UK: Catch The 2009 Current: The Audit Committee Knowledge

INTRODUCTION

The audit committee has become in recent years one of the main pillars of the corporate governance system in British public companies. With this increased importance has come increased responsibilities and the need for guidance on the duties of an audit committee. Last year, Deloitte published "Catch the current – the audit committee knowledge" with a view to meeting that need. It was designed to be a "one-stop shop" for audit committee members and received excellent feedback from readers.

At that time there were some signs of the challenging environment ahead but the current intensity of those challenges was not expected. The past twelve months have seen a number of significant events, both planned and unplanned, affecting audit committees. It was therefore timely and essential to produce "Catch the 2009 current". The new developments covered in this edition are:

• implementation of the European Statutory Audit and Accounting Directives;
• revision of the Combined Code and the Smith Guidance on audit committees;
• the Financial Reporting Council's confirmation of the continued validity of the 'true and fair' view;
• publication of the Financial Reporting Council's Audit Quality Framework;
• the introduction of liability limitation agreements;
• the Financial Services Authority's sanctions for failure to identify and disclose price-sensitive information;
• the Financial Reporting Council's Update for directors of listed companies on going concern and liquidity risk;
• publication of key questions for audit committees to consider in light of the challenges arising from current economic conditions; and
• the results of Deloitte's latest surveys on inter alia board structure, narrative reporting and interim management statements.

Appendix 5 provides an 'At a glance' summary of what is new in this edition.

The guidance in the document reflects the current requirements under the 2008 Combined Code and the revised Smith Guidance for audit committees. References to the Companies Act are to the 2006 Companies Act. Where future changes have been formally announced these are referred to in the appropriate sections. Regular updates on developments will be available from the corporate governance section of www.deloitte.com/uk and will be covered at events in the Deloitte Academy.

The key to the success of any audit committee remains constant, namely to ask the right questions. This publication includes questions for audit committee members to ask management to provide that an appropriate level of challenge is given. 2009 will be an interesting year.

1. SETTING THE SCENE

1.1 The Origins Of The Audit Committee

Audit committees are now a common component of governance – companies have them, government departments have them, councils have them and schools may have one. The composition and function of these committees varies from organisation to organisation, but the theory remains broadly the same. The audit committee is created with the aim of enhancing confidence in the integrity of an organisation's processes and procedures relating to internal control and corporate reporting.

Up until June 2008, for UK companies listed on the main market of the London Stock Exchange, audit committee requirements featured only in the Combined Code on Corporate Governance. Code provision C.3.1 states the following:

This did not impose a mandatory requirement for companies to have an audit committee as application of the Code is on a "comply or explain" basis, but having an audit committee was the accepted "norm" among listed companies (all but one FTSE 350 companies have established audit committees).

UK implementation of the European Union's Statutory Audit Directive, in the UKLA's Listing Rules, imposes a requirement, for all companies whose securities are traded on a regulated market in the EU to have an audit committee (or equivalent body). In this regard, the "comply or explain" basis referred to above is replaced by comply or face FSA sanctions. This new requirement is discussed in further detail in section 1.4 below.

The Combined Code is supported by the Smith Guidance on audit committees. This guidance was issued by the Financial Reporting Council in July 2003 and revised in October 2008. It is designed to assist company boards in making suitable arrangements for their audit committees and to assist directors serving on audit committees in carrying out their role. Where relevant this publication refers to the Smith guidance, as it represents the most definitive guidance for audit committees in the UK.

Throughout this document reference is made to "company" and "board of directors". The principles of governance apply equally to non-corporates including government departments, public agencies, charities and other public interest entities. In particular, they also apply to AIM companies which, whilst not caught by the rules are encouraged to comply voluntarily with the provisions of the Combined Code and the principles of the Quoted Companies Alliance publication "Corporate Governance Guidance for AIM Companies".

1.2 Why Have An Audit Committee?

The true benefits of having an audit committee will depend on the effectiveness of the committee in question. An audit committee can assist the board in discharging its duties by:

• strengthening the quality of financial reporting;
• creating a control environment which will reduce the opportunity for fraud;
• strengthening the independence of internal auditors from executive management;
• providing a forum for continuous review of internal control including risk assessment;
• improving communication among the board, management and the internal and external auditors, resulting in a more effective and efficient audit process; and
• increasing confidence in the credibility and objectivity of financial statements and of the board.

An effective audit committee will display the following characteristics:

A vital component in the success of the audit committee is the attitude of management. Audit committees require the support of management to provide the necessary information and resources to operate effectively and to meet their objectives in the key areas of financial reporting, internal control and the quality of the audit function. Indeed, it is essential that boards, management, internal auditors, external auditors and audit committees work together to ensure audit committees are effective and, as a result, make a real contribution to good corporate governance.

1.3 The UK Regulatory Environment

The fourth study by the City of London Corporation published in September 2008 continued to rate London first, ahead of New York, Singapore and Hong Kong as a global financial centre. The Corporation's Global Financial Centres Index evaluates the competitiveness of 59 financial centres worldwide. The results of the study show that London outperformed New York in all five areas of competitiveness: people, business environment, market access, infrastructure and general competitiveness. However, the three month rolling average of all assessments for London and New York for the past year shows that London's recovery from the credit crunch impact in August 2007 has been far slower than New York's. The report states that the recovery in confidence in London's competitiveness has been slowed by the collapse and subsequent handling of Northern Rock. It is also likely that London's perceived competitiveness over the past six months has been adversely affected by the proposed tax treatment of non-domiciled residents of the UK.

The UK regulatory system focuses on the empowerment of shareholders. Effective engagement of shareholders in the UK is facilitated by the Combined Code on Corporate Governance. The success of the Code relies on its "comply or explain" approach and shareholders with genuine legal powers to hold directors to account. Companies have the flexibility to apply the principles of the Code in a way that suits the size and complexity of their organisation. Where a decision is taken not to comply with a Code requirement a company is able to explain why it believes the approach adopted is more suitable. It is then up to investors to decide whether the explanation is reasonable and justifiable and to take action accordingly.

Enhancing shareholder engagement was a key focus of the Companies Act 2006 which received Royal Assent in November 2006, after almost nine years of consultation and debate. The new Act is a significant overhaul of UK company law. The Government's objective in undertaking this exercise was to make company law more modern and accessible and to make UK companies more competitive. The development of the Act was founded on four key themes which were:

• to enhance shareholder engagement and a long-term investment culture;
• to ensure better regulation and a "Think Small First" approach;
• to make it easier to set up and run a company; and
• to provide flexibility for the future.

The 2006 Act provides a statutory statement of directors' duties for the first time, codifying much of what has built up in common law and equitable principles over the years. Although there are seven general directors' duties the most focus has been centered on the duty to promote the success of the company. This section of the Act provides that directors must in fulfilling this duty have regard to (amongst other matters):

• the likely consequences of any decision in the long term;
• the interests of the company's employees;
• the need to foster the company's business relationships with suppliers, customers and others;
• the impact of the company's operations on the community and the environment;
• the desirability of the company maintaining a reputation for high standards of business conduct; and
• the need to act fairly as between members of the company.

Shareholders are given a new statutory right to bring a claim, on behalf of the company, for negligence, default, breach of duty or breach of trust. This is wider than the current position in that claims can be brought for negligence and because there is no need to show that the person against whom the claim is made has benefited from his or her actions.

The Government has been careful to build in a number of safeguards to the new system to prevent spurious and unmeritorious claims. The effects of these new provisions in practice will emerge in due course. It is hoped that the US experience of class actions will not be repeated in the UK.

1.4 The European Dimension

In June 2008, the Financial Services Authority (FSA) implemented the European Union's Statutory Audit Directive. Under Article 41.1 of the Directive, Member States must require various listed entities to have an audit committee (or equivalent body).

For periods commencing on or after 29 June 2008, the FSA rules have been amended to include a new Disclosure and Transparency Rule (DTR 7.1) on companies whose securities are traded on a regulated market in the EU to:

1. have in place a body which:
   
   
   1. fulfils the functions set out below; and
   2. has within its composition at least one independent member and one person with competence in accounting and/or auditing (who may or may not be the same individual); and
      
      
2. issue a statement which identifies the body and describes how that body is composed.

The minimum functions of the audit committee (or equivalent body) are to:

1. monitor the financial reporting process;
2. monitor the effectiveness of the issuer's internal control, internal audit (where applicable) and risk management systems;
3. monitor the statutory audit of the annual and consolidated accounts; and
4. review and monitor the independence of the statutory auditor and in particular the provision of additional services to the issuer.

The rules state that an issuer must base any proposal to appoint a statutory auditor on a recommendation made by the audit committee.

The FSA has concluded that compliance with provisions A.1.2, C.3.1, C.3.2 and C.3.3 of the Combined Code will result in compliance with the new DTR 7.1. This means that entities already complying in full with the Code requirements will not need to do anything further to comply with DTR 7.1.

DTR 7.2 requires all UK registered issuers to include a corporate governance statement in their directors' report referring to:

• the corporate governance code that the company has decided to apply or is subject to under the law of the Member State in which it is incorporated;
• an explanation as to whether, and to what extent, the company complies with that code. To the extent that a company departs from the code, the company should explain from which parts of the code it departs and the reasons for doing so;
• a description of the main features of the company's internal control and risk management systems in relation to the financial reporting process;
• major shareholdings and related matters already required by the Takeover Directive; and
• a description of the composition and operation of the company's administrative, management and supervisory bodies and their committees.

DTR 7.2 makes it clear where there is overlap with the existing Combined Code provisions and states that companies complying in full with the relevant provisions of the Code will not need to do anything further to satisfy the requirements of DTR 7.2.

A company may elect that, instead of including its corporate governance statement in its directors' report, the information be set out:

• in a separate report published together with and in the same manner as its annual report; or
• by means of a reference in its directors' report to where such document is publicly available on the company's website.

2. ESTABLISHMENT OF AN AUDIT COMMITTEE

2.1 Terms Of Reference

The terms of reference of an audit committee should record clearly and concisely the authority, responsibilities, specific duties and resources available to the audit committee. Clearly, the specific duties will vary from company to company.

The Smith Guidance comments that "the terms of reference should be tailored to the particular circumstances of the company" (section 3.2). As explained in Section 1.4 DTR 7.1 introduces new rules regarding the establishment of an audit committee body (or equivalent body). The FSA is clear that compliance with provisions C.3.2 and C.3.3 of the Combined Code will result in compliance with the requirements of DTR 7.1.3.

Where the provision above says that the terms of reference "should be made available" this may be satisfied by making them available on request or by including the information on a website that is maintained by or on behalf of the company. It would be unusual to include them in the annual report itself. The external and internal auditors should also be given copies of the terms of reference.

The Deloitte publication "Write from the start" surveyed narrative reporting in the annual reports of 100 listed companies. The study found that 58% of companies included in the survey referred the reader to the company website for the terms of reference of the audit committee. Only 4% included this information with the annual report and none of the companies that did so came from the top 350 companies. More surprisingly, over a quarter of companies in the sample (29%) gave no information on the terms of the reference of the audit committee.

The terms of reference should be reviewed periodically to assess their continuing relevance in light of the requirements and priorities of the board. Any changes should be approved by the board. The audit committee should use the responsibilities outlined in the terms of reference to develop a responsibility checklist and meeting agendas that are designed to ensure that the provisions of the terms of reference are constantly in the forefront of audit committee members' minds and are executed in an appropriate and timely manner. (See section 4 below for further discussion of meeting agendas.)

Illustration 1 provides specimen terms of reference. These terms of reference are provided for illustrative purposes only and in practice the terms of reference will need to be carefully tailored to reflect a company's particular circumstances.

2.2 Membership Of An Audit Committee

Code provision C.3.1 states the following:

Section 2.3 below covers issues of independence and section 2.5 below covers the determination of the audit committee financial expert.

The Smith Guidance repeats the Code provision above and provides the following further guidance (sections 2.4 and 2.5 of the Smith Guidance):

The Deloitte 2008 survey of board structure and non-executive directors' fees used information available in the annual reports and accounts of the companies in the FTSE 350 as of 30 June 2008, excluding 43 investment trusts. This survey provides the following data on audit committee membership.

If an audit committee is to be effective, its members must have a strong understanding of the company's business processes and procedures and its industry sector. At the same time, the members of the audit committee should have a broad business background and bring with them a variety of skills. Each member of the audit committee needs to:

• understand the social, political, ethical, economic and legal framework within which the company operates;
• be aware of the company's organisational structure and policies;
• understand the operations of the company, its planning, control and production methods;
• have a sufficient understanding of accounting and financial matters to understand the issues before the audit committee; and
• be objective in spirit and judgement, willing to ask the right questions, obtain the necessary facts and act accordingly.

In this context, audit committee members need to have access to the necessary resources to enable them to discharge their responsibilities effectively. The Smith Guidance makes the following comments on resources (sections 2.11 to 2.14 of the Smith Guidance).

Further to its recent review of the Combined Code in 2007, the Financial Reporting Council has amended the Code to allow the chairman of a smaller listed company to be a member of the audit committee where he or she was considered independent on appointment. As shown above, Code provision C.3.1 has been amended to allow the chairman of listed companies outside the FTSE 350 to be a member of the audit committee. The chairman of the company is not allowed to chair the audit committee and cannot be counted as an independent member of the committee.

2.3 Issues Of Independence

Code provision A.3.1 sets out criteria to determine whether a non-executive director is independent.

The Deloitte 2008 survey, "At the helm", used a tailored questionnaire to gather data from 84 companies representing around 16% of the FTSE All Share companies excluding investment trusts. This broke down into 26 FTSE 100 companies, 36 FTSE 250 companies and 22 FTSE SmallCap companies.

"At the helm" revealed that 77% of FTSE 100 and 56% of FTSE 250 companies comply with the Combined Code requirement that at least 50% of the board (excluding the chairman) should comprise of independent non-executive directors. In 23% of companies (16% last year) the audit committee includes a director who is not independent as defined by the Combined Code.

2.4 Induction And Training

Induction and training are vital components in the establishment of an effective audit committee. The Smith Guidance makes the following recommendations (sections 2.17 to 2.19 of the Smith Guidance).

The Deloitte "At the helm" 2008 Survey identified that, overall, there continues to be an increase in the number of companies operating induction programmes for directors joining the board and providing regular updates on an on-going basis to ensure skills and knowledge are refreshed. 71% of participants in the Survey stated that they provide formal training on appointment and 70% of companies have on-going training programmes in place for directors. A quarter of the companies who do not have some form of process in place plan to introduce a formal training and development process in the future.

2.5 Determination Of The Audit Committee Financial Expert

Guidance on what constitutes "recent and relevant financial experience" is provided in section 2.16 of the Smith Guidance.

Almost all audit committees within the "At the helm" survey include a member that has recent and relevant financial experience with 98% of companies confirming this in the annual report compared to 97% in 2007.

This is now part of the new Disclosure and Transparency Rules. DTR 7.1.1 states that: "At least one member of that body must be independent and at least one member must have competence in accounting and/or auditing."

Audit committees may wish to document their consideration of this topic and consider whether further training might be useful (see sections 2.4 and 2.7).

2.6 Fees

The Smith Guidance (section 2.15) states the following:

Deloitte's 2008 board structure and non-executive directors' fees survey revealed that many companies disclose separate committee chairman fees, particularly for the audit and remuneration committees. Fees for nomination committee membership are much less common, reflecting the fact that these tend to meet only when there is a vacancy for the board.

Some companies differentiate among committees and where this is the case the fees for chairing the audit committee will typically be higher than for other committees. Currently 79 companies (60% of FTSE 100 and 27% of FTSE 250 companies disclosing the structure) pay a higher fee for chairing the audit committee. This has not changed significantly from 2007.

The following table shows the range of fees disclosed and the number of companies disclosing separate fees.

2.7 Performance Evaluation

The Smith Guidance recommends two forms of performance evaluation for the audit committee. The first is a self-evaluation exercise of the effectiveness of the audit committee and the second is a review by the board of the effectiveness of the audit committee. The Guidance recommends that both of these evaluation exercises should be performed on an annual basis (sections 3.3 and 3.4 of the Smith Guidance).

The requirement for the board to review the effectiveness of the audit committee stems from Code principle A.6.

These evaluations are usually performed using a questionnaire, interviews or, in some cases, an external assessor.

A good example of disclosure of this evaluation in the annual report is as follows:

"Board Effectiveness

The effectiveness of the board is vital to the success of the group. The company undertakes a rigorous evaluation each year in order to assess how well the board, its committees, the directors and the chairman are performing. The process is led by the chairman and supported by the group company secretary. All directors complete a questionnaire evaluating the board and committees' processes, their effectiveness and where improvements may be considered. The process also includes a peer review in which directors assess their fellow directors' performance against set criteria, including the skills that they bring to the company and the contribution they make. This process is complemented by separate meetings between each director and the chairman where feedback is discussed.

In 2007, following the process introduced in 2006, the directors completed a comprehensive questionnaire which was returned to an independent third-party who had helped with the preparation of the questions, and who then collated comments, drew the conclusions and presented the findings to the board." [Aviva plc Annual Report and Accounts 2007]

Appendix 4 to this document includes a self-assessment checklist. It would be reasonable to assume that the board would ask similar questions when evaluating the performance of the audit committee.

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