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Audit Committees step into the Limelight

Author: Aidan Lambe

by Aidan Lambe A recent conference I attended referred to a 'global shift towards greater focus on corporate governance, transparency and disclosure'. There is no doubt that the corporate world is experiencing huge change. After a number of years of intense activity among legislators, regulators and policy makers aimed at establishing new regulatory structures and requirements to improve governance, we have now moved into the implementation phase.

Soon, we will see the first reporting by listed companies on their compliance with the requirements of the revised Combined Code on Corporate Governance, which includes new requirements for audit committees arising from the Smith Report.

In the Republic of Ireland, the CA 2003 included new statutory provisions relating to audit committees; along with most of that legislation, we await further developments regarding commencement of these provisions.

There have been many common themes and purposes in the various initiatives internationally aimed at improving corporate governance. While some measures, such as the Sarbanes-Oxley Act, have been developed through 'hard law', and are essentially rules based approaches, others, including the Combined Code, are based very much on a framework, and adopt a 'comply or explain' approach.

AUDIT COMMITTEES A clear theme in all of these corporate governance reforms has been a greatly enhanced and visible role for audit committees. There has almost been a 'reinventing' of audit committees with the purpose of giving them, along with non-executive directors, a primary role in providing additional shareholder protection. The audit committee is now being viewed as a principal player in the effort to implement governance reforms and to rebuild public confidence in financial reporting.

As a result of these new measures and responsibilities, there will also be changing relationships between management, the audit committee, and the external auditor. Perhaps three particular priorities for audit committees stand out:

-Effective oversight of management and financial reporting; -Strengthening communication between management and the external auditor (and effective monitoring of the external auditor); and -Independence and knowledge

Oversight A key element in shareholder protection through oversight of the financial reporting process is ensuring that the culture within an organisation towards financial reporting supports openness, and is honest and vigorous. Such a culture (sometimes referred to as 'the tone at the top') must come from the highest level within an organisation. The relationship, therefore, between the audit committee and executive management is critical. This needs to be based on mutual respect, support, and trust. Audit committee members depend on executive management to assist their understanding of the details of financial performance, the operation of the financial reporting process, and internal controls. Management should ensure that the audit committee is kept fully informed and should be prepared to take the initiative in supplying information rather than waiting to be asked. The audit committee, for its part, must support management in its efforts to create an environment that strives to establish sound financial reporting practices.

Communication and monitoring Communication between the audit committee and the external auditor needs to be effective. Audit committees will need to approach meetings with the external auditor in a robust manner. Such meetings will need to address matters such as audit approach and processes, industry experience, and, in particular, the independence of the auditor.

Monitoring auditor independence is now a key responsibility of the audit committee. Independence and knowledge Independence and possessing the requisite skills are essential qualities for all audit committee members.

Most 'new' legal requirements / codes on corporate governance, include specific measures addressing the independence of audit committee members. Similarly, skills such as financial literacy are seen as almost a necessity for audit committees.

Audit committees will need to appreciate the issues arising in financial statements and be in a position to challenge management; they will need to possess an ability to formulate and ask probing questions.

This, of course, suggests the need for audit committee members to receive the necessary training, including continuing training, and having access to independent expert advice - time and money!

THE SMITH REPORT A telling and significant comment in the Smith Report is that “under its guidance, audit committees will have wide ranging, time consuming, and sometimes intensive work to do”. The report further comments that companies will need to make available the necessary resources to enable audit committee members to meet their obligations - including suitable payment. There is an expectation that the new code requirements will mean that audit committee members will need to commit a significant amount of additional time to the role.

Role of audit committee According to Smith, the main role and responsibilities of the audit committee are as follows: -Monitoring integrity of financial statements, other official financial performance announcements; reviewing significant judgements; -Reviewing internal financial controls and internal control and risk management systems; -Monitoring effectiveness of internal audit; -Recommending appointment of external auditor; -Reviewing auditor independence and objectivity and audit effectiveness; -Implementing policies on supply of non-audit services.

While the report acknowledges that the primary role of an audit committee is to ensure the integrity of financial reporting and the independence of the external audit process, it sees an expanded role of the audit committee to include ensuring that the company has a sound system of internal financial control as well as systems for the control of non-financial risks. In addition, the audit committee should report to the Board, identifying any matters in respect of which it considers that action or improvement is needed, and make recommendations as to the steps to be taken.

Smith also comments that these functions may place the audit committee in an adversarial relationship with management and external auditors - the committee should not shirk this and be prepared to take on this role if necessary!

Membership and Appointment Smith's basic requirements for membership of the audit committee include:

-Independent non-executive directors (NEDs), at least one with recent and relevant financial experience -Company chairman should not to be a member of Audit Committee -Appointed by Board (on recommendation of the Nominations Committee.) -3 year term (extendable by maximum of 2 further terms)

However, ultimately, the effectiveness or otherwise of an audit committee will depend on the personal qualities of audit committee members. Smith describes these as including tough, knowledgeable, and independence of mind. Audit committees should be prepared to assess how they measure up to these attributes.

Frequency of meetings We are now likely to see audit committees meeting on a much more frequent basis. Smith has as a minimum, 3 times a year. In light of new responsibilities of committees, in practice this is likely to be much more.

Remuneration Companies need to consider the time commitment on members of audit committee members and this should be reflected in remuneration.

Skills and experience Smith comments on the desirability of that committee member whom the board considers to have recent and relevant financial experience having a professional accountancy qualification. The experience should be relevant to the nature of the business of the company. Induction and ongoing training programmes should also be provided.

Other issues Other issues that the Audit Committee should consider in assessing effectiveness include:

-Questioning management about risks of material misstatement in accounts and management's response to these questions; -How well does it understand the choice of critical accounting policies - how were these applied; what about the transparency of disclosures - does it have a proper understanding of these? -Meetings with external auditors? -Review of unrecorded audit adjustments? -Is there consideration of the level of non-audit services? -Review of unrecorded audit adjustments? -Access to sufficient training? -Access to outside expertise?

COMPANIES (AUDITING & ACCOUNTING) ACT 2003 It's interesting to compare the audit committee requirements of Smith with those of the CA 2003.

Whereas the Smith recommendations on audit committees have been incorporated into the Combined Code, attached to the Listing Rules, and operated on a 'comply or explain' approach, in Republic of Ireland, establishment of audit committees by certain companies will, on commencement of the relevant section of the 2003 Act, become a legal requirement for certain companies. There are 14 specific duties of audit committees set out in the Act. Broadly, these can be classified as follows:

-Reviewing the financial statements for compliance with company law and accounting standards and whether they give a true and fair view, and recommending to the board whether to approve the financial statements; -Assessing whether the company has kept proper books of account; -Reviewing the directors' compliance statements and, again, recommending whether the board should approve these; and -Overseeing the company's relationship with its external auditors, including their independence.

The scope of these responsibilities are broadly in line with current best practice; however, it is undoubtedly an ambitious remit and for certain companies, the audit committee will have the challenge of combining their obligations under the CA 2003 with those under the Combined Code.

With regard to the so-called 'directors' compliance statements' there audit committee also has a responsibility. That is to review the 'annual statement of compliance' and to determine whether it is 'fair and reasonable' and is based on 'due and careful enquiry'. In addition, there are requirements aimed at addressing the independence of audit committee members. Notable by its absence is any requirement for an audit committee to have among its membership anyone possessing relevant financial expertise.

Immediate challenges A number of issues present themselves as immediate challenges to audit committees. Obviously, there is a very real challenge of adapting practices, policies and procedures of audit committees in anticipation of the new statutory obligations they will face. In light of the revisions coming from the Combined Code and the 2003 Act etc, there is a very real risk of an expectation gap emerging between the oversight role of the audit committee and perhaps shareholder expectation of the committee being a guarantor of a company's financial reporting.

There is also a danger, with this myriad of reforms, that committees will become less focussed on enhancing overall effectiveness and more so on 'box ticking' - there is always a danger of too many requirements leading to too much checking off and not enough thinking.

One specific item worthy of mention is the transition to International Financial Reporting Standards in 2005. The Audit Committee will need to be in a position to make recommendations to Boards concerning the approval of IFRS compliant financial statements. Are audit committees ready to do this? Questions that audit committees might ask of themselves include:

-Is there an adequate understanding among committee members of the implications for their company in moving to this new financial reporting framework? -What has been the role of the audit committee in their company's plan for the IFRS transition? -Has it assessed the effectiveness of the company's implementation plan? Has it received regular progress reports? -Importantly, is the audit committee alert to the possibility of the transition to IFRS being taken as an opportunity to misstate financial figures?

A recent survey conducted by the National Association of Pension Funds and Institutional Shareholder Services in the UK, revealed that many boardroom structures and practices of many leading UK companies are falling short of what the revised Combined Code now requires.

The study voiced particular concern over the composition of audit committees, and in particular the role of the company chairman - one in four company chairmen sat on either the audit committee or remuneration committee, therefore violating the requirements of the Code as regards independence. Although the Code adopts a 'comply or explain' approach, the NAPF has promised a 'robust' dialogue with those companies which could result in 'no' votes against any non-independent director who sits on an audit committee.

And just when you thought things were about to settle down the European Union has decided to get involved in the action. Recent draft proposals have stressed the need for listed companies to have audit committees with terms of reference including overseeing auditor independence, objectivity and effectiveness. Many of its proposals are similar to those we have heard about already, including the need for audit committees to possess the necessary financial expertise.

In conclusion, we are seeing a reshaping and redefining of the roles, responsibilities, and accountabilities of audit committees, senior management, and internal and external audit. Audit committees, working more closely with external auditors, will in future play a key role in restoring and maintaining trust and credibility between companies and their shareholders. To succeed in this role, audit committees must bring to bear a process of open communication, independence, healthy scepticism, and knowledge.

Aidan Lambe, FCA, is Deputy Director, Professional Standards, with the Institute of Chartered Accountants in Ireland.

Audit Committees step into the Limelight

Author: Aidan Lambe

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