Is ‘comply or explain’ working?

Yes and no is the view of the Financial Reporting Council (FRC) citing research by Grant Thornton which shows that whilst 96% of FTSE 350 companies comply with corporate governance codes, those that do not should provide greater detail when they choose to exempt themselves from corporate governance procedures.

The concept of “comply or explain” has been the foundation of the corporate governance rules that have been developed and implemented since the early 1990s.

A company should comply with the code – for instance not having the same person acting as chairman or chief executive – but can choose not to if they are able to explain their actions convincingly to shareholders.

The research noted that the vast majority of UK companies abide by all the provisions in the Code but noted a small number of firms who provided inadequate justifications for ignoring certain clauses.

Grant Thornton said that some of these justifications “can come across as an assertion of difference rather than a full explanation of why the company in question has chosen to deviate from agreed best practice”

The EU is also concerned about the reasons companies give for their deviation from the rules set out in the codes.

By defining a “substantive explanation” and increasing pressure on companies to follow suit the FRC hopes to avoid the need to introduce additional regulation.

Baroness Sarah Hogg, chair of the FRC, commented: “The comply or explain approach to corporate governance has given us flexibility and enabled us to raise the standards of UK corporate governance over the years in ways that regulation cannot always achieve.

“This exercise is designed to reinforce our approach at a time when Europe has shown signs of driving towards more prescriptive regulation with a consequent diminution of shareholder rights.”

The Code came into force during 2010 but Britain’s light-touch approach to governance regulation faces reform as part of European Commission proposals.

The FRC has held a couple of discussions on what counts as a convincing explanation.

There are three basic elements:

  • Set the context and historical background.
  • Give a convincing rationale for the action.
  • Describe mitigating action to address the deviations from the code.

The explanation should also indicate whether the deviation from the code’s provision was limited and when the company intended to return to conforming with the provisions.

The FRC is now considering whether to incorporate these ideas into future consultations on the code.

However a leading accounting academic does not think that this goes far enough and has said that the FRC itself should be scrapped because it has failed to deal with major accounting and auditing problems highlighted by the banking crisis and has supported “onerous and costly” reporting rules for small and medium-sized businesses.

In response to a consultation on plans to streamline the UK’s regulator for accounting and auditing and corporate governance, Stella Fearnley, professor in accounting at Bournemouth University, said the FRC had “failed to take an effective lead in the UK’s interests regarding both the accounting and auditing problems associated with the financial crisis and market concentration in the audit market”.

A joint consultation with the department for Business Innovation and Skills and the FRC suggested narrowing the body’s regulatory functions and streamlining its structure, but Fearnley said more radical changes were needed.

She added the FRC should be disbanded and its oversight of listed companies taken over by a separate securities commission with “overall responsibility for market regulation and oversight of standard setting, and enforcement of accounting and auditing activities”.

Fearnley also said the Accountancy and Actuarial Discipline Board should be abolished because its remit is too limited.

“Qualified accountants and firms in the listed market should be treated like any other party suspected of committing an offence and if they are found guilty, it should up to the professional bodies to decide on their continuing membership,” Fearnley wrote in a submission to the FRC consultation last week.

She said small and medium-sized businesses and the not-for-profit sector had “been badly served by the FRC for a long time”.

Fearnley added an independent commission should be set up to focus on accounting and auditing regulation of these two sectors.

She may have a point. Clearly there is some concern that our corporate governance regulation is too light touch at the top and too onerous lower down. What is needed is regulation which will inspire investor confidence and avoid major corporate calamities without stifling growth and entrepreneurship.

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