Governance is more than regulation, which is its servant. Every public interest entity (‘PIE’), operating for the benefit of stakeholders and employees, functions within a regulatory structure that balances operational freedom, risk and cost. Finding and maintaining a lasting balance between these potentially competing elements is the province of good governance, and ensuring its effectiveness is the remit of the board of directors and, increasingly, its audit committee
The main board’s ambit is far too wide for it to become involved in the details of governance, which is why it relies on the audit committee, through its chairman, to keep it informed of key developments in risk, progress in addressing these issues and recommending action points. The committee itself relies, in turn, on internal audit as its force on the ground, tasked with prescribing appropriate internal control systems and enforcing compliance.
The new EU Audit Regulations & Directive (‘ARD’) will have a major impact on the functional profile of audit committees, and the Financial Reporting Council (‘FRC’) has strengthened the applicable provisions of the UK governance code.
Selecting external auditors
ARD rules on rotation of external audit appointments will cause audit committees to become involved, more formally and regularly than previously, in the selection process. Specifically, they will play a key role in identifying suitable candidates, basing their recommendations on such matters as knowledge of the business, an understanding of its commercial environment and awareness of competitors and peers. Auditors already acting for a competitor would obviously be rendered ineligible.
Prohibiting external auditors from providing lucrative non-audit services will make it easier for companies to negotiate and agree fee levels, as volatility will arise mainly from changes in the client’s own size, corporate structure and risk profile of new and discontinued activities.
“Monitoring audit effectiveness”
Audit committees will take on the critical role of monitoring external audit effectiveness, and meetings between the committee and external auditors, with no one else present, will be an important element in the monitoring process. Committees will note in particular any tendency to take invigilation and scrutiny off the boil, as a virtually assured 10-year tenure may easily instil a sense of complacency.
Ironically, this is the very factor capable of undermining the independence and effectiveness of the audit committee itself. The condition to be guarded against is, in a word, “cosiness”. Audit committees, by and large, are composed of non-executive directors, and many of these take on NED roles as a post-retirement vocation, perhaps making a practice of collecting appointments that are generally unchallenging yet immensely lucrative.
Since many NEDs are ex-partners in the largest audit practices their external audit selections may be perceived lack true independence. Even if such suspicions are wholly unfounded, it is crucial that NEDs’ conduct is seen to be beyond any such taint. Granting them two 3-year terms as the norm, with an added 3-year term in special cases, may strengthen their independence.
When integrity is put to the test by being confronted with questionable business practices – from imposing unfair working conditions to accounting skulduggery, any of which carry huge reputational risks – NEDs must be prepared to face up to the directors who appointed them and who, conversely, have the power to sack them.
To be worth their salt audit committee members must therefore be prepared to resist the “go with the flow” line of least resistance. This is particularly the case when faced with problematic accounting issues. If the chairman of the audit committee chairman is its only qualified accountant, others will be expected to follow his lead on potentially acrimonious debates on such matters as recognising revenue. A current example: technology giant Oracle is facing a claim for unfair dismissal from an employee alleging that reported revenue figures were materially overstated by the practice of including accruals unsupported by bills to customers.
Right now no one knows the answer, but evidence from the audit committee’s minutes will reveal the nature and thoroughness of its deliberations, as led by the chairman’s expression of views, which are bound to be revealing.
As ever, it’s a question of calibre.