Speech by Stephen Haddrill at Ernst & Young's Financial Reporting Outlook Conference
News types: Speeches
Published: 5 November 2012
Find below the plain text version of Stephen Haddrill's speech at Ernst & Young's Financial Reporting Council on 5th November 2012.
"Good morning ladies and gentlemen. It is a privilege to be able to talk to you. My profound thanks go to E&Y for allowing me to do so.
I am planning to talk about our recent work at the FRC, including the changes to the Corporate Governance Code, and what we have in the pipeline. But first I want to say something about the kind of regulator we try to be and why we go about our job as we do. I hope that will give you a better idea of what we are trying to achieve.
Our mission is to promote high quality corporate governance and reporting to foster investment in the UK economy. We want investors to be able to trust what they are told by companies and trust how they are governed. We believe that this will encourage higher levels of investment by our fellow citizens and more investment coming into the UK from abroad.
We also believe that, armed with good quality information, investors will be better placed to decide which companies most deserve their money and so the efficiency of the markets in allocating capital will improve.
In addition, good governance enhances corporate performance. A good strong, well governed Board will be clear about its vision for the business and its strategy for achieving it. At the same time, it will manage risk effectively and be a good steward of the assets entrusted to it, all of which should enhance sustained profitability.
Now how do we go about achieving these goals? We have many tools – the Corporate Governance and Stewardship Codes and accounting, audit and actuarial standards. We monitor the quality of company accounts, we review the quality of audit and, if necessary, we can take action against those who do their job badly. These are all powerful interventions.
At the heart of our strategy is a profound belief that success depends on quality people on boards exercising great judgement, explaining that judgement and listening hard to their shareholders’ views. In short, great stewardship of investors’ money rests on sound, honest judgement.
Is such great stewardship alive and well in British boardrooms? Absolutely. Just look at how well most companies have come through the worst recession for eighty years. They have managed risk and remained well capitalised. They have helped maintain a relatively low level of unemployment. They have continued to innovate.
However, this is, of course, not the complete picture. Trust in business is in short supply. To a degree, this reflects a general loss of trust in institutions across society as a whole. But that said businesses have made some big mistakes, most notably the banks, but other companies too. And these mistakes were not in peripheral matters but were fundamental in poor understanding of matters at the core of the business; poor attention to the law; excessive compensation.
Against that background, what is our vision for restoring trust. And, in particular, reinforcing the right kind of business culture.
Everyone’s first instinct at the moment is to regulate. That is hardly surprising and in certain areas clearly necessary. We need new prudential rules in banking, for example. However, if we pause for a minute, we might reflect that more rules can only take us so far, and perhaps not very far at all in addressing weaknesses in culture and ethics. If the thousands of pages of the financial services rule book did not protect us in 2008, I question whether we can just place our faith in more and more rules restoring trust in future. There need to be other ingredients in the mix.
We need people of good judgement, openness and honesty in the driving seat of our companies; not compliance junkies. We want people of sound business ethics who will tell their shareholders clearly what they are trying to do and be accountable if it doesn’t go so well.
That’s the vision. How’s it to be done? What’s the strategy? What else, apart from the rules, goes into the mix?
First, we are committed working with business. As a regulator, we multiply our impact immeasurably if business understands and buys into our goals. That is why we work so closely with directors, investors and the professions. That is why we do not apologise for extensive consultation. Yes, we could sometimes organise it more efficiently, but I have no doubt of its need. It is a check on us from taking the easiest path, just writing more rules.
Over the last two years we have run a consultation called Effective Company Stewardship. This has been our vehicle for working out how to strengthen stewardship at every level in the chain of investment and so rebuild confidence.
The first conclusion of this work was that we have to harness the power of transparency through corporate reporting. We must recognise that corporate reporting has a dual purpose. Company reports and accounts make information available to investors. We all understand that. Less well recognised is the impact that the requirement to report has on the stewardship of the business. The preparation of the report provides a backbone to the preparation of other reports to shareholders. But most importantly it helps ensure that the right conversations are being held in the company.
The need for the directors to sign the annual report, including what it says about governance, risk and going concern, requires them to discuss and review these matters. So to those who say the annual report is irrelevant, that investors do not read it, I say you clearly do not get the fundamental role that reporting has in stewardship.
That does not mean that corporate reporting is doing its job well. We have allowed clutter and boilerplate blurb to obscure the messages of the report. That hinders investors. But the worst of it is that it encourages the unscrupulous in business to think that they can weasel their way out of open reporting through a cloud of obfuscation, weakening the check that openness has on behaviours. We were therefore pleased to hear the International Accounting Standards Board start to talk about the problems of clutter and I hope that now it has abandoned its goal of convergence with the US, it can also rediscover the importance of good stewardship and the role of reporting and accounts in fostering it.
We have also set up the Financial Reporting Lab to help companies enhance the quality of their reports and tackle clutter. I am pleased that Sue Harding, its director, has been invited to talk about its work later today.
Our recognition of the importance of transparency has led to some key changes to the Corporate Governance Code.
The Code now says that the Board should ensure that their report as a whole, and I stress as a whole, is fair, balanced and understandable. We want to bring an end to any part of the report being used to puff up the company without due regard to the quality of information. We also want the directors to judge the report against these three simple words: fair, balanced and understandable. It did not take long for the first lawyer to get on the phone and ask what guidance we were going to provide on what each word meant, to which our answer is simple: work it out. As I have said before, stewardship is about judgement, not being spoon-fed. A principles-based stewardship regime is tough work. It requires people to make up their own minds and take responsibility. That is its strength. The more guidance we provide, the more we emasculate our approach.
The Code has also been changed in relation to the audit committee’s report. Audit committees are now to provide shareholders with information on how they have carried out their responsibilities, including how they have assessed the effectiveness of the audit. We believe this will give investors greater insight into what the company is doing to promote their interests. We should like investors to take a deeper interest in audit issues and we hope the report will help them to engage.
We are separately asking auditors to report, by exception, whether the Board’s statement that the report is fair, balanced and understandable is consistent with the knowledge they have acquired in the course of the audit. In addition, if the audit committee does not report on materially significant matters the auditors has raised with them they, as auditors, must say so. Here again you can see the links between reporting and good governance. It will no doubt be rare for the auditor to have to raise concerns in the report, but the obligation to report if necessary should empower the auditor in their discussions with management and the audit committee and help ensure a proper review of shareholder interests.
Good governance depends on audit quality and the auditor’s judgement – that word again. Every company should therefore try to secure the best auditor it can. We believe the only way of establishing whether this has been achieved is through retendering of the audit contract. Even if the incumbent auditor wins the competition, our experience shows that there are still considerable benefits from retendering. The incumbent will look at the audit plan afresh and consider whether they are really committing the right resource.
Therefore, we have introduced into the code that FTSE 350 Companies should retender the audit at least once every ten years, subject to a comply or explain provision if circumstances justify a delay – perhaps if a merger is taking place for example.
There are risks with retendering. Audit fees get driven down and some suggest that could endanger audit quality. We are not blind to this risk and will specifically monitor the impact of retendering on quality, using our audit inspections to see that quality is being maintained.
In Brussels the European Commission has proposed compulsory rotation of the audit every six years, rather than retendering. In other words, the incumbent auditor has to go, however good a job they are doing. We do not support this because it reduces choice. In some sectors where only two or three major auditors operate, and where some may be providing non-audit services, it could reduce choice to zero. We commend the retendering route and urge the Commission not to go further. But what do you think? We have a question for you on this and look forward to seeing your response.
These changes to the Code will be further supported in the near future by work on going concern.
We shall issue for consultation our views on the work of the Sharman Inquiry into going concern by the end of the year. As many of you will be aware, the panel’s key recommendations included that the primary purpose of the going concern assessment and reporting should be to reinforce responsible behaviour in the management of going concern risks; that the going concern considerations made by directors and reviewed by auditors should cover both solvency and liquidity; and that these should be considered over the cycle, taking an appropriately prudent view of future prospects.
It also proposed that the going concern assessment is integrated with business planning and risk management and that investors should be given a fuller picture of the principal risks the entity is facing in pursuit of its business model rather than only highlighting going concern risks when there are significant doubts about the entity’s immediate survival. Again you see the link between reporting and stewardship and Lord Sharman’s wish to use that link to create more focus in the business on its longer term sustainability.
I am also delighted to say that last week the FRC approved the advice from its Accounting Council and will issue two new UK Financial Reporting Standards. These will introduce a new reduced disclosure framework allowing subsidiaries to prepare financial statements using the recognition and measurement requirements of IFRS but without the full disclosures of IFRS. This recognises that it is cost effective for a group to maintain accounting records using consistent accounting policies, but that the disclosure requirement in IFRS may not be proportionate for subsidiary accounts. We are issuing this shortly so that it will be available for use for December year ends. We anticipate our final third new standard will be issued in the New Year.
Now, finally, I want to turn to the monitoring and enforcement of the Code. The UK Code is based on the principle of complain or explain. ked about the balance of rules and transparency. We monitor the quality of corporate reports, of audit and of governance. We are promoting best practice in the quality of explanations when companies depart from corporate governance code. We do not, however, enforce the code. It rests on the principle of comply or explain and it is for investors to judge if they accept the explanation. This approach has served the UK well. Comply or explain reinforces the exercise of judgement rather than unthinking compliance. It has also enabled us to be more aspirational: companies have accepted change more readily knowing they have flexibility in adoption. So the UK has achieved annual election of directors, separation of the roles of Chairman and CEO and independent audit committees well ahead of other countries.
However, this approach depends on investors and their fund managers paying attention to what companies tell them. The fund management industry must play its full part in stewardship if we are to maintain our UK model. This means engaging with companies and exerting their influence. Some do this very well but not all are willing to invest the time. Through the Stewardship Code for fund managers we strongly encourage them to do so. We need a shareholder summer of sound steady constructive engagement to blossom in the wake of the shareholder spring.
The question that many ask, however, is whether our approach is right for banks. The FRC’s general policy is one of developing codes and standards and carrying out conduct activities in a way that applies across public interest entities regardless of sector. Should they have a separate code and their own accounting standards?
However, issues around responses to the financial crisis, in particular on banking, confront us with a challenge – to what extent, for the purposes of our work should banks be regarded differently? This conference is too good an opportunity to waste and we have a question for the audience on this.
Ladies and gentleman, thank you for the chance to talk to you today. Effective stewardship at every level of the investment chain, in companies, by auditors, in fund management houses is essential to the restoration of trust. We need a balance of judgement, transparency and regulation to achieve it, not a simplistic compliance mentality and certainly not the fungus of boilerplate. The changes to the Code are principles-based, they are about transparency driving performance, not rules and I hope your business will be able to pursue them in the spirit in which they are intended.
Thank you."
I am planning to talk about our recent work at the FRC, including the changes to the Corporate Governance Code, and what we have in the pipeline. But first I want to say something about the kind of regulator we try to be and why we go about our job as we do. I hope that will give you a better idea of what we are trying to achieve.
Our mission is to promote high quality corporate governance and reporting to foster investment in the UK economy. We want investors to be able to trust what they are told by companies and trust how they are governed. We believe that this will encourage higher levels of investment by our fellow citizens and more investment coming into the UK from abroad.
We also believe that, armed with good quality information, investors will be better placed to decide which companies most deserve their money and so the efficiency of the markets in allocating capital will improve.
In addition, good governance enhances corporate performance. A good strong, well governed Board will be clear about its vision for the business and its strategy for achieving it. At the same time, it will manage risk effectively and be a good steward of the assets entrusted to it, all of which should enhance sustained profitability.
Now how do we go about achieving these goals? We have many tools – the Corporate Governance and Stewardship Codes and accounting, audit and actuarial standards. We monitor the quality of company accounts, we review the quality of audit and, if necessary, we can take action against those who do their job badly. These are all powerful interventions.
At the heart of our strategy is a profound belief that success depends on quality people on boards exercising great judgement, explaining that judgement and listening hard to their shareholders’ views. In short, great stewardship of investors’ money rests on sound, honest judgement.
Is such great stewardship alive and well in British boardrooms? Absolutely. Just look at how well most companies have come through the worst recession for eighty years. They have managed risk and remained well capitalised. They have helped maintain a relatively low level of unemployment. They have continued to innovate.
However, this is, of course, not the complete picture. Trust in business is in short supply. To a degree, this reflects a general loss of trust in institutions across society as a whole. But that said businesses have made some big mistakes, most notably the banks, but other companies too. And these mistakes were not in peripheral matters but were fundamental in poor understanding of matters at the core of the business; poor attention to the law; excessive compensation.
Against that background, what is our vision for restoring trust. And, in particular, reinforcing the right kind of business culture.
Everyone’s first instinct at the moment is to regulate. That is hardly surprising and in certain areas clearly necessary. We need new prudential rules in banking, for example. However, if we pause for a minute, we might reflect that more rules can only take us so far, and perhaps not very far at all in addressing weaknesses in culture and ethics. If the thousands of pages of the financial services rule book did not protect us in 2008, I question whether we can just place our faith in more and more rules restoring trust in future. There need to be other ingredients in the mix.
We need people of good judgement, openness and honesty in the driving seat of our companies; not compliance junkies. We want people of sound business ethics who will tell their shareholders clearly what they are trying to do and be accountable if it doesn’t go so well.
That’s the vision. How’s it to be done? What’s the strategy? What else, apart from the rules, goes into the mix?
First, we are committed working with business. As a regulator, we multiply our impact immeasurably if business understands and buys into our goals. That is why we work so closely with directors, investors and the professions. That is why we do not apologise for extensive consultation. Yes, we could sometimes organise it more efficiently, but I have no doubt of its need. It is a check on us from taking the easiest path, just writing more rules.
Over the last two years we have run a consultation called Effective Company Stewardship. This has been our vehicle for working out how to strengthen stewardship at every level in the chain of investment and so rebuild confidence.
The first conclusion of this work was that we have to harness the power of transparency through corporate reporting. We must recognise that corporate reporting has a dual purpose. Company reports and accounts make information available to investors. We all understand that. Less well recognised is the impact that the requirement to report has on the stewardship of the business. The preparation of the report provides a backbone to the preparation of other reports to shareholders. But most importantly it helps ensure that the right conversations are being held in the company.
The need for the directors to sign the annual report, including what it says about governance, risk and going concern, requires them to discuss and review these matters. So to those who say the annual report is irrelevant, that investors do not read it, I say you clearly do not get the fundamental role that reporting has in stewardship.
That does not mean that corporate reporting is doing its job well. We have allowed clutter and boilerplate blurb to obscure the messages of the report. That hinders investors. But the worst of it is that it encourages the unscrupulous in business to think that they can weasel their way out of open reporting through a cloud of obfuscation, weakening the check that openness has on behaviours. We were therefore pleased to hear the International Accounting Standards Board start to talk about the problems of clutter and I hope that now it has abandoned its goal of convergence with the US, it can also rediscover the importance of good stewardship and the role of reporting and accounts in fostering it.
We have also set up the Financial Reporting Lab to help companies enhance the quality of their reports and tackle clutter. I am pleased that Sue Harding, its director, has been invited to talk about its work later today.
Our recognition of the importance of transparency has led to some key changes to the Corporate Governance Code.
The Code now says that the Board should ensure that their report as a whole, and I stress as a whole, is fair, balanced and understandable. We want to bring an end to any part of the report being used to puff up the company without due regard to the quality of information. We also want the directors to judge the report against these three simple words: fair, balanced and understandable. It did not take long for the first lawyer to get on the phone and ask what guidance we were going to provide on what each word meant, to which our answer is simple: work it out. As I have said before, stewardship is about judgement, not being spoon-fed. A principles-based stewardship regime is tough work. It requires people to make up their own minds and take responsibility. That is its strength. The more guidance we provide, the more we emasculate our approach.
The Code has also been changed in relation to the audit committee’s report. Audit committees are now to provide shareholders with information on how they have carried out their responsibilities, including how they have assessed the effectiveness of the audit. We believe this will give investors greater insight into what the company is doing to promote their interests. We should like investors to take a deeper interest in audit issues and we hope the report will help them to engage.
We are separately asking auditors to report, by exception, whether the Board’s statement that the report is fair, balanced and understandable is consistent with the knowledge they have acquired in the course of the audit. In addition, if the audit committee does not report on materially significant matters the auditors has raised with them they, as auditors, must say so. Here again you can see the links between reporting and good governance. It will no doubt be rare for the auditor to have to raise concerns in the report, but the obligation to report if necessary should empower the auditor in their discussions with management and the audit committee and help ensure a proper review of shareholder interests.
Good governance depends on audit quality and the auditor’s judgement – that word again. Every company should therefore try to secure the best auditor it can. We believe the only way of establishing whether this has been achieved is through retendering of the audit contract. Even if the incumbent auditor wins the competition, our experience shows that there are still considerable benefits from retendering. The incumbent will look at the audit plan afresh and consider whether they are really committing the right resource.
Therefore, we have introduced into the code that FTSE 350 Companies should retender the audit at least once every ten years, subject to a comply or explain provision if circumstances justify a delay – perhaps if a merger is taking place for example.
There are risks with retendering. Audit fees get driven down and some suggest that could endanger audit quality. We are not blind to this risk and will specifically monitor the impact of retendering on quality, using our audit inspections to see that quality is being maintained.
In Brussels the European Commission has proposed compulsory rotation of the audit every six years, rather than retendering. In other words, the incumbent auditor has to go, however good a job they are doing. We do not support this because it reduces choice. In some sectors where only two or three major auditors operate, and where some may be providing non-audit services, it could reduce choice to zero. We commend the retendering route and urge the Commission not to go further. But what do you think? We have a question for you on this and look forward to seeing your response.
These changes to the Code will be further supported in the near future by work on going concern.
We shall issue for consultation our views on the work of the Sharman Inquiry into going concern by the end of the year. As many of you will be aware, the panel’s key recommendations included that the primary purpose of the going concern assessment and reporting should be to reinforce responsible behaviour in the management of going concern risks; that the going concern considerations made by directors and reviewed by auditors should cover both solvency and liquidity; and that these should be considered over the cycle, taking an appropriately prudent view of future prospects.
It also proposed that the going concern assessment is integrated with business planning and risk management and that investors should be given a fuller picture of the principal risks the entity is facing in pursuit of its business model rather than only highlighting going concern risks when there are significant doubts about the entity’s immediate survival. Again you see the link between reporting and stewardship and Lord Sharman’s wish to use that link to create more focus in the business on its longer term sustainability.
I am also delighted to say that last week the FRC approved the advice from its Accounting Council and will issue two new UK Financial Reporting Standards. These will introduce a new reduced disclosure framework allowing subsidiaries to prepare financial statements using the recognition and measurement requirements of IFRS but without the full disclosures of IFRS. This recognises that it is cost effective for a group to maintain accounting records using consistent accounting policies, but that the disclosure requirement in IFRS may not be proportionate for subsidiary accounts. We are issuing this shortly so that it will be available for use for December year ends. We anticipate our final third new standard will be issued in the New Year.
Now, finally, I want to turn to the monitoring and enforcement of the Code. The UK Code is based on the principle of complain or explain. ked about the balance of rules and transparency. We monitor the quality of corporate reports, of audit and of governance. We are promoting best practice in the quality of explanations when companies depart from corporate governance code. We do not, however, enforce the code. It rests on the principle of comply or explain and it is for investors to judge if they accept the explanation. This approach has served the UK well. Comply or explain reinforces the exercise of judgement rather than unthinking compliance. It has also enabled us to be more aspirational: companies have accepted change more readily knowing they have flexibility in adoption. So the UK has achieved annual election of directors, separation of the roles of Chairman and CEO and independent audit committees well ahead of other countries.
However, this approach depends on investors and their fund managers paying attention to what companies tell them. The fund management industry must play its full part in stewardship if we are to maintain our UK model. This means engaging with companies and exerting their influence. Some do this very well but not all are willing to invest the time. Through the Stewardship Code for fund managers we strongly encourage them to do so. We need a shareholder summer of sound steady constructive engagement to blossom in the wake of the shareholder spring.
The question that many ask, however, is whether our approach is right for banks. The FRC’s general policy is one of developing codes and standards and carrying out conduct activities in a way that applies across public interest entities regardless of sector. Should they have a separate code and their own accounting standards?
However, issues around responses to the financial crisis, in particular on banking, confront us with a challenge – to what extent, for the purposes of our work should banks be regarded differently? This conference is too good an opportunity to waste and we have a question for the audience on this.
Ladies and gentleman, thank you for the chance to talk to you today. Effective stewardship at every level of the investment chain, in companies, by auditors, in fund management houses is essential to the restoration of trust. We need a balance of judgement, transparency and regulation to achieve it, not a simplistic compliance mentality and certainly not the fungus of boilerplate. The changes to the Code are principles-based, they are about transparency driving performance, not rules and I hope your business will be able to pursue them in the spirit in which they are intended.
Thank you."