Scandalous accounting frauds during the past decade precipitated a strengthening of the corporate governance system. In the coming months, this new system will be put to the test again when publicly accountable enterprises convert their accounting frameworks from the current Canadian generally accepted accounting principles (GAAP) to International Financial Reporting Standards (IFRS). This article explains the audit committee's role in this process.
The IFRS related role of the audit committee is multifaceted, but can generally be considered in two parts:
1. During the transition, the committee must monitor the conversion to ensure that the process is driven by management, that responsibility rests with an appropriate individual and that sufficient resources have been allocated.
The committee must ensure that all relevant parties receive the necessary training and that deadlines are met. The committee has a vested interest in ensuring the company is able to issue its first IFRS compliant financial statements on time.
2. The committee must understand the results and conclusions of the conversion process, to be able to keep the board informed of progress and issues. Significant issues, in terms of their impact on reported position and performance and any areas requiring exercise of judgment, need to be understood.
European Union countries adopted IFRS with effect from 2005. Subsequent research1 found that preparers' views of the board's understanding of the financial impact of IFRS were "broadly positive" but "significant minorities were not confident of the board's understanding". Even after transition, "company boards were still in need of more advice and assistance on accounting matters than was the case prior to the transition."
Changing the financial accounting framework means the way in which an entity has historically reported its financial position and results will have to be reinvented, or at least subjected to close scrutiny. While the conclusions and actual impact of the change may not be revolutionary, it will mean that all aspects of the reporting entity's accounting system and other operating systems will be brought into the conversion debate.
An effective audit committee asks simple and direct questions in order to obtain information and explanations from management. Nothing needs to change for the committee to discharge many of its IFRS related responsibilities. However, some level of knowledge of the new accounting framework will be essential when the audit committee probes management for the effect of IFRS on continuous disclosures and their relation to the capital markets or challenges the judgments made by management: the committee has to be able to identify issues without being led by management.
To provide some examples, IFRS may give rise to the following issues:
- Recognition of liabilities that were not recognized under the previous GAAP, which may be problematic for meeting financial covenants. Similarly, de-recognition of assets or a change in operating results may have the same effect.
- Different entity performance due to changes in accounting for items within net income.
- Any of these changes may also drive a change in quantity of management remuneration.
- A risk exists that the effect of past errors in accounting are characterized as conversion differences instead of being reported as corrections of past accounting errors.
The composition of the audit committee is the most pertinent aspect of the new corporate governance model as it relates to the risks posed by the change in accounting framework. All bodies that operate in the public environment – including management and staff, regulators, shareholders, board members, analysts and rating agencies and auditors – will need some level of understanding of international standards. However, audit committees cannot hope to be effective if they do not have the requisite financial literacy.
How audit committee members should acquire this knowledge is not mandated, but is left to the discretion of individual committees or members. Different approaches to this task have their own unique pros and cons.
- Management: The audit committee provides the final review and approval of the entity's financial reporting prior to release. The review and approval process is most effective if it is performed fresh and is not directed in any way by management. Having committee members trained by management may introduce bias into the committee's review process that would be difficult, if not impossible, to overcome.
- Independent auditor: By definition, the entity's auditor is independent of the organization and of management. Furthermore, the auditor already has a degree of familiarity with the company and its environment and is therefore well positioned to provide training. However, the auditor may look at the task through the audit lens so there may be a loss of creative thinking.
- Third party: A truly independent training provider would be most valuable because the audit committee would be positioned to approach the governance role with fresh eyes.
Whichever approach is adopted, the curriculum should be tailored to the specific industry and to the entity's circumstances with sufficient breadth and technical depth to ensure it can be applied.
1 According to a report prepared for the EU by the Institute of Chartered Accountants in England and Wales – entitled EU Implementation of IFRS and the Fair Value Directive.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.