Corporate governance changes

In May 2023 the Financial Reporting Council (FRC) launched a public consultation on proposed revisions to the UK Corporate Governance Code (the Code), the first changes to the Code since 2018. Its aim is to increase the Code’s effectiveness in promoting good corporate governance.

The Code is an effective driver of good governance in those companies that adopt it, either as a requirement of the Listing Rules or because they choose to do so voluntarily. The consultation sets out important proposals, signposting the future direction of travel for UK corporate governance. Accountants need to be aware of them.

Scope

The FRC describes this as a ‘limited revision’ to the Code. Unlike the wide-ranging review in 2018, there are no planned changes to its structure. The five existing sections will remain, with section 4 (audit, risk and internal control) subject to greatest revision. The Code’s hallmark of having principles that companies must apply, supported by provisions to which a ‘comply or explain’ approach is taken, continues.

The proposals are significant, despite their limited scope. They represent the latest step in the government’s reform programme designed to restore trust in big business. The prime area of focus is the internal control framework, which is highly relevant for accountants.

Internal control

Following consultation on ‘Restoring trust in audit and corporate governance’ in 2022, the government’s response to the Department for Business, Energy and Industrial Strategy (BEIS) white paper invited the FRC to amend the Code by strengthening board accountability for and reporting on internal controls.

Rather than introducing a legislative requirement (as in the US with the Sarbanes-Oxley Act), the government recommended a Code-based approach as being both more appropriate and proportionate. The FRC responded positively in its position paper last year and these proposals are the outcome.

The ultimate aim is to strengthen board accountability. The FRC proposes setting out a revised Code framework of prudent and effective controls, providing a stronger basis for reporting on and evidencing their effectiveness. This revised approach provides greater disclosure, confirming that the board has put in place and maintains effective systems that deliver the expected outcomes.

Impact on Section 4

The proposals will impact section 4 in a number of ways.

The overarching Code principle here (currently principle O) will be changed to reflect the new emphasis that the board should ‘establish and maintain’ an effective risk management and internal control framework.

The current provision already addresses the board’s responsibility to monitor the effectiveness of the risk and internal control systems, including all material controls – financial, operational and compliance. A review should be conducted at least annually, although the results do not have to be disclosed.

The FRC proposes the following enhanced disclosures in the annual report:

• a declaration of whether the board can reasonably conclude that the company’s risk management and internal control systems have been effective throughout
• an explanation of the basis for its declaration, including how it has monitored and reviewed the effectiveness of these systems
• a description of any material weaknesses or failures identified and the remedial action taken.

Regarding the scope of the provision, the FRC proposes replacing the current reference to ‘financial’ controls with a reference to ‘reporting’ controls. This reflects the importance to investors of narrative reporting information provided in the annual report (eg on strategy, principal risks and ESG matters).

In addition to internal controls, there are four other areas of focus in the consultation.

Leadership on ESG

The FRC is proposing revising the Code to reflect the wider responsibilities of the board and audit committee for sustainability and ESG reporting and, where commissioned by the company, appropriate assurance in accordance with a company’s audit and assurance policy.

Rather than recommending new sustainability committees, the FRC believes that the audit committee is best positioned to oversee ESG disclosures, controls, processes and assurance. The proposals give the audit committee a new responsibility for monitoring the integrity of narrative reporting, including sustainability reporting and ESG metrics and for describing its work in this area in the annual report.

Audit committee standard

A new standard for audit committees was issued in May 2023: Audit Committees and the External Audit: Minimum Standard. This sets out minimum standards for the appointment and oversight of auditors. Many current audit committee responsibilities and reporting obligations mirror those in the new standard. These will be removed from the Code to avoid duplication, with the new Code instead simply referring companies to the standard.

Comply or explain

The FRC aims to improve the functioning of comply or explain reporting through the introduction of a new principle in section 1. The focus in future will be on outcome-based reporting, moving from boilerplate statements in the annual report to delivering greater transparency on the outcomes of governance activities to benefit investors.

Aligning with regulation

The FRC has used the consultation to align the Code with the requirements of the government’s response to the white paper. This includes providing greater transparency around companies’ malus and clawback arrangements for directors engaging in misconduct, or other serious failings, through new provisions in section 5.

Overall, the proposed revisions have been welcomed in working towards the FRC’s stated goal to ‘meet the needs of all corporate stakeholders, including investors, employees and suppliers, and boost the resilience of the UK economy, ensuring it continues to attract talent and investment’.