethe accessibility of the annual report andits components.

Recent studies and market commentary haveexpressed concern at the increasing length of AnnualReports and at the difficulty in finding specificinformation within the report. Listed companies nowmake their Annual Reports and accounts available to allstakeholders on their web sites and send them in hardcopy to shareholders who request them.

However, not all companies have made their AnnualReports searchable on the web. The most significanttechnology available is eXtensible Business ReportingLanguage (XBRL) [http://www.xbrl.org], a taggingsystem that enables investors and other stakeholdersto find more quickly specific items of data in AnnualReports.

It has already been mandated in other markets, notablythe USA [http://www.sec.gov/spotlight/xbrl.shtml].

Access to the information in Annual Reports would beimproved if companies were to:

• provide access to Annual Reports and accountsthrough the web in a form that enables them to besearched quickly and easily;

• adopt common reporting languages such asXBRL if that would facilitate engagement7; and

• be relieved of the burden of producing AnnualReports and accounts in printed form which is adrain on the resources they have for developingbetter methods.

6 The FRC is keen to avoid replicating the costs that have arisen from the US Sarbanes-Oxley Act

7 As it is at the heart of the iXBRL tax filing requirements recently introduced by HMRC and is a permitted format for filings at Companies

House, XBRL provides a practical option for increasing the accessibility of information in Annual Reports for the benefit of investors and

other users.


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CHAPTER FOUR: ASSURING INTEGRITY

Key Points:-• Investors need to have confidence in theintegrity of the narrative and financialinformation they receive in the Annual Report.

• Confidence in corporate reporting should bereinforced by a more effective and transparentassurance regime that involves:

•• a quality audit of the financial statements;

•• the revision of auditing standards toexpand the nature and extent of the reportprovided by auditors to Audit Committees;

•• fuller reports by Audit Committeesexplaining how they have discharged theirresponsibilities for the integrity of theAnnual Report and other aspects of theirremit (such as, their oversight of theexternal audit process, and theappointment of the external auditors);

•• an expanded audit report that includes:

- a separate new section on thecompleteness and reasonableness ofthe Audit Committee report; and

- identification of any matters in theAnnual Report that the auditors believeare incorrect or inconsistent, with theinformation contained in the financialstatements or obtained in the course oftheir audit.

• There should be greater investor involvement inthe process by which auditors are appointed.

The previous chapter set out the changes thatwe propose to address the needs of users ofAnnual Reports in the modern and highlycomplex financial and investment environment.It is clearly essential that investors and otherusers have confidence in corporate reports –this is particularly true if shareholders are todischarge their stewardship responsibilitieseffectively, make sound investment decisions,and thereby ensure the effective operation ofthe capital markets. This chapter considers howusers can be assured of the integrity of suchAnnual Reports.

At the inception of corporate reporting in the19th Century, the audit was developed toaddress the issues of that time – principallywhether past transactions and their impact onassets and liabilities were correctly recorded inpublished financial information. Since then,technology has materially changed financialreporting. With computers processingtransactions and allocating sale proceeds inaccordance with accounting requirements,numerical issues are less problematic.

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Recently accounting has also moved away fromhistorical cost. Instead, some assets and liabilities arebooked at their market value when the accounts close,rather than at cost. This change has enhanced thevalue of accounts – historical numbers are easy toobtain but often meaningless – but has increased thecomplexity of accounting standards and requirespreparers and auditors to exercise significantly greaterjudgement.

As a result of these changes, the reliability of financialstatements is now more dependent on:

• The effectiveness of the systems that a companyhas in place to monitor the activities of the businessand the risks associated with those activities.

• Establishing the current values of assets andliabilities.

• The quality of the external audit, including, forexample, whether it has properly considered:

•• the appropriateness of the accounting policiesadopted; and

•• the methods and the judgements made invaluing assets and liabilities.

• The approach taken by all responsible for thefinancial statements to achieve a 'true and fair'presentation of the financial position of thecompany.

Users and, in particular, investors are increasingly awareof the importance of these factors. If they are to haveconfidence in the way financial statements are prepared,there must therefore be appropriate disclosure of theapproach taken to these matters by the company and,where appropriate, by the auditors, and that disclosure must be subject to an effective and transparentassurance regime. Above all, to be useful, disclosuremust be tailored to the position of the particularcompany – and must not descend into boilerplate,uninformative text. These are all key issues for AuditCommittees in their work with management and toensure good quality audit.

A quality audit of the financial statements

It is clear from the research that the FRC and othershave undertaken that users recognise that an auditthat is undertaken in an independent and thoroughmanner provides effective and objective assuranceabout a company’s financial statements.

However, the recent financial crisis has given rise toconsiderable concern about the role and value of auditin relation to the financial services sector. Someimportant questions have been asked about theeffectiveness of audit in circumstances where banksfailed shortly after their financial statements receivedunqualified audit opinions. Those questions includewhether the risks and uncertainties facing the bankswere adequately described and/or it was appropriatefor the financial statements to be prepared on a goingconcern basis. Concerns were also raised about theeffects of accounting standards.

Under current company law and standards the auditoramongst other things addresses:

(i) whether the financial statements present a true andfair view of the financial health of the company at thebalance sheet date; and

(ii) that it was reasonable for the directors to preparethe accounts on a going concern basis - i.e. that thecompany would be able to pay its debts as theyfall due for the next twelve months.

No forward-looking analysis can be proof against theimpact of unforeseen events, and so the auditors’ viewson the directors’ going concern statements cannotprovide as much assurance as auditors give withrespect to the financial statements. However, questionsdo have to be asked when a company fails shortly afterthe audit has been completed.

Whilst we have found that audit work could have beenmore effective if auditors had shown more scepticism,we have established no circumstances where financialstatements were materially misstated: rather corporateand financial reporting was overtaken by exceptional


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market conditions. During the financial crisis, theanalyses that were considered reasonable at the timethe report and accounts were finalised became rapidlyobsolete as markets deteriorated, and the requirementsof the listing regime that were intended to ensure thatmarkets were kept properly informed of suchdevelopments proved inadequate to address theexceptional circumstances that arose. Audit, by itself,could not have prevented the collapse of the creditmarkets. That could only have been achieved if actionhad been taken by those responsible for macroeconomic affairs and prudential regulation.

In relation to audit’s future role, we believe there is acase for improvements to audit practice so audit cancontribute more to the identification of emerging issueswhile there is still time to take remedial action.

The FRC is particularly keen to ensure that the rightenvironment is created for increased auditor scepticismwhen assessing material assumptions and estimates.Audit Committees have an important role to play increating the appropriate environment for the audit teamto challenge material assumptions and estimates in aneffective way and to communicate their views in aforthright and constructive manner.

Audit Committees are likely to want to be convincedthat key judgements are supported by a greater degreeof rigour and analysis in challenging economic

environments and to consider how such matters havebeen explained in the Annual Report. As part of thisprocess they should set the appropriate expectationson the audit team and management.

Clearly the auditor needs to have the capability ofresponding to such expectations. The effective exerciseof professional judgement is fundamental to the qualityof every audit and it is required at numerous stagesduring an audit8. If auditors are to exercise thatprofessional judgement effectively, they must approachissues such as these with an appropriate mindset – amindset that includes professional scepticism9. Suchscepticism would be enhanced by greater transparency,with the assessments made by auditors being open toeffective challenge by the Audit Committee and investors.

We propose, therefore, that the standards governingthe provision of reports by auditors to Audit Committees(such as ISA (UK & Ireland) 720) should be enhanced toensure that they provide the information that is necessaryto enable committees to understand fully the factorsthat auditors have relied upon in exercising theirprofessional judgement in the course of the audit and,in particular, in reaching their audit opinion. These arelikely to include, at a minimum, the auditors’ views on:

8 Professional judgement is required, for example when:

• assessing whether and, if so, how a company’s financial statements may be vulnerable to misstatement;

• deciding the levels of materiality that are appropriate;

• reviewing the quality of the accounting systems and the effectiveness of the control environment, including risk management;

• reaching conclusions on the appropriateness of the accounting policies;

• evaluating the reasonableness of management’s approach to estimates and valuations (including impairments of tangible and

intangible assets);

• assessing the quality of management’s disclosures in the Annual Report;

• reviewing the approach taken by management to issues raised by auditors in the course of the audit; and

• considering the meaning of “reasonable assurance” in the context of a specific audit and assessing the sufficiency of the audit

evidence available to support an audit opinion.

9 Professional scepticism goes to the heart of auditors’ judgement and audit effectiveness. Two consultations are already taking place which

address this issue:

• The FSA and the FRC issued a joint consultation paper on the importance of professional scepticism in audits of financial services

firms and how that can be enhanced, particularly when auditing assets valued on a fair value basis.

• The APB and POB have issued “Auditor Scepticism – Raising the Bar”, which examines whether more needs to be done generally to

promote and develop professional scepticism in auditors.

These papers raise questions about the need for enhancements to professional development, to auditing standards, and to the way

professional scepticism is addressed in the recruitment, development and retention of audit personnel.


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• the effectiveness of the company’s controls(including their assessment of the risks arisingfrom the company’s business model) and howthey have been tested, including the extent of thetesting undertaken by the auditors as part of theiragreed audit process;

• the judgements made in the audit plan about whatis of material significance and the implications ofthose judgements for the level of assuranceprovided by the audit;

• the appropriateness of the accounting policies(viewed individually and in aggregate);

• the valuations of the company’s assets andliabilities provided by management (with particularreference to those that are significant to thefinancial statements); and

• any other matters identified in the audit plan orby the audit committee as material to the properpresentations of the company’s financial position.

A greater awareness of such matters would have fourbenefits. First, the discipline of providing such reportsshould enhance the quality of the auditor’s exercise ofprofessional judgement. Secondly, it would increasethe transparency of the audit process to the auditcommittee. Thirdly, it would help the audit committeeform its own view of the appropriateness of thepresentation of the company’s financial performancein the financial statements. And, fourthly, it wouldprovide important information to the audit committeewhen deciding what information to include in its report.

Auditors who are independent of theirclient, acting without fear of dismissal forbeing challenging

Auditor objectivity, integrity and independence are keyingredients if investors are to have confidence in thereliability of financial statements. The Auditing PracticesBoard (APB) has recently concluded a full review of theEthical Standards that auditors must comply with. Thatreview focused particularly on whether auditors shouldprovide some or any non-audit services.

The APB concluded that Audit Committees shouldexercise greater oversight over the non-audit servicesthat auditors provide to the company they audit.Changes to the reporting regime have therefore beenannounced to reinforce Audit Committee responsibilityfor such services and improvements are being made tothe regime for reporting such fees in the Annual Report.

We will keep the effectiveness of these changes underreview and strengthen them if necessary.

Co-operation between regulators andauditors

One of the lessons learned from the financial crisis isthat all relevant information should be made available tothose responsible for regulatory oversight. In thefinancial services sector, the FRC is working with boththe Bank of England and the Financial ServicesAuthority (FSA) to develop the procedures and practicesneeded to facilitate the two way dialogue betweensupervisors and regulators, and audit firms.Consideration may also need to be given to establishinglines of communication between auditors of companiesoperating in other sectors and relevant regulators.


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10 This would include:

• establishing whether the auditor met the agreed audit plan, understanding any changes, and the work undertaken to address any changes

in perceived audit risks.

• considering the robustness and perceptiveness of the auditors’ handling of key accounting and audit judgements, responding to questions

from the audit committee and their commentary on the systems of internal control.

• obtaining feedback about the conduct of the audit from key personnel involved within the company, and

• reviewing the auditor’s management letter, the manner in which any recommendations have been complied with and, where they have not

been complied with, the reasons for management not having done so.

Fuller reports by Audit Committeesexplaining how they have dischargedresponsibilities for the integrity of theAnnual Report and other aspects of theirremit (such as their oversight of theexternal audit process and theappointment of the external auditors)

The role that an Audit Committee performs on behalf ofthe Board is set out in the Corporate Governance Codeand, in summary, is to oversee the integrity of acompany’s financial affairs (from the effectiveness ofits internal control regime to the fair presentation of thecompany’s financial position in its Annual Report).

When the original corporate governance code was firstintroduced, the focus of Audit Committees (andauditors) was almost exclusively on the statutoryfinancial statements. However, there has since been araft of further material that, by legislation or regulation,companies are required to include in their AnnualReports. In addition, the complexity of accountingstandards has led companies to include extensivematerial to support the information now contained infinancial statements. Such disclosures increasinglyinclude significant statements of belief and explanationsabout the future, both of which are made bymanagement.

Much of the information disclosed is important to manycategories of users (and to shareholders and investorsin particular) and has the potential to affect materially theapparent financial performance of a company.However, it is not subject to any form of independentassurance beyond the limited requirements of theexternal audit.

Some have suggested that auditors should provide anadditional and separate report setting out their views onthese matters. However, the provision of suchinformation is clearly the responsibility of directors andthe training, skills and experience of auditors wouldneed to be substantially enhanced if this approachwere to be pursued. More importantly, the proposalthat auditors should play such a substantive rolecompromises a fundamental principle of stewardship –namely, that the directors and management areexclusively responsible for the management of acompany, including the use to which its assets are putand the liabilities that it incurs (subject only to theoverarching rights reserved to the shareholders).

Instead we propose that Audit Committees report onthe approach that they have taken to the discharge oftheir responsibilities, including describing in such termsas they consider appropriate, having regard to thecommercial interests of the company concerned:

• The key areas of sensitivity or risk, including thechoice of accounting policies, that they identifiedto the integrity of the Annual Report, including thefinancial statements, and how they arranged forthose to be addressed;

• Any matters of material significance identified bythe auditors in their report to the Audit Committeethat are not addressed elsewhere in the AnnualReport and which, in the directors' view, should beknown to users if the Annual Report, taken as awhole, is to be fair and balanced;

• The steps that they took to assess theeffectiveness of the audit10;

• The policies that they adopted in relation to theprovision of non-audit services to avoid theindependence of the company’s auditors beingcompromised;


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• The process by which they reached theirrecommendation to appoint or reappoint (as thecase may be) the company’s external auditorsand the reasons for that recommendation; and

• The nature of any dialogue that they may havehad with investors in relation to any material auditrelated issues (not covered elsewhere in theirreport).

Such a report by the Audit Committee would supportthe confirmation by the Board of directors that theAnnual Report properly and fairly describes the businessand its financial performance.

An expanded audit report

The FRC also welcomes views on whether anexpanded audit report should be the final piece of thejigsaw that is necessary to give users confidence inmodern day corporate reporting.

Users of financial statements have become increasinglyaware that the matters that determine the scope andeffectiveness of the audit and which are thereforeimportant to the auditors in reaching their opinion arenot expressly addressed in the audit opinion. The auditopinion contains nothing more than a pro-formastatement about the auditing and ethical standardsthat the auditor has complied with, and does not relatethose standards to the actual work that has been donein the course of the particular engagement. Nor doesthe audit committee report on such matters. As a resultusers lack the information to enable them to assessthe extent to which it is appropriate for them to rely onthe financial statements.

It would not be appropriate to dictate by detailedregulation the information to be provided to meet users’needs – not least because different information will beappropriate for different companies and because someusers will attach importance to particular information.Nor would it be appropriate to dictate by whom suchinformation should be provided.

However, if our proposals are implemented (so thatauditors provide a report to a company’s AuditCommittee, and Audit Committees report on theapproach that they have taken to the discharge of theirresponsibilities), auditors should be required to reporton the completeness and reasonableness of the auditcommittee report and, if necessary, set out any furtherinformation required to achieve that outcome. Thatwould assure users that they had been provided witha comprehensive report on the matters that the auditorsconsidered important in the course of their audit and inreaching their audit opinion.

A further area where auditors can provide a measure ofassurance relates to those matters, other than thefinancial statements, contained elsewhere in the AnnualReport. For the reasons discussed above, it would notbe appropriate to require auditors to provide a separatereport on such matters – but there is no reason whythey should not be required to report, based on thework that they have done in the course of their audit,whether they are aware of any facts or matters in theAnnual Report that are incorrect or inconsistent withthe information contained in the financial statementsor obtained in the course of their audit.

There should be greater investorinvolvement in the process by whichauditors are appointed.

We recognise that, although shareholders confirmauditor appointments, management is perceived todetermine the appointment (or re-appointment) andremuneration of auditors and that, therefore, auditorindependence is compromised. In fact the appointmentof auditors is overseen by the Audit Committee. This isappropriate. They are in a good position to ensure theprocess is properly run.

However, there is a case for the independence of thedecision to be reinforced by the Audit Committeeseeking greater shareholder involvement. In such anapproach Audit Committees should be required either:


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• to report on the process by which they reachedtheir recommendation to appoint or re-appoint(as the case may be) the company's externalauditors and the reasons for theirrecommendation; or

• to discuss with a number of principal investorsthe approach to be taken to the appointment orre-appointment of its auditors, including the meritsor otherwise of putting its audit out to tender andthen report on that consultation to shareholdersgenerally.

Safe Harbour

The proposals discussed in this paper will result inadditional requirements on directors, officers andauditors of companies. Some of those requirementsmay involve forward looking statements of belief orjudgement. As a result, directors and officers ofcompanies, including their auditors, may seek someform of “safe harbour”.

To facilitate acceptance of its proposals, the FRC wouldsupport the provision of a “safe harbour” defence todirectors, officers and auditors to the extent that theymake or give assurance in relation to forward-lookingstatements, and provided that such statements orjudgements were not made recklessly, dishonestly orfraudulently.


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11 http://www.frc.org.uk/frrp/press/pub2349.html12 http://www.frc.org.uk/pob/audit/firmreports0910.cfm

IMPROVEMENTSCHAPTER FIVE:FOSTERING QUALITY

Key points:-

• The FRC’s responsibilities should bedeveloped to enable it to support andoversee the effective implementationof its proposals.

• The FRC should establish a marketparticipants group to advise it onmarket developments andinternational initiatives in the area ofcorporate reporting and the role ofassurance and on promoting bestpractice.

To ensure that its proposals can be implementedeffectively, the FRC believes that its powers need tobe reviewed to reinforce its effectiveness andindependence and to enable flexible, real-timeintervention in the interests of investors and theeffectiveness of capital markets.

Monitoring and enforcement

The FRRP and the Audit Inspection Unit (AIU) playimportant roles in assessing the quality of application ofAccounting and Auditing Standards. Both OperatingBodies have an approach that is founded on continuousimprovement supported by intervention where asignificant failure is identified.

The FRRP reviews the accounts of some 300companies per year and writes to companies where itappears that some form of non-compliance may bepresent. Where more difficult issues are identified thatcannot be resolved simply through correspondence,company directors are invited to meet the FRRP inperson. Many issues are resolved through undertakingsto improve disclosures in the next set of accounts, buton occasions a wider group of FRRP members withcurrent market experience will be created to assessan individual issue. The FRRP publishes the results of

its work on an annual basis identifying areas forimprovement [The Financial reporting Review Panel'sAnnual report 201011].

The AIU inspects some 100 public interest entity auditseach year. A key focus of an AIU inspection is to assessthe quality of evidence auditors have to support theirkey judgements and to understand how audit firmshave complied with auditing and ethical standards. Areport is sent to each audit firm inspected whichincludes undertakings given by the firm to makeimprovements to the quality of future audits. The AIUpublishes reports on the results of its work each year,including specific reports on the work of individual auditfirms12. In addition the AIU provides confidential reportson individual engagements which audit firms provideto the directors of the entities concerned. Some 175reports on individual audits have been issued in thelast two years the findings of which will have contributedto Audit Committees' assessment of the effectivenessof their audit arrangements.

The FRC believes that:

• The FRRP's remit should be extended to coverthe whole of the narrative content in AnnualReports and accounts; and

• The AIU's supervision should extend to theauditor's consideration of the narrative contentin Annual Reports.

It also believes that consideration should be given tohow, in the event of a corporate failure, a review mightbe carried out of that company's governance,accounts, and audit to ensure lessons, whereappropriate, are learned and to ascertain whetherfurther investigations or regulatory actions arenecessary.

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Thematic studies to guide best practice

The FRC and its operating Boards have published ad-hoc thematic studies designed to highlight genericdeficiencies and lead the development of best practice.

Recent studies of accounting topics have coveredimpairment assessments [FRC Review of GoodwillImpairment Disclosures, October 200813] triggered byreduced growth expectations, and mergers &acquisitions [FRC study: Accounting for acquisitions,January 201014] triggered by forecasts of an upturn inM&A activities that is now taking place. Studies ofnarrative reporting include “Rising to the challenge”recently published by the ASB. In addition, the FRChas been working with the FSA and contributed to theFSA recent discussion paper “Enhancing Disclosuresby Credit Institutions”.

The Auditing Practices Board and ProfessionalOversight Board have worked together on a numberof generic publications aimed at improving audit quality.In November 2006 they published a discussion paperPromoting Audit Quality which resulted in theidentification of five key drivers of audit quality whichwere published as an Audit Quality Framework inFebruary 2008. In August 2010 they published Auditorscepticism: Raising the bar which discusses the degreeof scepticism that auditors need to apply to conductan audit to a high standard. The UK has also led adiscussion with the leaders of the six largest globalaudit networks on the need for auditors to exercisegreater scepticism and has challenged them to identifyand take action to address its root cause.

During the financial crisis the FRC brought together agroup of market practitioners to assist in thedevelopment of additional analysis and guidance aboutgoing concern and liquidity risk. This resulted insupplementary guidance in 2008 [Update for directors:Going concern and liquidity risk] that analysed theoverlapping requirements of the Act, Listing Rules,

Code and UK and IFRS Accounting Standards andAuditing Standards in the context of current events.Consolidating revisions were made to the FRC guidanceon going concern in 2009.

Many have commented positively on the quality andtimeliness of the additional guidance on going concernand liquidity risk, which was in part due to the quality ofthe interaction with market practitioners and all parts ofthe FRC. The FRC believes that there are opportunitiesto build on the benefits of those experiences.

It therefore proposes to create:

• A forum comprised of market practitionerssupported by the FRC and UK Listing Authorityto exchange views about current marketdevelopments on a regular basis. This wouldenable participants to share experience ofdeveloping best practice and also help to identifywhere the FRC as regulator could be a catalystfor improved practice through thematic studiesand other outputs.

Two groups could be envisaged. One addressingfinancial services businesses in which the FSAprudential team would also participate and theother looking at non-financial services. It wouldbe appropriate for the groups to meet at leasttwice a year, possibly at the start of the planningseason for the majority of interim reports andseparately for the majority of Annual Reports.

• A ‘financial reporting lab’ where new financialreporting models and concepts could beexplored, tested and trialled (without liability) toenable greater innovation in the market.


13 http://www.frc.org.uk/publications/pub1745.html14 http://www.frc.org.uk/images/uploaded/documents/FRC%20Study%20-%20Accounting%20for%20acquisitions1.pdf

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In developing its proposals, the FRC has beenconscious of the Government's approach to newlegislation and regulation – and, in particular, its policyof not increasing the regulatory burden on companiesunless there are clear benefits in doing so.

The FRC believes that the proposals that it has set outin this paper would require only minimal legislation to:

• remove certain statutory requirements that dictatehow and where certain information is to set outin a company's Annual Report;

• provide for an investigation to be carried out inthe event of a corporate failure into thatcompany's governance, accounts, and audit; and

• extend the powers of the FRRP to include allaspects of a company's Annual Report.

The proposals would also require the development ofNarrative Reporting Standards by the ASB.

The FRC recognises that there will be additional workand, therefore, cost as a result of the proposed:

• expanded report by the auditors to the AuditCommittee; and

• Audit Committee report.

However, the FRC believes that the benefits in terms ofincreased confidence in corporate reporting outweighthe costs involved in such additional regulation.

CHAPTER SIX:THE LEGISLATIVE AND COST IMPLICATIONS OF THEFRC’s PROPOSALS

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Contact details

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Tel: 020 7492 2300

For general information about the work of the FRC, please see our website at http://www.frc.org.uk

For any further enquiries, please contact us at the above address.

© The Financial Reporting Council Limited 2011

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Registered Office: 5th Floor, Aldwych House, 71-91 Aldwych, London WC2B 4HN.


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Documents

Effective Company Stewardship - frc.org.uk