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www.pwc.co.uk Board radar Scanning what’s ahead that will affect your business Second quarter 2014
www.pwc.co.uk
Board radar Scanning what’s ahead that will affect your business
Second quarter 2014
Board radar
PwC • Contents
Contents Editorial 1
Executive summary 2
Reporting 4
Direct and indirect tax 7
Pensions 10
The economy 12
Corporate governance 14
Sustainability 15
Assurance 17
Remuneration 20
Board radar Scanning what's ahead that will affect your business It can be a challenge for business to keep abreast of developments in everything from reporting, tax and pensions to governance, capital markets, sustainability, and remuneration. Our quarterly update highlights what management needs to think about, where the board might want to comment or engage with policy makers, and what actions to consider. To subscribe, or for further information, email: [email protected]
Board radar
PwC • 1
Four lessons from the UK floods
Dr Celine Herweijer, a partner in PwC's sustainability team examines the wider lessons The world can’t insure its way out of climate change Insurance does not reduce total risk, it just helps us deal with the financial cost of the impact of that risk. The only way to reduce risk is through investment in adaptation and risk-informed development planning. Without the latter two, the long-term affordability and availability of insurance could be under threat.
Strategies exist for adapting our homes and infrastructure to flood risk Robust and enforced building codes that take into account present and future risk are ‘no regret’ strategies. Limiting development in high risk areas, and repairing damaged properties to make them more resilient to extreme weather events present no downside. Even in the face of higher storm surges and more intense rain events, the right adaptation investments, including flood defences, elevated buildings and engineered foundations and reinforced cladding, can reduce future risk below present day levels. For example, studies have shown that adaptation could reduce annual losses from storm surges for individual properties in high risk coastal communities in the 2030s to below present-day levels.
Property owners and investors need the right support and incentives to act Alongside government investment in hard defences and better and tougher planning controls, we need financial incentives for home owners and property developers in higher risk areas. People in high risk areas need help to make the right short-term investment decisions, whether that’s tax rebates, loans, or insurance premium reductions that reward positive action. With climate change increasing risk levels over the long term in the UK’s coastal and riverine floodplains, those most at risk need help transitioning to better buildings and at the most extreme, to better locations. Gradual support is far better than waking up one day to find that your property is uninsurable, and unsellable.
It’s not just a rainy day problem Year to year we are experiencing record breaking extremes and weather events in many areas – headlines of the record-breaking US drought, Australian open heatwave, and the wettest UK winter all in the past few months. Here in the UK we may be consumed with the devastation of floods today, but it won’t be long before the UK experiences another record breaking summer extreme of prolonged drought and water bans, and/or heatwaves or cold spells, crippling our transport systems and interrupting business – price volatility will ensue. We are loading the dice all around on extreme weather events, and the story is the same for all perils – plan and invest for the risks of the future, not for the risks of the past.
PwC estimates the cost of continuing UK floods to the insurance industry at up to £500m for the January and December weather impacts, and the economic damage at £630m.
Editorial
Board radar
Key: Key: Priority for 2014
M – Monitor
R – Respond
L – Lobby
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Emerging issues Pg Action
Reporting
New guidance – further opportunity for change?
6
• The FRC is due to publish final narrative reporting guidance on the BIS regulations in April 2014
• The aim is to encourage consideration of: materiality; where information is put within the annual report; and how key content elements link with each other
M
Presenting financial performance – is change on the horizon?
6 • In January, the IFRS Interpretations Committee considered a request from ESMA to clarify some IAS 1 presentation requirements
• ESMA is concerned about measures of performance, and in February published draft guidelines for listed companies
• The FRC has identified a number of companies where the disclosure of exceptional items falls short of the clarity required
M
Regulator focus on structured pension arrangements
8 • FRC has commented on structured arrangements involving company pension plans
• It is concerned about the accounting for certain arrangements afforded equity treatment
• This highlights broader concerns about using structured vehicles to achieve a desired accounting outcome
ML
Direct and indirect tax
Proposed new transfer pricing documentation requirements including country-by-country information
9 • As part of its BEPS Action Plan, the OECD issued a discussion draft on 30 January
• The draft updates guidance on preparing transfer pricing documents
• It includes a template for reporting country-by-country information to tax authorities
• Final guidance expected in June 2014. UK effective date will depend on passage through parliament
M
Patent box Code of Conduct review
10 • All nine EU intellectual property tax incentive regimes are being reviewed, including the UK's patent box
• Many companies expect to benefit from the UK's patent box and want to know what impact the review might have
• The EU Business Code of Conduct Group will report findings in June 2014
• Any changes unlikely to take effect until 2016/17
M
Evaluating tax controls and risk management
10 • Tax authorities are encouraging large groups and multinationals to enhance their tax control environment and tax risk management
• COSO has a widely recognised standard for evaluating controls
M
Tax and transparency messages getting through
11 • The 100 Group made a substantial economic impact and an increased total tax contribution (TTC) in 2013
• The overall tax contribution of the Group rose despite a decline in profits earned in the UK by these businesses
• TTC rose from £77.1bn to £77.6bn
M
Pensions
UK GAAP changes may force accounting changes for Defined Benefit pensions
12 • Pension scheme accounting to change from 1 January 2015 • There are three main changes that have an impact on UK
companies with defined benefit pension schemes who report under UK GAAP
M
Global pension survey shows that defined benefit is a thing of the past
13 • Survey reports that the death of defined benefits pensions is a global phenomenon
• Only 6% of companies view DB as their preferred pension provision for the future, while 90% plan to focus on defined contribution
• 83% of employers believe they need to give more flexibility to their employees in the way they save for retirement and take their benefits
M
Executive summary
Board radar
Key: Key: Priority for 2014
M – Monitor
R – Respond
L – Lobby
PwC • 3
Emerging issues Pg Action
The economy
Growth: Fact or fiction
14 • A key question for 2014 is whether the outlook for advanced economies will live up to expectations
• US outlook seems the most secure of the major advanced economies
• Peripheral Europe remains fragile, while Core Europe has a more positive outlook
M
Corporate governance
UK governance update
16 • Audit committees need to keep EU developments on audit tendering and rotation under review
• Look out for final FRC guidance on risk management, internal control and going concern
M
Sustainability
The business of changing demographics
17 • 60% of CEOs put demographic shifts in their top three megatrends that will transform their business in the next 5 years
• 52% of CEOs are concerned about shifts in consumer spending and behaviour
• 82% of CEOs agree that improving workforce and board diversity is important for their business
M
Assurance
EU audit reform update
19 • Highly likely that new EU audit market legislation will be introduced later this year
• But no provisions will be binding until mid-2016 • Significant areas of ambiguity remain
M L
EU adopts ISAs at last
20 • EU adoption of ISAs as issued by the IAASB is finally happening
• It's an important step for international consistency as not all countries have yet adopted in their national standards
M
M R Competition Commission: redraft expected
20 • In mid-January, the CC announced a revised timetable for the implementation of its remedies to allow time to consider the implications of the EU's proposals
• We expect a redraft of the Orders to be issued for consultation in Q3 2014
IAASB consults on its future strategy and work plan
21 • The IAASB is seeking views on its proposed strategic direction and work programme
• In 2015-2016, the IAASB intends to focus on quality control, professional scepticism and special audit considerations relevant to financial institutions
• The board will also continue to give priority to completing its project on auditor reporting this year
R
Remuneration
Update on the new remuneration reporting regime
22 • The first binding votes have been cast at January and February AGMs on the Directors' Remuneration Policy
• For the 20 companies with September year ends, the level of support has been consistently high
• Companies with December and March year ends will face the challenge of meeting investor requirements while retaining flexibility
M
Pay: what goes up must come down
22 • Are the forces shaping executive pay here to stay? More regulation is tending to dampen pay; and simpler pay packages are reducing pay too
• UK executive pay has doubled since the millennium • But in the last two years, bonuses to FTSE100 chief
executives have fallen and salary freezes have become commonplace
M
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Current issues
New guidance – further opportunity for change?
After much consultation and deliberation the Financial Reporting Council (FRC) is due to publish its final guidance on the BIS narrative reporting regulations in April 2014.
While the regulations set out what's required, the guidance indicates the real purpose of them - encouraging preparers to reflect on the content, structure, strategic intent and narrative flow. In particular, the guidance encourages consideration of materiality, where information is put within the annual report, and greater focus on how key content elements link with each other.
Our review of early reporters of the regulations, published in January, shows:
• A significant increase in the involvement, engagement and challenge of management and boards through the reporting process
• General compliance with the regulations, although the limited time to respond to the regulations meant there were varying degrees of compliance
• Improved focus on the reporting of strategy and business model year-on-year for a number of the individual reporters
• Challenges around what to include in the strategic report, for example, how to define senior management, the scope of GHG emissions and how to articulate human rights policy
Initial evidence shows that many companies have a lot to do to lift their reporting up to the level of good practice. But we expect to see an improving trend as the stronger management focus on strategy and the business model starts to come through into reporting, boosted by the FRC's new guidance. We think BIS's original objective for the regulations to 'get the standard of narrative reporting up to the level
of the very best' is achievable in the medium term.
Management teams may want to look out for the FRC's guidance in April and consider how best to improve the quality of their information for internal as well as external reporting and decision making.
Presenting financial performance – is change on the horizon?
Regulators and standard-setters have long grappled with the question of how companies should best present financial performance without misleading the reader. In some jurisdictions, the answer has been to enforce a standard format for the income statement, with no additional sub-totals or analysis permitted anywhere on the face of the statement itself.
The UK approach has been rather more flexible, dating back to FRS 3 in the early 1990s. Many UK companies use columns, boxes, sub-totals and other approaches in an attempt to convey to the reader an impression of what underlying or sustainable earnings might be.
But this approach is not without its critics.
In January, the IFRS Interpretations Committee (IFRS IC) considered a request from the European Securities and Markets Authority (ESMA) to clarify some of the IAS 1 presentation requirements. One of ESMA’s concerns was the use of columns, boxes and sub-totals we commonly see in the UK.
The IFRS IC tentatively decided not to take the matter onto its agenda. They observed that IAS 1 does permit flexibility in presentation, which may come as a relief to many UK companies. They also noted the requirement for companies to present additional line items, headings and subtotals when such presentation is relevant to an understanding of a company’s financial performance. But they have suggested that the IASB might wish to explore the matter further as part of its broader project to improve disclosure under IFRS (on which we expect an exposure draft in the near future).
Reporting
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ESMA is clearly concerned about measures of performance and in February it published draft guidelines for listed companies that would build on existing recommendations published in 2005 under the auspices of the Committee of European Securities Regulators (ESMA’s predecessor body).
Closer to home, the Financial Reporting Council (FRC) issued a press release in December to remind boards of the need to improve the reporting of exceptional items and ensure consistency in their presentation. This follows October’s Corporate Reporting Review annual report, which drew attention to the need for investors to understand the quality of profits reported by companies, citing exceptional items as one source of concern.
The FRC does not object, in principle, to exceptional items and alternative performance measures. In its Corporate Reporting Review annual report, the FRC states that it: “supports the inclusion of alternative performance measures when they provide users with additional useful, relevant information. When management use such measures – for example, financial KPIs – in their own management reporting, their inclusion in the business review or accounts, together with appropriate explanation of trends and variances, can help users understand the business through management’s eyes”.
However, the FRC, through its Financial Reporting Review Panel (FRRP), has identified a number of companies where the disclosure of exceptional items falls short of the consistency and clarity required. And this has affected the profit reported before such items.
The FRRP has considered the relevant principles in the law and under IFRS and concluded that management should consider the following when judging what to include in additional items and underlying profit.
• The approach taken to identify additional items that qualify for separate presentation should be even-handed between gains and losses, clearly disclosed and applied consistently from one year to the next. Boards should ensure that it is not only bad news (expenses and losses) that is considered for separate presentation;
significant gains would also be presented separately.
• When presenting additional line items and discussing alternative performance measures, it should be clear which are IFRS measures and which are not.
• Gains and losses should not be netted off to arrive at the amount disclosed as exceptional, unless otherwise permitted.
• Where the same category of material items recurs each year and in similar amounts (for example, restructuring costs), boards should consider whether such amounts are actually normal costs of running the business and should therefore be included as part of underlying profit.
• Where significant items of expense are unlikely to be finalised for a number of years, or might subsequently be reversed, the income statement effect of such changes should be identified as additional items in subsequent periods, and readers should be able to track movements in respect of these items between periods. The FRC makes it clear that any release of provisions should be presented in the same line item as the original expense; and, if that original expense is presented separately, the release should also be presented separately.
• The tax effect of additional items should be explained. If the purpose of disclosing exceptional items is to help readers to understand ‘underlying earnings’, the tax effect of those exceptional items should also be disclosed.
• Similar to the previous comment, material cash amounts related to additional items should be presented clearly in the cash flow statement.
• Where underlying profit is used in determining executive remuneration, or in the definition of loan covenants, boards should take care to disclose clearly the measures used.
• Management commentary on results should be clear about which measures of profit are being commented on and should discuss all significant items that make up the profit determined according to IFRS.
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It’s clear that regulators and standard setters will continue to focus on the presentation of financial performance. For UK listed companies, there is also a need for boards to consider their response to the Corporate Governance Code principle that the annual report as a whole should be ‘fair, balanced and understandable’.
It is likely that we have not heard the last on this subject.
Regulator focus on structured pension arrangements
In a separate press release, the FRC has commented on structured arrangements involving company pension plans.
In recent years the FRC, through its Financial Reporting Review Panel (FRRP), has challenged several companies that implemented asset-backed funding arrangements involving structured entities, such as Scottish Limited Partnerships (SLPs). Funding structures involving SLPs have been used widely for genuine commercial reasons, but the FRC has raised objections where they believe such structures have had the effect of transforming a pension funding obligation into an equity instrument in a company’s consolidated accounts.
The current press notice focuses on concerns over the accounting for certain arrangements afforded equity treatment. But we believe it highlights broader concerns about circumstances where companies may use structured vehicles to achieve a desired accounting outcome that may not best reflect the substance of the arrangement.
The FRC’s Conduct Committee and FRRP chair Richard Fleck noted: “the FRRP believes that it is important that companies and their advisers are aware that the FRRP will ordinarily open an enquiry into the financial reporting of any company in which material pension liabilities are reclassified from debt to equity.”
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Current issues
Proposed new transfer pricing documentation requirements including country-by-country information
As part of its Base Erosion and Profit Shifting (BEPS) Action Plan, the OECD issued a discussion draft on 30 January with updated guidance on the preparation of transfer pricing documentation.
One element is the inclusion of a template for reporting of country-by-country information to tax authorities. The increased reporting obligations present a significant challenge for multinational organisations to comply with.
A two-tiered approach to documentation would consist of a ‘master file’ giving details of the group's global business and a specific ‘local file’ for each territory, including a description of the local management structure and details of who they report to. The OECD proposes prescriptive lists of the information that should be included in each file. The headline changes to what currently applies in the UK include the following new information:
• Title and main office location of the 25 most highly compensated employees in each business line
• Charts showing the supply chain for all material products and services supplied by the group
• Details of any tax rulings, advance pricing agreements or matters pending for consideration under ‘Mutual agreement procedures’
• A detailed country-by-country reporting template, giving various financial metrics for each entity in the group (this would include revenues, profits, cash taxes paid, employee costs, tangible assets and payments of interest, royalties and service fees to other group companies).
Small and medium-sized enterprises would be required to complete the country-by-country
reporting template, although the draft recommends simplification measures for the other transfer pricing documentation.
The proposals, which are likely to be taken on by HMRC and other territories, may have an impact on:
• Resource allocation – most organisations will not have this data at their fingertips, and for some it may be necessary to recruit specifically to meet these requirements.
• Data availability – in some cases systems upgrades will be required to extract necessary data in the prescribed format.
• Confidentiality – some of the information required can be commercially sensitive. It is not clear what safeguards will be introduced to avoid leakage.
• Tax authority engagement strategy – it may lead to a rethink of the best approach to engaging with tax authorities.
If the OECD finalises its guidance in June 2014, as expected, it would be effective in the UK in accordance with an order which would have to be made by HM Treasury and passed through parliament.
For more insight on the proposals, see this Bulletin and the recorded webcast of 13 February.
This country-by-country reporting to tax authorities is different from the various initiatives for public disclosures. For more recent developments in the public country-by-country reporting debate, see Tax transparency: country-by-country reporting.
With responses to the OECD having to be made by 23 February, the timetable was always going to be particularly tight.
While the final changes are being agreed, companies should start to assess what they would need to do to comply.
Direct and indirect tax
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Patent box Code of Conduct review
The EU Business Code of Conduct Group is reviewing all nine EU intellectual property (IP) tax incentive regimes, which includes the UK’s patent box. The other member states with IP regimes are Belgium, Cyprus, France, Hungary, Luxembourg, Malta, the Netherlands and Spain.
The Code Group will report findings in June 2014 at the end of the Greek Presidency. It will be considering, in particular, whether these IP regimes encourage genuine economic activity together with the level of required economic substance.
HM Treasury (HMT) has also confirmed there is an early scoping review under state aid, but that this is not a formal review, and, in its view, is perhaps unlikely to progress that far.
Many companies expect to benefit from the UK’s patent box, and therefore want to know what impact, if any, the review might have.
HMT has already shared a very strong message that UK businesses should continue to make patent box claims and treat this very much as ‘business as usual’. They believe (and we agree) that the UK patent box is here to stay. Where the review does lead to minor changes to the legislation, HMRC suggested that these are unlikely to take effect until 2016/17.
HMT’s Fergus Harradence provided an update on the review so far in a PwC webcast on 14 February 2014. A recording of the webcast is now available here.
Companies should keep up-to-date with progress on these discussions. They should also continue to feed in to HMRC/HMT their experience of how the patent box is working in practice.
Evaluating tax controls and risk management
Tax authorities are encouraging multinationals and large groups to enhance their tax control environment and tax risk management, following the increased scrutiny of companies’ tax affairs.
In this context, it’s clearly important that management teams are clear about the effectiveness of their organisation’s tax operating model and tax controls. This will enable them to develop plans to ensure they can meet strategic objectives and address shareholder needs.
There is a widely recognised standard for evaluating the quality of any control environment (published by COSO, the Committee of Sponsoring Organisations of the Treadway Commission). This gives a good indication of the areas to consider in establishing a suitable tax control framework.
There is not necessarily a right level, but management teams need to understand the current state of their controls to determine whether they’re meeting strategic objectives. That also makes it possible to benchmark against similar organisations, evaluate ambition levels and develop a strategy for improvement. That can, in turn, be clearly communicated to key stakeholders.
Key components of a tax control framework Key elements of a framework might include:
• Strategy, values and levels of tax awareness • Status, control and documentation of
business processes • Approach and controls to ensure
compliance and reporting across all taxes (and alignment with tax strategy)
• Identification of tax risks (and implementation of controls to mitigate them)
• Internal monitoring activity to periodically assess the design and operating effectiveness of existing tax controls (implementing change as required)
• External assurance provided by a third party over the tax control framework and an assessment of the design and operating effectiveness of tax controls.
We have developed an easy to use online tool, the Tax Management Maturity Model (T3M), to enable us to work with companies to assess the current state of their tax operating model and control environment and to help identify potential areas of focus for further development.
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Tax and transparency messages getting through
Our latest ‘total tax contribution’ survey with the 100 Group – Total tax contribution – showed that FTSE 100 companies made a substantial economic impact and an increased total tax contribution in 2013. This reporting is an important part of demonstrating a commitment to tax transparency.
The rise in the overall tax contribution of 100 Group companies in the 2013 survey came despite a decline in profits earned in the UK by these businesses, with total tax contributed up from £77.1bn to £77.6bn. The report shows that this increase is predominantly due to higher employment taxes, VAT and excise duties – for every £1 of corporation tax paid, the UK’s big firms now pay £2.86 in other taxes.
At the same time, it shows that taxes represent only one element of the wider contribution to the UK economy by the Group. Wider contributions include:
• Employment of over 2.1m people (7.2% of the UK workforce) who have seen an average wage increase of 2.5%
• Investment of over £26bn in fixed assets (21.4% of UK business investment)
• Over £5bn invested in business research and development (31.1% of UK business R&D spend).
For more details from the report see: Total tax contribution and the wider economic impact.
While tax transparency, both in the 100 Group and beyond, is clearly growing, the emphasis must be on information that’s understandable and capable of being used appropriately by the intended recipient, rather than data for data’s sake.
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Current issues
UK GAAP changes may force accounting changes for Defined Benefit pensions
The way that pension schemes are accounted for under UK accounting standards (FRS 17) is going to change for accounting periods beginning on or after 1 January 2015.
Last year, the Financial Reporting Council (FRC) issued FRS 102, the new main standard operating under UK GAAP. One of the key areas affected by the new standard is pensions. Many of the changes to the FRS 17 (which is being replaced by section 28 of FRS 102) represent an alignment with the equivalent standard in IFRS (IAS 19 revised).
The changes mean that many UK companies will see a higher reported pension expense in the profit and loss (P&L) statement and some will have to show a defined benefit asset or liability for the first time.
The amended standard is effective for financial reporting periods beginning on or after 1 January 2015. Early adoption is permitted. Companies need to restate comparative information, which is likely to involve considering the impact from 1 January 2014 onwards.
Summary of changes There are three main changes that will have an impact on UK companies with defined benefit pension schemes who report under UK GAAP.
First, the interest cost and the expected return on assets elements of the P&L pension expense calculation will be combined. Net interest will still be charged to the P&L but will be calculated by applying the discount rate assumption to the net balance sheet pension asset or liability at the beginning of the period.
Companies will no longer be able to take an income statement credit for anticipated asset investment performance above that of high-
quality corporate bonds. This will likely see an increase in the net pension expense (due to reduced investment returns credited to the P&L) reported in P&L calculated under UK GAAP.
Second, the surplus recognition rules have changed which means pension schemes are more likely to be able to recognise a surplus.
Third, groups with multi-employer or group plans, who take advantage of the multi-employer exemption under FRS 17 to account for their defined benefit plans as defined contribution plans within the separate accounts of their subsidiaries, may have to recognise these plans differently.
At the consolidated accounts level, we do not anticipate that the changes will have an impact on companies reporting under the International Accounting Standard, but it will impact those reporting under UK GAAP.
The main impact Where the changes may have an impact is for a company that has a defined benefit pension scheme that is accounted for as a defined contribution scheme. This can happen when the company operates the pension scheme across a number of subsidiaries and/or associated companies.
Until now, it has often been acceptable to account for the pension scheme within the individual company accounts similarly to a defined contribution scheme. It has been at the consolidated level only that the defined benefit accounting (including recognition of deficits) has been required.
Under the changes, at least one company will have to recognise the deficit and – if a contractual agreement or formal policy for recharging the net defined benefit cost amongst the entities is in place – it may be required for the deficit to be spread out among the various group companies.
As well as introducing administrative complexity this might also impact ability to pay
Pensions
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dividends from specific companies or to restructure or sell parts of the business.
Companies need to be prepared for these changes and to ensure that they have a considered policy in place that specifies how the accounting treatment of any defined benefit schemes will be operated.
Global pension survey shows that defined benefit is a thing of the past
A new survey – Moving on: Global retirement benefits in a post-defined benefits world – has some clear messages on pensions. The survey, by PwC, covers 114 multinational companies from the global Fortune 500 representing 4.7m employees and US$950 billion in pension assets.
Key findings include:
• The death of defined benefits pensions (DB) is a global phenomenon. Only 6% of companies view DB as their preferred pension provision for the future. By contrast 90% plan to focus on defined contribution (DC)
• Legacy DB plans are seen as an existential threat to the company. Almost half the companies surveyed said they intended to transfer pension liabilities off balance sheet. This has significant implications. It shows that there is enormous pent up demand and must raise concerns about whether the capacity of the buyout market will be sufficient
• 90% of employers surveyed believe that they still need to help employees make the right decisions about pension saving
• 83% of employers believe they need to give more flexibility to their employees in the way that they save for retirement and take their benefits
The survey report also considers what issues Finance and HR need to consider with the global board. It is clear that pension governance and control remains a work in progress. Organisations may need to increase central control and oversight of pension schemes around the world.
A new form of paternalism is emerging This recognises the protecting role that employers have to help employees make appropriate decisions and take responsibility for their own retirement needs.
In practical terms, this means giving employees access to knowledge and resources, but leaving the choices to them. The employer also needs to put in place some protective safeguards or constraints to protect employees from risks such as inflation, investment performance and volatility and longevity increases.
Management teams may find the survey results provide useful context for their own plans.
A copy of the survey can be downloaded here.
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Current issues
Growth: Fact or fiction
CEOs see rosy outlook for advanced economies One of the central messages coming out of Davos last month was the clear shift in CEO sentiment in favour of advanced economies. This, in turn, was driven by the improving growth outlook in advanced economies. Our Global CEO survey, which was launched at Davos, shows that the shift was strongest in the US, closely followed by Germany and the UK.
However, in the past five years we’ve seen hopes of a sustained economic recovery dashed a couple of times. So, a key question for 2014 is whether the outlook for advanced economies will live up to expectations.
Figure 1: CEOs name most important countries for growth
US: Don’t stop me now In our view, the US outlook seems the most secure out of the major advanced economies. This is driven by two main factors: households have paid down their debt to more manageable levels (see figure 2), which has encouraged consumers to spend more; and the financial sector has restructured.
In the medium term, the outlook for the US economy remains bright. As economic growth strengthens, spare capacity will gradually diminish. This could spark an investment spree
by US cash-rich firms, which could help create more jobs in the future with positive knock-on effects on the rest of the economy. US economic output already stands 6% higher compared to Q4 2007, which is the second best performance in the G7 (Canada has grown by around 7%).
Peripheral Europe: Still fragile For peripheral Europe, the outlook is better than last year. In our main scenario, we project that economic growth will return to the peripheral economies in 2014. However modest headwinds remain for the business, households and financial sector.
Net trade was the only component of GDP that grew positively last year. Given the weak state of the private sector and ongoing public sector consolidation, we expect that the economy will continue to rely on foreign demand as its main source of growth.
Households in the periphery also carry a relatively high level of debt and will face similar pressures where unemployment levels remain high. Unlike the US, we expect European banks to face potential capital shortfalls of around €280 billion as the European Central Bank completes its Comprehensive Assessment and other regulatory measures take effect.
Core Europe: More positive outlook For core Europe, however, the outlook is more positive. We project Germany to grow by 1.4% per annum in 2014 on the back of strong export growth. Most German businesses have strengths in key areas. On the supply side, they have access to relatively cheap credit and skilled labour. On the demand side, its world class automotive, chemicals and engineering industries are well linked into overseas growth markets, most of which are nurturing rapidly expanding middle-income classes.
Despite the uneven growth pattern across the Eurozone, the overall outlook for 2014 is much better than last year. In our main scenario –
The economy
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where we assume structural reforms continue unabated – we project Eurozone GDP will expand by 0.8% in 2014.
A solid recovery is also developing in the UK with an easing of the two significant headwinds
for growth: high inflation and the Eurozone crisis have eased.
For more information on the economic recovery, please visit Global Economy Watch.
Figure 2: US household debt as a proportion of GDP
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Current issues
UK governance update
There are a number of very significant matters in the offing that will affect UK governance arrangements over the next few years.
First, boards - particularly audit committees - will have been keeping developments in the EU on audit tendering and mandatory firm rotation under review (see EU audit reform update).
It will be essential to keep an eye on the interplay between these and the existing UK Corporate Governance Code provision on tendering, along with the Competition Commission’s (CC) draft Order imposing mandatory tenders at least every ten years.
In particular, the transitional arrangements provisionally agreed by the EU institutions and those of the Competition Commission are not aligned. The CC built some extra time into its implementation timetable in January – we hope it will be used to harmonise transition with the EU as far as possible. Until this happens, UK companies may find themselves making decisions on tenders without having full information available to them.
The EU provisional agreement would also create new restrictions on external auditors providing non-audit services and a cap on the ratio of non-audit to audit services (see EU audit reform update).
There has been much interest among audit committees in how this will be implemented in practice, but we may not know the detail of this for the UK until after the next general election in 2015. Again, this is hardly a satisfactory position and the sooner matters are clarified the better.
A step change in risk management? The other ‘next big thing’ on the horizon is the finalisation of the Financial Reporting Council’s (FRC) guidance on risk management, internal
control and going concern. The consultation period closed in January and guidance is expected by the middle of this year. We reported on the content of these proposals in January but since then we have had a number of discussions with the FRC and others to debate the extent to which the proposed guidance represents a step change in the requirements around risk management and going concern.
It’s clear from these discussions that the intention is that the new guidance will require most companies to revisit their processes in these areas in detail. It is possible that they will be satisfied with what they find, but the expectation in the market is that most will not be. So it’s likely that there will be much more demand from boards for support and assurance from management to allow them to make the new formal confirmation that they have carried out a robust assessment of the principal risks facing the company.
In this respect there are parallels between the risk management and internal control proposals and the statement that boards are currently making for the first time that the annual report taken as a whole is ‘fair, balanced and understandable’. None of these three terms is new, but the requirement for the directors to make a formal statement, and the specific auditor reporting that relates to it, have led most companies to focus again on the quality of their year-end reporting processes.
The renewed focus on year-end reporting is very much in line with the intentions of the FRC as set out in the Developments in corporate governance 2013; its focus is now very much on improving the standard of implementation of governance rather than creating significant new requirements.
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Current issues
The business of changing demographics
The global population is expanding; it will hit 8 billion in 2025. But this growth won’t be uniform. By 2020, the median age in Europe will be 43, 38 in China and just 20 in Africa. The working-age population is undergoing major geographic shifts too. It’s still growing rapidly in countries like India.
But population growth has already peaked in China and South Korea, and has been falling for more than a decade in Germany, according to World Population Prospect: The 2010 Revision (UN).
People are moving to cities. Over the next four decades, the number of city dwellers is projected to rise by 72%. If the US is anything to go by, it’s good news for business with urban households spending 18% more, and good news for workers, earning 32% more than rural counterparts. In India, the contrast is more stark with the average urban earnings (monthly per capita estimate) 84% higher for urban dwellers than rural.
But, with fast expansion comes infrastructure and health issues. For instance, fewer than 35% of cities in developing countries have treated wastewater, and half of the solid waste is not collected in most cities in low-income and middle-income countries, according to the WEF. Los Angeles experiences at least one extra day a year of smog that exceeds federal limits because of nitrogen oxides and carbon monoxide emitted by Chinese factories producing for export, drifting across the Pacific Ocean.
What does this all mean for business?
Sustainability extends to people too. Without a healthy workforce with the right skills and good working environment, optimal production isn’t achieved and reputation risks are exposed. Quality suffers. Turnover, absenteeism and
recruitment costs soar, and workers’ health and safety is jeopardised.
Business will need to factor people-related issues into its strategic thinking to reduce the risk implications. This could, for example, mean updating training practices, implementing health and safety programmes and meeting new or emerging market expectations or regulatory requirements. Factor in, the implications of a multi-lingual workforce as well, the impact of immigration on the local community, and the need to review alternative site locations and distribution.
At the same time, one billion people are set to be better off and with a steady rise in the middle classes, consumer spending is set to increase. For business, this creates opportunities in sectors in which richer consumers typically spend, such as culture, recreation, services and healthcare.
But what’s the ultimate cost? As demand for goods increases, so does the demand for raw materials, water, energy and carbon that are involved in their manufacture and distribution. This puts pressure on supply chains, communities, infrastructure and governments. Growth can come at a hefty price. So, how can you make sure your growth is ‘good’, i.e, real, inclusive, responsible and lasting?
Thinking about sustainability at the beginning of this growth phase will ensure an element of future proofing is built in. Some companies are exploring ways to de-couple their growth from their resource use, building in efficiencies and innovating to reduce reliance on scarce materials and potentially reduce costs too. Some are developing closed-loop manufacturing practices, extending their control over more of their value chain with the aim to remove waste and recycle/reuse materials. The benefits here are numerous: eg, reduction in carbon emissions, waste, water usage, pollution and energy consumption.
To find out more about how sustainability is core to business success, read the sustainability perspective here.
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Management teams should think about their total impact as a business now to help identify strengths and weaknesses in their current set-up and flag where change needs to happen most.
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Current issues
EU audit reform update The legislative process and timing The European Commission, Parliament and the Council of Ministers reached agreement in trilogue discussion on 17 December on draft legislation to reform the audit market within the EU. The draft was subsequently approved by a vote of the JURI (Legal Affairs) Committee on 21 January and a parliamentary plenary vote is scheduled for early April.
This means that it’s now highly likely that the new legislation will be introduced later this year. Although at that point the new legislation has official stature, no provisions will become binding until two years later, in mid-2016.
The draft legislation consists of a directive and a regulation, both of which contain numerous member state options. In the UK, constraints on parliamentary time pre-general election will probably mean that primary legislation to introduce the new rules will not be brought to parliament until after the election, possibly in early 2016. BIS will work closely with the FRC in drafting the necessary UK legislation and is planning to hold a public consultation process during 2014.
The number of member state options in the draft legislation, together with the ambiguity of much of the drafting, means that extensive interpretation will be needed. This creates the risk of different application in each of the 28 member states. This will increase the complexity for business and the audit profession in responding to the new requirements.
The sections below highlight the areas of greatest uncertainty.
Restrictions on non-audit services The new legislation restricts the non-audit services that can be provided by the auditor of a public interest entity, and by the auditor’s network firms. These restrictions will apply
from mid-2016 and have the potential to be much more stringent than the current regime in the UK.
In this area, there are a number of options for member states and national supervisors (the FRC in the UK) whereby they can make national application less onerous or more stringent. There will also be a need for national guidance on interpreting the text where it is imprecise.
Fees received for non-audit services will not be allowed to exceed 70% of the audit fees received (there is some ambiguity around the precise operation of this cap). There is also a list of non-audit services that cannot be provided to public interest entities, or to parents and subsidiaries in the EU. These were summarised in the January briefing.
Mandatory audit firm rotation The core legislation mandates that the maximum period for which a firm can be appointed auditor of a public interest entity is 10 years. Member states can choose to make this period shorter, or they can choose to allow extensions: to 20 years if a competitive tender is held at the 10 year point, or to 24 years in the case of a joint audit appointment. Transition arrangements vary depending on the length of time auditors have been incumbent, with the first rotations required in 2020.
The audit proposals have now reached almost the final stage of their passage through the EU institutions. The focus now shifts to issues of national implementation and the corporate community should be prepared to engage with the BIS and the FRC in the coming months on matters such as the exercise of member state options.
There remain significant areas of ambiguity in the current text. Some of these may be corrected or clarified as the legislation is finalised. It is important that Management teams exercise caution in interpreting the current wording in the proposals.
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EU adopts ISAs at last Another aspect of the EU audit reforms that is worthy of note is the adoption of the International Standards on Auditing (ISAs).
In his statement, Commissioner Michel Barnier said: “Taken together, the agreed measures will considerably strengthen audit quality across the EU…I particularly welcome the agreement on the harmonisation of the ISAs.”
Many EU member states, including the UK, have long since adopted the ISAs as issued by the International Auditing and Assurance Standards Board (IAASB) in their national standards; but not all.
The European Commission (EC) has been working towards this for a number of years. It consulted on the adoption of the ISAs in the EU in June 2009, and commissioned studies on the impact of ISA implementation in the EU, as well as a comparison between the ISAs and the US PCAOB’s auditing standards.
As with IFRS, it is not a blanket endorsement. Rather, the EC will be empowered to adopt them. In doing so, the Commission will be expected to take into account the due process in their development, and whether they contribute to a high level of credibility and quality in financial statements, and are ‘conductive to the EU public good’.
The Directive and Regulation include a number of specific requirements, in particular, in the auditor’s report and report to the audit committee. Any ISAs adopted cannot amend or override those requirements, but can supplement them.
So far, most believe that the ISAs as issued by the IAASB are able to meet these criteria.
Finally, after a decade or more of effort, the ISAs may be adopted across Europe. That’s a positive step in the best interests of audit quality and consistency.
Competition Commission: redraft expected In its final report last October, the Competition Commission (CC) acknowledged the uncertainty over audit reform legislation in Europe. It noted that it had not sought to design its remedies around the draft EU proposals, but that should the final EU position prove to be irreconcilable with the CC remedies then the CC had the power to amend its conclusions.
In mid-January, the CC announced a revised timetable for the implementation of its remedies to allow time to consider the implications of the EU’s proposals on its own Orders. We now expect a redraft of the Orders to be issued for formal consultation in the third quarter of 2014, with implementation in the final quarter.
We understand that the CC will reconsider its transition arrangements, and also the clear principle in the CC’s final report that tenders should be considered after five years, and only deferred beyond that point with an explanation to investors. Neither of these aspects fits well with the European proposals.
The CC’s reconsideration is a welcome step, but there is now uncertainty for companies about the eventual outcome.
FRC response to recommendations Also in January, the FRC published a letter from Stephen Haddrill to the CC, responding to those of the CC’s recommendations addressed directly to the FRC.
The FRC has accepted in principle the CC's recommendation to extend its regime of Audit Quality Review inspections and reporting. However, there are significant resource challenges, and the FRC only expects to meet the CC's target by the 2016-17 inspection cycle.
The CC recommended that the UK Corporate Governance Code should require audit committees of FTSE 350 companies to disclose the findings of AQR inspections concluded during the reporting period, including grades awarded and the response of the auditor and the audit committee.
In its letter, the FRC highlights the complexities associated with this and indicates that it will seek views of market participants as part of a
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consultation on various Code matters to be launched during the first half of 2014.
A postscript to the letter notes that individual companies/audit committees should not take any action on this until after the consultation is concluded.
The uncertainties created by the coincidence of the EU and CC proposals mean that it is difficult for FTSE 350 companies to make informed decisions about the timing of audit tendering at present.
In relation to the UK Corporate Governance Code requirements and disclosures on tendering, a possible approach is for companies to explain clearly in their annual reports their tendering intentions. This can be done even if the explanation is that they are still considering the appropriate timing of the tender.
It may also be worth noting that timing could change due to the current uncertainty over implementation of the Competition Commission's proposals to introduce mandatory audit tendering, in the light of developments in EU audit reform legislation.
Management teams should be prepared to engage with the CC when the redrafted Orders are published for consultation in the third quarter of 2014.
Emerging issues
IAASB consults on its future strategy and work plan The International Audit and Assurance Standards Board (IAASB) is seeking views on its proposed forward strategic direction and work programme.
In 2015—2016, the IAASB intends to focus on quality control, professional scepticism and special audit considerations relevant to financial institutions. The board concluded that it was best to focus resources on a few projects rather than have a broader programme that could take longer to progress to completion.
2014: completing auditor reporting project The board will also continue to give priority to completing its project on auditor reporting this year and is committed to supporting the
adoption and implementation of the new reporting model once released. Early in 2014, the board also expects to issue a revised exposure draft on the auditor’s responsibilities with respect to the front part of the annual report as part of the financial statement audit.
Both projects have been the subject of much debate both globally and in the US, where the PCAOB has proposals out for comment as well.
Further ahead: integrated reporting and audit Looking a bit further ahead, the IAASB intends to monitor developments and seek information on integrated reporting and group audits.
This workplan is based on the assumption that the board’s operating structure remains unchanged and that it operates within current budgetary levels.
These project priorities are selected in the context of the board’s proposed strategic objectives:
• Developing and maintaining ISAs that are accepted as the basis for high quality financial statement audits
• Ensuring the board’s suite of standards (which include standards for review engagements and assurance engagements) continue to be relevant in a changing world
• Collaborating and cooperating with others in the financial reporting supply chain to foster audit quality and stay informed.
The IAASB’s strategy and work plan should be informed by the views of all participants in the corporate reporting supply chain. The ISAs as issued by the IAASB provide the basis for the FRC’s ISAs (UK & Ireland) and the FRC seeks to influence their development.
Therefore, the views of UK preparers on areas they believe the audit could be improved, or evolved to better meet the needs of companies, shareholders and markets would be valuable input to the IAASB.
Comments on the draft Strategy and work plan are due 4th April 2014.
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Current issues
Update on the new remuneration reporting regime
Since the last update, the institutional investor representative bodies have issued their voting guidance on the first remuneration reports to be published in accordance with the new requirements. The first binding votes have been cast at January and February AGMs on the Directors’ Remuneration Policy, contained within the remuneration reports for 30 September 2013 and later year ends.
Two striking facts emerge from the AGM season for the approximately 20 companies with September year ends which were the first to comply with the new regulations:
• Around a third of those companies were required to clarify their intentions about discretion or flexibility reserved in their directors’ remuneration policy
• The level of support for both the directors’ remuneration policy and the annual report on remuneration has been consistently high (typically above 90%)
There are some interesting trends emerging from the remuneration reports for September year ends:
• Only 6% of companies disclosed a maximum opportunity in respect of salary
• The majority of companies stated that salary increases would not exceed those of employees/ inflation
• Less than a quarter disclosed performance targets retrospectively for annual bonuses, the majority relying on the opt-out for commercially sensitive information
• Around two-thirds of companies retained discretion to provide additional awards on appointment that were in excess of normal remuneration policy
• Every company reserved flexibility for the remuneration committee to exercise judgement in the event of termination
It has become clear that institutional investors will not tolerate open-ended discretion in the recruitment policy and a number of investors have indicated that they are not prepared to accept retrospective reliance on the commercially sensitive opt-out indefinitely.
Companies with December year ends have been watching the AGM outcomes with interest. Having observed the touch points for September year ends, many are taking a more circumspect approach to open-ended discretion. Meanwhile, they are thinking more strategically about where discretion may be necessary during the expected three-year life of their directors’ remuneration policy.
It’s likely that shareholders are showing a level of leniency towards companies with September year ends, given the short period of time they had to comply with the regulations. The challenge for companies with December and March year ends is to meet investor requirements while retaining the necessary flexibility to operate the policy over three years.
Emerging issues
Pay: what goes up must come down
For proof that the world can change in unexpected ways, those concerned about executive pay need look no further than a 1976 Harvard Business Review article by David Kraus - entitled The ‘devaluation’ of the American executive. In it, he bemoaned the fact that the relative decline in executive pay experienced over the previous decade was ‘probably here to stay’.
Such sentiments might seem bizarre today, given the doubling of UK executive pay since the millennium over a period in which average earnings have increased by only 10% in real terms. But equally, when Kraus was writing, would anyone have thought that, within a
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decade, such great executive pay inflation would be underway?
Pay stagnation: blip or long-term trend? Perhaps times are changing again: bonuses paid to FTSE-100 chief executives have fallen in each of the last two years and salary freezes have become commonplace. Many believe this is simply a blip and the relentless upward trajectory of executive pay will resume, once the economy recovers.
But this is unlikely. Executive pay seems likely to stagnate in real terms. A decline is even possible, as the forces driving up executive pay abate or go into reverse.
One of the reasons often cited for executive pay inflation in the UK is that companies try to keep up with their global competitors in the war for talent. The globalisation of pay levels may now have run its course. Research shows there is significant convergence of pay levels globally. Pay in the US is declining at a time when it has risen in Europe and emerging markets. International benchmarks are no longer an inflationary force.
Simpler packages bring lower pay Another factor driving increases in executive pay has been the increase in complexity. Following the Greenbury Report in 1995, companies introduced new long-term incentive plans alongside existing share option arrangements.
By 2004, four out of five FTSE-100 companies used at least two long-term incentive plans, and one in five companies used three plans. But complexity has back-fired: our research with the London School of Economics and Political Science shows that executives drastically discount pay packages that are overly complex and would be happier being paid less in a simpler (more certain) form. The revolt against complexity has already begun in the UK and we are beginning to see examples of pay coming down, as it simplifies.
Remarkably, some pay benchmarks are also starting to come down. As the attraction of the ‘star CEO’ has waned, companies are investing more in succession planning. Three quarters of CEO appointments in the FTSE-100 are now internal candidates. Over the last year these CEOs have been appointed on a salary that is
(on average) 13% below that of their predecessor. This trend is likely to have a sustained dampening influence on executive pay. Benchmarking has been blamed for ratcheting up executive pay, but it simply accelerates trends. We could now see the use of benchmarks acting as a brake on pay.
More regulation: less pay Finally, there is no doubt that regulation has a role to play in the volatility of executive pay. Research shows that pay in financial services companies tends to be inversely correlated with the intensity of regulatory intervention. Over the period when banking was deregulated, a pay bubble formed in that sector which had spill-over effects across the economy. The current regulatory tightening will put this into reverse. Pay in investment banking has already fallen by nearly 40% since 2007 and further falls are expected over the next decade.
Over the last 35 years, the share of profits in GDP has grown relentlessly at the expense of wages paid to labour. And as the share of profits grows, so does executive pay. But what goes around comes around. Just as 1976 turned out to be a high water mark for wages as a share of GDP, so 2013 could turn out to be a high point for profits (and hence executive pay). With the post-war gains for labour now reversed, surely the likelihood is for a correction, or at least a plateau.
Who knows what surprises the future holds, but we should beware the cognitive bias of assuming things will carry on as they have done in the recent past.
What are the lessons for policy makers? The world often changes in unexpected ways, but don’t expect to be able to do much about it. Whether executive pay goes up or down will be determined by forces beyond the ability of governments to shape.
Disclaimer This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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