Statutory Auditors (Amendment of Companies Act 2006 and Delegation of Functions etc.) Order 2012

Lord Young of Norwood Green Excerpts

Monday 25th June 2012 Grand Committee

[Baroness Hogg]

My Lords, as chairman of the Financial Reporting Council, I thank the Minister very much for pursuing these reforms, which, as she has said, and this has been reinforced, were largely stimulated by an important report by a Select Committee of this House on its inquiry into the audit profession. These changes will enable us to break down some of the silos within the existing regulatory structure of seven operating bodies to which the Minister rightly referred. We need to be able to share knowledge across the organisation in order to operate more effectively, both in our conduct role in the UK and in the international debate on codes and standards, which has been so rightly pointed out. An example of the issues here is that the point is not just the forum in which the international financial reporting standards are set but the process for implementation, because a number of important changes are due to take place to elements of the IFRS, of great importance in respect of banks, that it falls to the European Commission to implement. At the moment, the Commission is taking the view that it does not wish to implement until all amendments have been concluded, but we are urging the Commission to get on with this because we think that some important changes are needed.

If I may help the Minister to respond on the appointment issue that has been much discussed, as the Minister is aware, I, as chairman of the FRC, am appointed by the Secretary of State, as is the deputy chairman. We then appoint the executive team. We have taken the view with these changes that there needs to be some outside input into the process for appointing other members of the board. In much the same way, we are adopting the practice that is common for many public appointments now of appointing an outside assessor to review the way in which we consider appointments to the council and are involved in the nominations process. There is no change in any of this with the change in the regulatory structure, but we thought it right to raise our game in this area and discuss this with the department, and we are putting those arrangements in place.

The changes before the Committee today are to enable us to determine and impose proportionate sanctions for poor quality audits and expedite action by the recognised bodies where we have identified areas for improvement. This enables us to cut across the different bodies in order to put in place inquiries regarding codes, standards and performance. For example, I draw the Committee’s attention to the inquiry that we launched under the noble Lord, Lord Sharman, to look at the issue of going concern, which is the critical issue that came to the fore in the discussions over where the auditors were in relation to bank auditing during the financial crisis. The Committee may have noted the publication of this report very recently.

We see the reforms very much as a beginning rather than an end in themselves. We hope that the consultation will be a start of a deeper and wider relationship with our stakeholders, not just in the profession but, very importantly, within it, and we hope that we will help other regulators and other interests to identify and address the challenges facing all those responsible for corporate governance and reporting in the UK. I thank the Minister very much for bringing the reforms forward.

[Lord Young of Norwood Green]

My Lords, I, too, thank the Minister for her introduction to the statutory instrument. As we on the opposition Benches have argued for some time, we need a better and more responsible capitalism that better serves the people of this country.

That is why this side of the Committee supports the role of the Financial Reporting Council in promoting high standards of corporate reporting and governance in the UK which, as I think the Minister will recognise, we strengthened in 2004 through the Companies (Audit, Investigations and Community Enterprise) Act following major global corporate collapses such as that of Enron. With business rightly under particular scrutiny, the FRC’s work is more important than ever. The noble Lord, Lord Flight, stressed the importance of these changes and rightly asked where the auditors were during the financial crash. There are those who suggest that they were perhaps too close to the companies that they audited. I would welcome the Minister’s view on that.

Despite what I have just said, corporate reporting and governance in the UK are widely recognised domestically and internationally as being of a very high standard. The FRC’s integrated and market-led approach to regulation underpins these standards. We know that this approach continues to receive strong support from companies, investors, the accountancy profession and other stakeholders. The Minister may know that my honourable friend the Member for Hartlepool, following his line of questioning to the likes of Sir David Walker in the Enterprise and Regulatory Reform Bill Committee, has said that he is keen for the UK to maintain its undoubted place as the best country in the world for high quality corporate governance. Inward investment and the location of multinational firms here in the UK flow to some extent from the high-quality and stable regulatory corporate governance and auditing framework we have here. We cannot be complacent on this matter, as noble Lords have already said, and must ensure that it stays best in class.

The FRC should be central in ensuring good remuneration practice and shareholder activism so that it remains in the spotlight. That is why the shadow Business Secretary, Chuka Umunna, has called on the Government to make provision for the FRC to produce an annual report on the state of corporate governance in Britain. This would ensure that shareholder activism, good pay and remuneration practice were kept high on the national agenda. I would welcome the Minister’s views on that.

While we welcome today’s measures, it is disappointing that the Government are watering down their corporate governance measures as contained in the Enterprise and Regulatory Reform Bill with a climbdown on the proposal for annual binding shareholder votes on executive pay. On its own, this measure would not have been sufficient and would not have solved the issue of excessive director’s remuneration, but it would have been a step in the right direction.

I have a number of questions for the Minister. Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales, has been cautious about the proposed changes. He said recently:

“It is important for the FRC and the government to recognise that there might be a lot of people hoping that this new structure is effective but want it to be proved”.

That is not exactly a ringing endorsement from a key player in the accountancy profession. What evidence can the Minister provide to reassure those who have expressed concern about the new measures?

Page 17 of the impact assessment states:

“The primary focus for FRC regulation should be publicly traded and large private companies (defined as those with a turnover of £500m or more)”.

This is probably a naive question, because it is not an area in which I profess to be a great expert, but why was the limit set at £500 million or more? An awful of lot companies have turnovers just below that, so I would be interested to hear the Minister’s view.

With the FRC’s six standard-setting boards streamlined to two, the Accounting Standards Board will no longer exist. How will the Minister ensure that responsibility for ensuring the effective implementation of international financial reporting standards is maintained? Why will the reforms be reviewed only in three years? That seems a long time. Will there be any proposal for an interim review—let us say at two years, when I would think there would be quite a large body of evidence?

Given the importance of these changes, which has been stressed, I would have thought that would be worth while. Again, I would welcome that. Looking at the post-implementation review plan, under “Basis of review” it states:

“As part of its commitment to the principles of good regulation, the FRC is committed to reviewing the proposals in this reform package to ensure that they meet their objectives at a reduced overall cost to business”.

I do not cavil at reducing the cost to business; I understand that. However, I would tack on to the end of that, “while maintaining the quality of audit and independence”. I am sure that is what will happen, but when we are talking about the basis of the review, it seems to me that that ought to be on the top line, given the concerns we have expressed and not buried somewhere else in the post-implementation review plan.

The FRC’s inspection of accountancy firms earlier this year found that 10% of the audits sampled fell into the lowest category, with “significant concerns” raised, leaving the rate of improvement in auditing standards too slow in the aftermath of the financial crisis. Looking at the comment on page 23 of the Explanatory Memorandum, the situation really is quite disturbing. It states:

“Evidence from the Audit Inspection Unit shows that although standards of auditing in the UK are generally good there are areas for improvement. Of the 11 audits (13.5%) requiring significant improvements in 2010/11, six were listed or AIM companies and the audits of three unlisted subsidiaries of overseas banks (out of 10 bank and building society audits reviewed) were assessed as requiring significant improvements”.

I think that is quite a worrying comment, so once again I would welcome the Minister’s views.

Will today’s proposals make it easier for the FRC—[Interruption.] Someone has forgotten to turn their mobile to silent. We have all done it. Will today’s proposals make it easier, as the Government’s consultation paper has stated, for the FRC to,

“ensure it has the powers to respond proportionately and effectively where problems are identified”?

Page 27 of the Explanatory Memorandum says:

“The FRC estimates that the ability to resolve cases without going to tribunal will save the cost of 3 tribunals over the 10 year policy period”.

Again, I do not argue that that should not be done. I just want to add, “as long as we are confident that the quality of the investigation will not in any way deteriorate as a result of that change”. It makes me think back to the review process, which was perhaps shorter than the three-year proposed period.

What consideration has the Minister given to the Institute of Chartered Accountants in England and Wales Audit Quality Forum in pulling together these proposals? The forum has been in existence since 2004, tasked with promoting quality and confidence in the audit function. What specifically has the Minister taken from the forum’s work in drafting these proposals?

On a European dimension—and I certainly concur with what the noble Baroness, Lady Hogg, said—how does the proposal considered today fit in with the broader question currently taking place in the Commission regarding the future of audit and the condition of the audit market? What is the Government’s policy on some of the proposals coming out of the Commission, such as mandatory rotation of audit firms—which relates to the question of independence—mandatory tendering and the separation of audit from non-audit services?

While we are on the subject of Europe, are the Government satisfied that there is no risk that the new sanction powers proposed for exercise by the FRC will be subject to challenge from the European courts? What legal advice has the Minister taken with regards to this? I have read the impact assessment and see that the Government have downgraded the benefits provided by these proposals in the face of additional scrutiny from stakeholders. Has the Minister ensured that none of the measures proposed in today’s statutory instrument will inhibit investment and possible growth?

As we know, the FRC is connected to the capital markets, and capital-raising forms a part of this. Has an assessment of the efficiency of capital markets been made? Will the Minister act upon the demands of my honourable friend the Member for Streatham in the other place and get the Financial Reporting Council to produce an annual report on the state of corporate governance in Britain? Can the Minister confirm that the statutory requirement to publish business plans will not impede the existing flexible arrangements between the FRC and recognised supervisory bodies, which allow the flow of confidential information between the bodies? Is the Minister satisfied that the FRC is abiding by its own good governance guidelines—in particular, applying lay membership to its own oversight committees and ensuring independence in this regard from the operations of the body? Has the Minister seen any examples to date of the recognised supervisory bodies failing to exercise sanctions that fell short of what the FRC/BIS would have preferred to be applied?

I think that I have given the Minister enough to cogitate upon. I apologise for the number of questions but I concur with the noble Lord, Lord Flight, that this is a fundamentally important change. Given the problems resulting from the financial crisis and the eternal question, “Where were the auditors?”, I think that my questions are merited. I shall quite understand if the noble Baroness cannot answer every single one of them but I hope that I shall receive something in writing in due course.

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[Baroness Wilcox]

I thank noble Lords very much for the exchanges that we have had. I thank the noble Baroness, Lady Hogg, for being here today—I am delighted about that. She seems to have answered several questions for me, which is an enormous help. Of course, there are many questions to answer. This is a very big and wide area, and it affects so many different organisations that it is right that I should receive more questions than I can answer at the moment. However, I shall endeavour to answer some of them. In talking about appointment issues and so on, the noble Baroness, Lady Hogg, has more than likely provided answers but I shall try to respond to some of the questions from my noble friend Lord Flight.

I think that he asked who appoints the senior executives—a point that I think the noble Baroness, Lady Hogg, answered. The FRC is a company overseen by its board and it will appoint its senior executives in line with the best human resources practices. The additional points made by the noble Baroness were very useful and she gave a better answer than mine.

The Accounting Standards Board sets standards for financial reporting and has regard to best practice. This includes reference to international developments—the IFRS—as well as responding to developments and thinking in the United Kingdom. The use of international accounting standards is subject to EU approval, as always. The adoption of international standards, and amendments to those standards, follows consultation with the member states, and the FRC and the UK work closely with the EU and the IASB to influence these wherever they can.

My noble friend Lord Flight asked who the FRC will be accountable to following the reforms. The FRC will continue to be accountable to government and ultimately to Parliament in relation to the exercise of its statutory powers, and it will also be accountable to the key stakeholders, including the investor community, which relies on the quality of corporate governance and reporting in the United Kingdom. The FRC will report annually to the Secretary of State on the exercise of its powers.

My noble friend Lord Flight and the noble Lord, Lord Young, asked where the auditors were during the financial crisis. When considering financial institutions, it is important to note that the primary regulator of those institutions which was most prominent during the financial crisis was the Financial Services Authority and not the FRC. The FRC works closely with the Financial Services Authority with a view to ensuring that regulatory action is taken where appropriate. We believe that the changes to the FRC’s structure will enable it to bring its full resources to address any emerging problem much more quickly and effectively than was done at that time.

The financial crisis has been looked at, as we heard, by the House of Lords Economic Affairs Committee. Although it raised a number of issues relating to auditing, some of which are addressed by these measures, the Government do not take the view that these issues were at the heart of the crisis. The “going concern” issues mentioned by the noble Baroness, Lady Hogg, are important, but there were also failures of prudential regulation. If I have missed anything from those questions, it will of course be picked up by the sturdy band behind me, who have been frantically trying to answer all these questions.

Thankfully, the noble Lord, Lord Young, welcomed this measure before setting off with a flurry of questions, all of them right and relevant. I shall try to answer a few for the moment and then, if it is all right, I will reply in writing. Why is the FRC jettisoning the tried and tested ASB/APB brands, and what effect will this have on the FRC’s capability to influence at an international level? International influencing is a central objective of the FRC. The Government and the FRC recognise the contribution that the FRC’s standard-setting bodies have made, while remaining convinced that the changes proposed are needed to strengthen the UK voice. In the new structure the FRC should be better equipped to tackle the most strategic issues and to provide high-quality thought leadership, as well as continuing to develop excellent technical solutions. Standard-setting is increasingly debated in the United Kingdom, in the European Union and internationally in fora that cover a wide range of issues. The FRC needs to exert influence accordingly in these areas. The FRC board has the experience, the seniority and hopefully, through the new structure that we propose, the authority to do that.

On the question from the noble Lord, Lord Young, on auditors’ independence, the Government and the FRC acted in the wake of the crisis to improve transparency. Furthermore, proposals are now being considered in Europe on this very question. The noble Lord also asked about reporting on corporate governance. The FRC is required to make an annual report on its activities, and that report is laid in Parliament.

[Lord Young of Norwood Green]

Will that include corporate governance?

[Baroness Wilcox]

A quick nod from the Box, or a quick “We will write to you”?