Will government-owned companies be caught up by audit reform?

The Department for Business, Energy and Industrial Strategy (BEIS) published its long awaited consultation document Restoring trust in audit and corporate governance in March 2021. The proposed reforms include new reporting on controls and resilience, new duties for auditors, additional requirements for audit committees and a strengthened regulator – the Audit, Risk and Governance Authority (ARGA) - with greater enforcement powers against directors.

The government proposes that the majority of the reforms, at least initially, will apply only to public interest entities (PIEs). Currently PIEs are defined as entities whose transferable securities are admitted to trading on a regulated market, credit institutions or insurance undertakings.

Very few public sector bodies meet this definition so the additional regulatory requirements for them and their auditors do not apply. However, the consultation document contains proposals to expand the definition of PIEs to larger unlisted companies and suggests two options for what the new thresholds might be:

• Option 1: more than 2,000 employees or a turnover of more than £200m and a balance sheet of more than £2bn; or
• Option 2: more than 500 employees and a turnover of more than £500m.

BEIS estimated that an additional 2,066 companies would be brought into scope under option 1, while 1,163 companies would be captured by option 2. 

Although the consultation discusses options for third sector organisations, it is silent on the public sector and so it is unclear to what extent the proposals might capture state-owned organisations beyond NatWest Group (formerly the Royal Bank of Scotland), a listed company already classified as a PIE. The implication is that government departments and local authorities would not be captured by these proposals, even where they meet these size criteria, however it is unclear whether there would be any exemptions for publicly owned companies. 

That may be deliberate, as it can be argued that organisations such as Network Rail, NHS Property Services and Transport for London should be held to the highest standards of corporate governance and audit quality irrespective of whether they are publicly or privately owned. However, the proposals appear to leave some large central government-owned companies funded by grant-in-aid or capital funding outside of scope, assuming government funding is not treated as income for the purpose of the new PIE test. An example is HS2 Ltd, which only generated £109k income alongside the £3bn capital contribution it received from the Department for Transport and only had an average of 1,415 employees in 2019-20. Given HS2 has assets of £6bn already and intends to spend over £40bn building a critical piece of national infrastructure, it would be surprising if it was not captured when other less significant entities were. 

There is a clear public interest in the finances of these government-owned companies as they spend large sums of taxpayers’ money and safeguard significant assets, including those to a value of £75.6bn as at 31 March 2020 in the case of Network Rail. 

Many of the proposals in the white paper could strengthen the reporting and governance of these companies and, perhaps in some cases, larger government departments and local authorities. These include the proposed new requirements to report on financial resilience, supplier payment practices and steps taken to prevent and detect fraud, as well as the powers of ARGA to sanction directors that breach corporate reporting or fail to carry out audit-related responsibilities.

There are a number of significant differences between government-owned and privately-owned companies meaning that some of the proposals would not lead to governance improvements. For example, many larger public sector companies cannot pay dividends under their founding legislation or framework agreement with their sponsor Department. Therefore, it would not be a useful exercise for government-owned companies to invest resources in calculating and reporting the known distributable reserves as proposed.

The relevant Secretary of State is the sole shareholder for most government-owned companies and it is unclear how applicable some of the proposed new powers and responsibilities are to this category of shareholders. The Secretary of State uses the information in the annual report and accounts in a different way to a regular shareholder since, for example, policy objectives or legal restrictions will prevent them from potentially looking to sell their holdings or seek a listing on a regulated market.

Careful consideration is also required over how many existing and proposed requirements for the audits of PIEs interact with the National Audit Office’s (NAO) role as the statutory auditor of many government-owned companies. The existing requirements for PIEs over transparent audit tendering or mandatory rotation of auditors every ten years would therefore be inappropriate. 

More clarity is required on how other reforms, such as the proposed audit and assurance policy will operate, when the entity does not have the power to choose its own auditor, and the proposals to give shareholders a formal opportunity to engage with audit planning risks undermining the independence of the NAO if this power is given to Secretaries of State. 

Oliver Simms, Manager, Public Sector Audit and Assurance for ICAEW, commented: “The government should clarify its intentions regarding whether public sector companies will be designated as public interest entities under its proposed reforms to audit, financial reporting and corporate governance. If so, it must consider whether the definition of turnover should be broadened to capture government companies funded by grants.”

Simms continued: “While many of the proposed changes have the potential to strengthen the audit and corporate governance of government-owned companies if applied to them, some adaptation would be needed, for example to reflect the constitutional role of the National Audit Office and the differences in shareholding relationship given that the sole shareholder of many of these entities is the relevant Secretary of State.”