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Session 2003 - 04
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Standing Committee Debates
Companies (Audit, Investigations and Community Enterprise Bill [Lords]

Companies (Audit, Investigations and Community Enterprise Bill [Lords]

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Standing Committee A

Tuesday 14 September 2004


[David Taylor in the Chair]

Companies (Audit, Investigations and Community Enterprise) Bill [Lords]

2.30 pm

Clause 1 ordered to stand part of the Bill.

Clause 2

Arrangements to which additional

requirements for recognition relate

Mr. Andrew Mitchell (Sutton Coldfield) (Con): I beg to move amendment No. 4, in

    clause 2, page 3, line 32, after 'of', insert 'qualifying companies'.

The Chairman: With this it will be convenient to discuss the following amendments: No. 5, in

    clause 2, page 3, line 33, leave out paragraphs (a) and (b).

No. 7, in

    clause 2, page 3, line 33, leave out from 'securities' to 'or' in line 36 and insert

    'are a constituent of the FTSE-Actuaries 350 share index'.

No. 6, in

    clause 2, page 3, line 38, at end insert—

    '(3) Regulations may provide for what companies are qualifying companies both generally by description and, if the Secretary of State considers that there is a major public interest in the financial condition of a specified company, by reference to such specified company.'.

Mr. Mitchell: May I welcome you to the Chair, Mr. Taylor? We made a significant start this morning under your co-Chairman Mr. Conway. Although I was dismayed that none of the galaxy of proposals that I presented to the Minister found immediate favour with her, I sensed a willingness to look further at the terms of at least one of them. So, with a spirit of hope, I turn to the first of the four issues that, according to the order of consideration, we can discuss in detail this afternoon.

The purpose of the amendments is to alter the definition of a major audit. Major audits—in other words, those that call for independent monitoring—are those of listed companies and of companies chosen by the supervisory body as being of public interest. The amendments would empower the Secretary of State to make regulations on which company audits were major audits. In the spirit of generosity that characterised this morning's sitting, I have also tabled amendment No. 7, thereby giving the Government a choice—we are, after all, the party of choice—on which amendment to accept.

Whenever legislation imposes a new burden on industry, and however urgent the problem that the legislation is designed to tackle, it is essential that the most careful consideration be given to whether the burden is minimised. Alas, the proposals in the Bill, which provide for independent monitoring of audits of

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major companies, show no sign whatever of such careful consideration.

On Second Reading, I drew the House's attention to Anatole Kaletsky's series of articles on the burdens that British business and industry face and pointed out that thanks to a number of reforms—carried out by the last Conservative Government and by this Government—British businesses have done well compared with other European countries' businesses. However, although high tax was previously the major danger to British prosperity, it is now the high level of regulation. It is in that spirit that I consider the clause and propose the amendment.

We accept that there is a case for independent monitoring of certain more significant company audits. We agree with the Government that the relevant supervisory body should have responsibility for ensuring that its rules provide for such independent monitoring. At present, the proposal is that that independent monitoring should be a necessity in the case of major audits, by which is meant, according to the Bill, audits of listed companies and certain other companies

    ''in whose financial condition there is a major public interest.''

On this side of the Committee, we have concerns with both legs of the proposed definition of a major audit. We understand from the proposals that the Government accept that independent monitoring should be a requirement only in the case of larger companies or companies of some public importance. How, then, has the limitation to listed companies been chosen? On the simplistic basis expressed by Lord Evans of Temple Guiting in the Grand Committee, it appears:

    ''Audits of listed companies are, by nature of their listing, considered to be major.''—[Official Report, House of Lords, 16 March 2004; Vol. 659, c. GC29.]

I hope that that was not the thinking. If it was, I can say only that industry deserves that greater analysis and thought be applied in the preparation of such legislation.

There are some 1,200 listed companies, in many of which significant public involvement is limited. The mere fact that a company is listed is not enough to justify the imposition of further and additional regulation. Such an additional burden can be justified only where there is a real and significant public interest, not a notional one.

There are two main considerations. First, general investors should be able to have confidence in the audits of the companies in which they invest. Secondly, the economy as a whole should not be at risk from damage caused by a major corporate failure. Those are the two key issues; both call for added regulation to affect only the larger and more significant companies.

With regard to the first consideration, it is undoubtedly the case that the vast bulk of investment lies in a relatively small proportion of listed companies. That small number contains the large companies that make up the vast bulk of the market in value terms. It might be added that the investors in the smaller listed companies tend to be the

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professional, more experienced investors, who are usually well able to look after themselves.

As regards the second consideration, it is obvious that there is no great public interest or concern with small companies. The risk to the economy from the failure of companies with a market capitalisation of just a few hundred million pounds is small. It seems to Conservative Members that there is no great imperative for the independent monitoring of the audits of smaller companies, even if they are listed. Why are the Government proposing to impose on industry the cost of such independent monitoring? I hope the Minister will explain in detail or agree to my amendment.

The amendments would empower the Secretary of State to set out in regulations a more sensible and realistic benchmark for the independent monitoring requirement than the mere fact of being listed. The proposed listing benchmark has the merit of certainty and clarity, which we acknowledge, but it catches unnecessarily small fish in its net. If we allowed regulations to set the benchmark, the net's mesh could be set more carefully. In particular, there would be the merit of flexibility. The size of the mesh could be changed without the necessity of primary legislation.

Our initial suggestion is that the benchmark could be membership of the FTSE 350, or a similar index, at the beginning of the company's relevant accounting period. That would get round a fact that sharper-eyed members of the Committee may have already worked out: the composition of the FTSE 350 tends to change during the course of the year. Such a provision would catch some 96 per cent. of the whole market capitalisation, but would also release from the burden of the new measures some 700 or 800 companies. It would also significantly reduce the overall cost of the exercise.

The second limb of the Government's definition of major audit refers to

    ''a company in whose financial condition there is a major public interest.''

Again, we do not challenge the principle behind the proposal. Important companies may fall outside any general benchmarks set in regulations. Who, however, is to decide which those companies are, and how? It appears that it will be some supervisory body, but is it the role of such bodies to decide where a major public interest exists? Has anyone asked the existing supervisory bodies whether they feel qualified to decide such a question? Will the Minister enlighten us on that point?

What is more, what happens if a company wants to dispute a designation that its audit is a ''major audit''? Surely it is fair that it should be entitled to do so. Is it really the job of a body such as the Institute of Chartered Accountants in England and Wales to hold hearings on whether a major public interest exists? Indeed, there may be another problem if there is more than one supervisory body. Two such bodies might reach different conclusions on such a question of public interest. That would be undesirable in principle

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and might even lead to auditors preferring one supervisory body to another, or a company preferring one auditor to another merely because of its regulator.

Our proposal is that the body that decides whether a company's audit is a major audit on public interest grounds should be the party that is entrusted in this country, subject to the supervision of the courts, with the task of identifying where the public interest lies—namely, the Government. Our proposals to amend clause 2 would ensure that attention and resources are focused on areas in which an audit failure is likely to have the most significant adverse effects on the economy and the public. They would do that while minimising the burden on industry, which the Opposition regard as extremely important.

2.45 pm

The Minister for Industry and the Regions (Jacqui Smith): Welcome to the Chair, Mr. Taylor. We had a stimulating debate this morning, and I hope that we will continue in that vein this afternoon. It is certainly a pleasure to serve under your chairmanship for the first time.

We dealt with the new clauses this morning, and now move to the part of the Bill that aims specifically at improving the independence of standard-setting, monitoring and disciplinary arrangements, especially for audit. This is very much at the heart of what we have described as a post-Enron Bill and of what will be necessary to ensure, as I suggested on Second Reading, that we can all continue to have trust—whether as consumers, investors or suppliers—in corporate Britain. That trust is, after all, so important for the wealth-producing activities for which those businesses are responsible.

Our actions are the result of considerable discussion with stakeholders and a considerable amount of review of the position on auditing and accountancy in particular. When we reviewed the regulation of the auditing and accountancy professions in late 2002, we found no evidence that the UK's regulatory system was fundamentally flawed, but we did discover concerns about the perceived independence of key aspects of the system. We therefore concluded that independent regulation and review of audit should be strengthened. That, of course, came on top of other actions—some of which are non-legislative, some of which are in the Bill—to improve the position on audit in this post-Enron era.

We touched on some of those actions on Second Reading, but to set the context for this part of the Bill, it is worth reminding members of the Committee that so far as the non-legislative measures to improve audit are concerned we have already seen the development of much tougher ethical standards on auditor independence and objectivity, and more frequent rotation of audit partners, which is now every five years.

We are also seeing a longer cooling-off period before an auditor can be employed by a client. Those developments demonstrate the emphasis on ensuring the suitable distinction between the audit activity and the business being audited. We have also seen a focus

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in audit firms on greater transparency in their annual accounts, and we have considered the measure from the point of view of the company requesting the audit, with a much stronger role for a company's audit committee, formalised in a revised, combined code.

On top of that, the Financial Reporting Council has been restructured and strengthened. It will be at the centre of the independent elements of standard setting, monitoring and investigation and discipline to which the proposals relate. In particular, responsibility for fulfilling the requirements will be transferred to it. Further, there is the action that I shall mention shortly in relation to clauses 1 and 2.

Later in the Bill, in clause 7, there is the power to require companies to publish more information about the services that they receive from their auditors. In clause 8, there is a stronger power for auditors to require information and explanations from a wider group of people, while in clause 9 there is provision for a statement in a directors' report on the disclosure of information to auditors.

Having concluded that there was no fundamental problem in the regulatory regime, we were clear that there was a need to improve the independence of key aspects of the system. The provisions of clauses 1 and 2, and those that the hon. Member for Sutton Coldfield (Mr. Mitchell) is attacking with his amendments, are part of the action necessary to ensure that independence. The position is that, subject to the provisions of clauses 1 and 2, for a professional accountancy body to be recognised as a supervisory body for auditors, it must comply with the requirements of schedule 11 to the Companies Act 1989. Those requirements cover both the rules that the body must have in place on people's eligibility to be company auditors and the conduct of company audit work.

Clause 1 inserts additional requirements in schedule 11. It requires recognised supervisory bodies to participate in independent arrangements, demonstrating the Bill's emphasis on independence. It also sets audit standards in relation to both technical and ethical matters that relate to the integrity and independence of auditors—covered by the functions of the Auditing Practices Board—and, touching on the amendments, to the monitoring of audits of listed and other major companies, as well as to independent arrangements for investigating and disciplining auditors in relation to public interest cases.

The additional requirements introduced by the clauses represent an important strengthening of the independence of the regulatory regime for auditors, especially in the areas in which an audit failure is likely to have the most significant adverse impact on the economy. The result will be stronger, more independent and more effective regulation.

Clause 2 in particular describes the key features of the arrangements in which supervisory bodies for auditors must participate to satisfy the new requirements for recognition introduced in clause 1. Those supervisory bodies include the ICAEW, the Institute of Chartered Accountants of Scotland, which the hon. Member for Tweeddale, Ettrick and

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Lauderdale (Mr. Moore) referred to earlier, and other recognised supervisory bodies, which have been responsible for some functions which, under clauses 1 and 2, will be the responsibility of the independently-acting Financial Reporting Council.

One of the main purposes of clause 2 is to make the arrangements operationally independent of the supervisory bodies. Clause 2 provides that all the arrangements—the setting of technical audit standards, and standards relating to professional integrity and independence; the monitoring of audits of listed and other major companies; and the investigation and disciplining of auditors in public interest cases—operate independently of the supervisory bodies. Those bodies must not be involved in selecting or appointing the people who carry out the standard setting, monitoring, investigation and discipline that have been described, and of course they cannot be involved in carrying out any of those functions.

Clause 2 also provides that the arrangements must be funded—that where the arrangements provide that the bodies fund them, that will be a condition of recognition. That is another important way of ensuring the independence of the arrangements. It prevents the bodies in question from influencing the arrangements by withholding the necessary funding.

Clause 2, together with clause 1, strengthens in key respects the regulation of audit. The hon. Member for Sutton Coldfield majored in what he considers potential burdens—although I argue that those things are not burdensome—but he failed to recognise the significance of independence in the new arrangements. The provisions that allow for independence operate simply and efficiently, building on the existing regulatory framework, which is highly regarded. They have an important function—rebuilding confidence in the reliability of financial information provided by companies after the collapse of Enron and of WorldCom. It is essential to do this if the UK is to benefit from a regulatory regime that is recognised internationally as world class.

The amendments to which the hon. Gentleman spoke focus in particular on the independent monitoring function that is now to be vested in the audit investigation unit in the FRC. As he pointed out, amendments Nos. 4, 5 and 6 would give the Secretary of State the power to define what companies should fall within the scope of independent monitoring. Amendment No. 7 would limit the required minimum scope of the independent monitoring arrangements to the audit of FTSE 350 companies.

The hon. Gentleman, as he did this morning, claims that his amendments are helpful, but to me they suggest a lack of recognition of the significance of the independent monitoring of audits and/or a misunderstanding of how the function will be carried out. I hope I can reassure him that his amendments are both misguided and unnecessary.

The hon. Gentleman made significant play of the idea of additional burdens being placed on companies. I do not consider that the requirement for independent monitoring will result in additional burdens on

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business. The companies themselves should not be affected. The monitoring will be of not the companies that are being audited, but the audit function—the quality of the auditing of the companies. Monitoring is focused on the audit firm and the quality of the audits it has carried out.


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