Time for a governance overhaul

You would be wrong because Sir Bryan Nicholson, head of the UK Financial Reporting Council, has already hinted that he favours regular procedural reviews rather than episodic overhauls. You would be wrong because ‘events’ have the knack of keeping regulators in business, and change is never too far away.

But most of all you would be wrong because of an additional requirement already scheduled to kick in next year. Much has been written about the general effects of the Sarbanes-Oxley Act, less so about the effects of section 404 on UK companies.

Section 404 requires the annual reports of companies with US listings to include an internal control report of management. These reports have to explain management’s responsibilities for establishing and maintaining adequate internal controls and procedures for financial reporting for the company. They also have to set out management’s conclusions about the effectiveness of the company’s internal controls and procedures for financial reporting. And these reports require a company’s auditor to attest to, and report on, management’s evaluation of the company’s internal controls and procedures for financial reporting.

It’s that third leg of the stool that means section 404 will have a profound effect on UK companies and UK auditors. With almost half the FTSE100 also holding a US listing, when the rule kicks in mid-2004, it will take hold in and around Threadneedle Street and Wall Street.

It is inevitable that section 404 will soon become the de facto standard for FTSE100 companies, too, and it is bound to become obligatory for other listed companies.

But is that ideal? There may be merit in the aims that lie behind section 404, but is a US-drafted rule that crosses the Atlantic more by default than design really the best option for UK companies? Well, probably not.

Swift action by the Financial Reporting Council is required. Sir Bryan has suggested that he favours regular governance reviews, and there might be no better place to start than with section 404. Surely a UK-originated rule designed to improve internal controls in UK companies (with UK auditor support) is better than 404 by the back door?

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