There has been a good deal of discussion in the accountancy press about the role of audit committees. This is as a result of the issuance of a document on a proposed minimum standard for such bodies by the Financial Reporting Council (FRC), the regulator of the audit profession in the UK. Whilst this is designed to put forward a minimum standard for large Public Interest Entities (PIEs) quoted on the FTSE 350, many of the things that it talks about are relevant to audit practice globally.
The application of the minimum standard in the UK will not become mandatory until primary legislation is passed to bring the new Audit, Reporting and Governance Authority (ARGA) into being. A process which - to this observer at least - seems to be dragging on for an unconscionably long time. But regardless of that, it seems to be no bad thing to remind ourselves of what an effective audit committee can do. Or alternatively how a poorly functioning committee can become little more than a rubber-stamping exercise.
For me a prime function of an audit committee is to hold the executive to account. They are supposed to exercise this role with a good degree of objectivity. They should be taking auditor's opinions and recommendations very seriously and ensuring that when changes are agreed that they are subsequently implemented. Of course, a wide range of skills are needed in committee members, from experience and relevant knowledge to a probing mind. They should not be afraid to ruffle a few feathers if the occasion demands it. This is easy to describe, but not always so easy to find.
Core requirements
According to the FRC's proposed minimum standard, the audit committee has a few different roles. These include:
- Ensuring a fair choice of suitable external auditors when the next tender process takes place.
- Conducting these tenders and making recommendations to the board about the appointment, re-appointment and/or removal of external auditors, as well as their remuneration and terms of engagement.
- If appropriate, engaging with shareholders on the scope of external auditing.
- Ensuring the external auditor has full access to company staff and records.
- Inviting challenge by the external auditor and giving due consideration to changing financial statements where amendments are deemed necessary.
- Reviewing and monitoring the external auditor's independence and objectivity.
- Reviewing the effectiveness of the external audit process, considering relevant professional and regulatory requirements.
These roles focus very heavily on the relationship with external auditors. Whilst I agree that this is critical, I do think it is a shame that there is not a greater focus on holding the executive to account. This is implied in what is said, but from a personal perspective I wish it was more explicit than it is currently. Having been an executive director in a former life, I found the input of audit committee members to be invaluable. It is important that when we are discharging our responsibilities, we are open to the concept of external scrutiny and advice. Humility is a much-underrated quality, and we all know that "pride often comes before a fall".
Managing the auditors
Let's scrutinise the need for the audit committee to manage the relationship with auditors. This is strongly emphasised in the roles outlined in the proposed minimum standards.
They remind readers that in the UK PIEs are currently required to put their audit out to tender every ten years, and to rotate auditors every twenty. It is important to freshen up things from time to time. Relationships between auditor and auditee can become somewhat complacent if they go on for too long. Regular re-tendering allows a fresh set of eyes to be brought in to look over financial statements, and also to evaluate the general financial management culture in the audited entity.
A number of other points are included which are ambitious and have sometimes proved difficult to achieve.
For example, there is a requirement that all tenders received, including those from non-Big Four firms, are given fair and objective consideration. This is all well and good, but recent events suggest that it is harder to deliver this in practice than to talk about it in theory. In smaller firms issues with capacity can arise for example, and there may also be a lack of relevant experience. This brings us back to that old chestnut of how can experience be obtained without being given a chance at the job in the first place? On the other hand, Big Four firms have not had an easy ride in recent times. Frequent media stories concerning large fines and disciplinary action remind us that there is a good deal of room for improvement in the standard of auditing which is taking place in some cases.
Then there is the question of cost. The FRC's proposed minimum standard suggests that this should not be the key determinant in awarding a contract. This is great in principle, but for smaller businesses working on fine margins it is slightly simplistic. On the other hand, I know of cases where tenders in some countries have been awarded to the lowest bidder, and the audited entity has subsequently had cause to regret their decision.
Managing the managers
There is also a need to make sure that executive management does its part. Audit committees are in prime position to quiz management as to why deficiencies have arisen and what steps are being taken to deal with them. The greatest failure in an auditor-auditee relationship is when recommendations come up repeatedly and are not actioned. This is a waste of everybody's time and money. It is also poor risk management. A good auditor will be able to highlight the potential for things to go wrong because of control weaknesses, even if those events have not yet happened. Forewarned is forearmed - an approach which I welcomed as a director.
Audit committees should ideally be coordinating with internal as well as external audit. Whilst the two functions have different responsibilities, they both form an important part in maintaining effective financial management. By ensuring that internal auditors are examining significant risk areas and coming up with decent findings, financial management can be improved. Again, this is only effective if executive management action any findings and correct the weaknesses that internal auditors highlight.
It is also important of course that internal and external audit work well together, whilst at the same time maintaining an arm's length relationship. Again, easy enough to talk about in theory but not always so easy to apply in practice.
All of these aspects are important, and in my experience it is not easy to run an effective audit committee in real life. If problems roll over from one year to the next without being corrected, that is a sure sign that all is not well in this respect. Making sure that audit committees are working to their maximum possible potential could improve almost every business.
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