What Does an Effective Audit Committee Actually Do? – Part 2

In Part 1 of this post, we considered the role and functions of the audit committee in overseeing risk management and internal controls, and monitoring the effectiveness of internal and external auditors. In this post, we explore the practical arrangements which make the audit committee successful.

Composition of the Audit Committee

The UK Code states that an audit committee should have at least 2 members who are independent non-executive directors (3 for listed companies). (i.e. they are not salaried employees, ex-employees or otherwise in a business relationship with the organisation). Appointments should be made by the Board in consultation with the Audit Committee chair. Usually appointments are made for 3 years, extendable for further periods. At least one member should have ‘recent and relevant financial experience’ and ideally a professional accountancy qualification. The role of the Chair is critical to success of the committee. A good chair will be independently minded, promote open discussion, manage meetings to cover all business and encourage a candid approach from all participants. An interest in and knowledge of financial and risk management, audit, accounting concepts and standards, and the regulatory regime are also essential. A specialism in one of these areas would be an advantage. Outside the formal meetings, the chair will usually meet periodically with the CEO, finance director, external auditor and head of internal audit, as well as the Chair of the Board.

The committee will need access to suitable resources to ensure agendas, board packs are distributed in advance and timely, accurate minutes are prepared. As a matter of good practice, the company secretary should normally act as secretary to the audit committee. Audit committee members must be given suitable induction and ongoing training, which should include understanding of financial statements, application of accounting standards, regulatory and legal developments affecting the organisation’s business, as well as risk management techniques. Internal and external auditors could usefully help with this as part of their retainer.

What makes an effective audit committee?

Recent research by Grant Thornton (Knowing the Ropes, 2015) found that the following qualities are found in effective audit committee members (ranked in order):

  • Ability to ask challenging questions
  • Recent and relevant financial experience
  • Audit experience
  • Ability to think clearly
  • Experience from being an executive team member elsewhere
  • Relevant industry background
  • Good listening skills
  • An eye for detail
  • Experience of other audit committees
  • Team-working skills

The FRC has recently proposed an amendment to its guidelines which recommends the audit committee should include competence relevant to the specific sector in which the organisation operates.

Some key questions which the audit committee should address include:

How do we know that there is a comprehensive process for identifying and evaluating key risks across the organisation and deciding what levels of risk are tolerable?

How do we know that the culture of risk management in the organisation is appropriate and how well people are supported to manage risk well?

How do we know how well the organisation identifies and reviews emerging and novel risks?

How do we know that the internal audit strategy is appropriate to deliver reasonable assurance on risk, controls and governance?

How do we know that accounting policies, financial management, and accounts are highlighting hidden financial risks?

How appropriate are the anti-fraud, whistle-blowing and conflicts of interest policies?

How do we know that management follows up on recommendations by auditors?

How do we know we are being effective in our work as a committee and making an impact on the organisation?

Running the audit committee

The audit committee chair should decide the timing and frequency of committee meetings, and the committee should meet as many times as the role and responsibilities require – typically there will be 3-4 meetings per year. FRC Guidance suggests the following:

  • There should be at least 3 committee meetings per year, timed to coincide with key dates in the financial reporting and audit calendar, for example, to examine the audit plan before it commences, and to review the draft annual report and accounts before approval by the Board; to review the effectiveness of the audit process once it is complete.
  • Sufficient time should be allowed between audit committee meetings and meetings of the main board to allow work arising from the committee to be carried out and reported to the Board as a whole.
  • Only the audit committee chair and members are entitled to attend meetings of the committee. Salaried executives attend by invitation and may be asked to leave for certain items of business. It is usual for the Accounting Officer (usually the CEO) and Finance Director to attend regularly.
  • At least once a year, the audit committee should meet the external and internal auditors, without management being present, to discuss its responsibilities and any issues arising from the audit.
  • Work continues outside of formal meetings, with the Chair keeping in contact with key people such as the Board Chair, CEO , Finance Director, audit lead partner and head of internal audit.

It is very important to have a clear channel of communication between the audit committee and main Board. If the audit committee chair does not sit on the main board, it will be necessary to arrange for the chair of audit to meet with the Board to report on any findings and programme of work carried out. FRC Guidance recommends that the report should cover:

  • Any significant issues found with the financial statements and how these were addressed
  • An assessment of the effectiveness of external audit and recommendations on the selection, reappointment or removal of the auditor
  • Issues where the Board has asked for the audit committee’s opinion

A typical cycle of meetings might be

Meeting 1

  • approval of internal audit plan for following year in conjunction with review of risk register
  • consideration of external audit pre-scoping report
  • review of routine internal audit reports

Meeting 2 

  • presentation of draft accounts and statement of internal control
  • review of external audit report on accounts
  • review of annual internal audit report for year
  • review of other assurance reports for year
  • review of risk register

Meeting 3

  • post audit effectiveness review
  • review of routine internal audit reports
  • review of strategic and operational risk registers
  • ‘deep dive review’ of a key risk area

Meeting 4 

  • review of routine internal audit reports
  • review of risk registers
  • ‘deep dive review’ of a key risk area

Strive for continuous improvement

Audit Committees should assess their performance annually. Typically, this review will cover areas such as reviewing and, if necessary, updating their terms of reference, assessing whether sufficient resources have been deployed to support their activities, the effectiveness of meetings, procedures for induction, training and succession planning,  and the quality and value of internal and external audit activities. An external review can help to bring an independent perspective. The Committee should draw up its own plan for improvement as a result of the self-assessment, either  requesting future training or development for members, or in changes to its processes and procedures.

Final thoughts

Audit Committees have a crucial role to play in the governance of any organisation – unless they report effectively on the relevance and rigour of the underlying structures and processes and on the assurances that the Board receives, the entire governance framework can be compromised. Effective audit committees provide comfort and reassurance to senior managers, ensuring that the organisation has a sound base for growth and protection against nasty surprises. Audit Committee members must therefore take responsibility for scrutinising the risks and controls affecting every aspect of the business. Whilst the role of an Audit Committee member is demanding, it can also be an enriching and rewarding experience.

If you need help in establishing an audit committee, an independent review of its effectiveness or advice on any other aspect of corporate governance, please get in touch.

 


Mark Johnson is an experienced solicitor & chartered company secretary supporting businesses, charities, social enterprises & academy trusts on governance, compliance & legal affairs. He also serves as an independent audit committee member for a leading Multi-Academy Trust. Please get in touch info@elderflowerlegal.co.uk or 01625 260577.

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What Does an Effective Audit Committee Actually Do?

Part 1 – Role of the Audit Committee

The audit committee makes up one of the three pillars of the Board committee system and forms a critical part of the overall framework of corporate governance for medium to large companies, housing associations, charities, academy trusts and public sector bodies. Experience shows that the role is not an intuitive one and there is often confusion about the purpose of an audit committee.

For example, in a recent Education Funding Agency webinar, a leading accountancy practitioner was asked what is the role of the audit committee in an academy trust? He replied that its job was ‘to manage risk in the organisation’. That may be his perception, but in practice how can this group of usually 3-5 non-executive members possibly have eyes and ears in every corner of the organisation? Do they really have the time and resources to achieve that result? Or is it more a case of providing oversight and ‘reasonable assurances’ to the Board and external stakeholders that appropriate systems and controls are in place? In this piece, I look at the role and functions of the audit committee and share some lessons on what makes it effective.

Why have an audit committee?

In the education sector, all academy trusts with an annual income over £50 million are required by the Financial Handbook to appoint a dedicated audit committee (smaller ones may combine this function with other committee business), under the NHS Codes of Conduct and Accountability and the Monitor Governance Code health trusts are required to establish one, local authorities are required by accounting standards to establish one, the National Housing Federation Governance Code requires that ‘All but small non-developing organisations must have a committee primarily responsible for audit, and arrangements for an effective internal audit function’. Similarly, HM Treasury requires that all government departments, executive agencies and arm’s length bodies should establish an ‘audit and risk assurance committee’. UK listed companies are required by law to have an audit committee.

The UK Corporate Governance Code (widely regarded as the gold standard of best practice) requires that boards should establish formal and transparent arrangements for:

  • Consideration of how they should apply reporting and risk management and principles of internal control; and
  • Maintaining an appropriate relationship with the organisation’s external auditors

These functions are discharged by establishing a formal audit committee with clear terms of reference.

The Board must put in place governance structures and processes to ensure that the organisation operates effectively, meets its strategic objectives and provides the Board with assurance that this is the case. However, even the best structures and processes can let down an organisation if they, and the assurances they provide, are not operated with sufficient rigour. Boards are ultimately responsible for assessing risk, signing off financial statements and the accuracy of public announcements. There can be significant personal liabilities for getting it wrong. Board members need to be reassured that they can rely on the information being presented to them.  Boards look to their audit committee to review and report on the relevance and rigour of the governance structures in place and the assurances the Board receives. The Audit Committee supports the Board in this area by obtaining assurances that controls are working as designed and by challenging poor sources of assurance.

What are the functions of an audit committee?

The UK Code lists the role and responsibilities of an audit committee:

  • To monitor the integrity of the organisation’s financial statements and any formal announcements relating to financial performance
  • To review the organisation’s internal financial controls, internal control and risk management systems
  • To monitor and review the effectiveness of the organisation’s internal audit function (if it has one, and if there is not, annually consider whether there ought to be one in the light of current risks and trends in the market)
  • To make recommendations to the board in relation to the appointment, reappointment or removal of the organisation’s external auditors
  • To approve the remuneration and terms of engagement of the external auditors
  • To review and monitor the independence of the external auditors, as well as the objectivity and effectiveness of the audit process
  • To develop and implement a policy on using external auditors to provide any non-audit services
  • To report to the board on how it has discharged its responsibilities.

The Code recommends that part of the organisation’s annual report should describe the work of the audit committee.

The Financial Reporting Council has published extensive guidance on the role of the audit committee. Of particular note are the following points:

  • The organisation’s management is under an obligation to make sure that the audit committee is kept properly informed and should take the initiative in providing the committee with information instead of waiting to be asked – this is crucial since the audit committee can only work properly if it is kept informed.
  • Whilst the core duties of the audit committee are oversight, assessment and review of systems and functions in the organisation, it is not the duty of the committee itself to carry out those functions or to make or endorse substantive decisions. Executive management prepares financial statements, auditors prepare audit plans. Executive management is responsible for actually managing risk (within the risk appetite and tolerances set by the Board as whole). The audit committee’s role is to provide reasonable assurance to the board and external stakeholders that the functions are being carried out properly. They must flag up issues indentified. FRC guidance recognises that, faced with unsatisfactory explanations by management, the committee may ‘have no alternative but to grapple with the detail and perhaps seek independent advice’. They might also from time to time carry out thematic reviews of known areas of high risk on their own initiative.

In the public sector, HM Treasury sees the role of the audit committee ‘is also to act as the conscience of the organisation’ and to provide insight and constructive challenge where required, for example, on risks arising from increasing constraints on resources, new service delivery models, information flows on risk and control and the general agility of the organisation to respond to new risks.

Oversight of risk management and controls

The effective development and delivery of an organisation’s strategic objectives, its ability to seize new opportunities and to ensure its own long-term survival depend on its identification, understanding of, and response to, the risks it faces. In an earlier post we looked at how boards can develop an effective approach to risk management. Risk appetite is the level of risk that the organisation is willing to take in pursuit of its objectives (it can have ‘upside’ as well as ‘downside’). It is concerned with the amount and types of risk the Board would like the organisation to take without a serious threat to its financial stability – it can be quantified so that prudent limits can be set. Setting that level of risk appetite is a key role for the Board as a whole.

The UK Corporate Governance Code requires that ‘the Board should satisfy itself that appropriate systems are in place to identify, evaluate and manage the significant risks faced by the organisation’. The Board should carry out a review of the effectiveness of risk management systems in the organisation. The work of the audit committee helps to inform this, but it must always be remembered that ‘the buck stops’ with the Board.

An internal control system must be effective in preventing losses arising from risk events, identifying risk events and taking corrective action when they occur. An internal control system is concerned with managing business risks which are largely internal to the organisation. Controls will include the policies, processes, procedures, methods, measures, tasks and behaviours to ensure that operational activities progress effectively. It is designed to provide assurance on the achievement of objectives as follows:

  • Effectiveness and efficiency of operations
  • Reliability of financial reporting
  • Compliance with applicable laws and regulations

Internal controls can be classified into 3 main types:

Preventive controls – intended to prevent an adverse risk event from occurring, e.g. fraud by employees

Detective controls – for detecting risk events when they occur, so that an appropriate person is alerted and corrective action can be taken

Corrective controls – measures for dealing with the consequences of risk events that have occurred.

The various sources of assurance make up what is known as the ‘three lines of defence’:

First line: management assurance from frontline or operational areas;

Second line: oversight of management activity, separate from those responsible for delivery (but still part of management chain);

Third line: independent and objective assurances from internal audit and external bodies.

Together these assurances make up the Assurance Framework.

“The Assurance Framework is the ‘lens’ through which the Board examines the assurances it requires to discharge its duties. The key question Board members need to ask is ‘How do we know what we know?’ The Assurance Framework should provide the answer.” (NHS Audit Committee Handbook 2011).

The role of ‘internal audit’ in assisting the committee

‘Internal audit’s role is to enhance and protect organisational value by providing risk-based and objective assurance, advice and insight’–  Institute of Internal Auditors.

The role of internal audit is to provide independent assurance that an organisation’s risk management, governance and internal control processes are operating effectively. Unlike external auditors, they look beyond financial risks and statements to consider wider issues, such as operational effectiveness, the organisation’s reputation, growth prospects, impact on the environment, dealings with employees and compliance with regulations. The internal audit function can be performed by directly employed staff (with appropriate reporting lines), or alternatively the function can be outsourced to a specialist firm. The scale and frequency of activities really depends on the complexity of the organisation. A properly resourced internal audit function can provide management with valuable objective assurance and advice on risk management and controls. The data and reports produced by internal audit will be valuable data to feed into the audit committee meetings, particularly where they highlight trends or recurring problems which the committee may need to probe more deeply.

In part 2, we will consider the composition of the Audit Committee, how it can manage its business effectively and the qualities to look for in effective members.


Mark Johnson is an experienced solicitor & chartered company secretary supporting businesses, charities, social enterprises & academy trusts on governance, compliance & legal affairs. He also serves as an audit committee member for a leading multi-academy trust. Please get in touch info@elderflowerlegal.co.uk or 01625 260577.

If you would like to be kept up to date on more topics like this, then why not sign up to receive our regular newsletter.

 

Top Ten Legal Risks for Enterprise and How to Manage Them

As 2016 dawns, now is a good time to reflect on your business plans for the year ahead. Make some time to consider these legal risks and how you would manage them. A modest investment now could pay handsome dividends later.

  1. Get your company structure in order

Are you using the optimum legal format for your enterprise? Have circumstances changed so that you need to revisit this? For example, if you are a sole trader or partnership taking on more liabilities and risk, is now a good time to incorporate and benefit from limited liability status? If you plan to raise external funding, will funders require you to adopt a specific legal structure, such as a company limited by shares or a community interest company with an ‘asset lock’? Are you making the most of any tax reliefs available, for example by adopting charitable status? Is your company’s constitution in order – is it clear who is responsible for what, who can spend the organisation’s money and up to what limit, who is authorised to enter into contracts or employ staff? If you are working with new partners or external investors, have you got a shareholders’ or partnership agreement in place which protects your position properly, sets out clearly what is expected of each party, how the risks and rewards will be shared and how any falling out would be dealt with? Download our free guide to legal structures here for more tips.

  1. Understand the implications of taking on business premises

If you are planning to take on business premises this year, make sure you understand the risks involved. Taking on a long term inflexible lease can be a real millstone around your neck. Are there more flexible arrangements you could use instead, such as an informal licence, sharing space with others or the increasingly popular shared business centres for start-ups? If you do decide to take the plunge on a lease, understand the implications. Is the rent realistic and affordable, how will it increase during the term of the lease? Insurance and repairs: landlords like to get tenants to sign up to ‘full repairing and insuring’ leases – which means you will be responsible for the costs of insuring the building as well as the rent; you will also be responsible for carrying out works to put the property into a good state of repair at the end (known as ‘dilapidations’) and paying a service charge to cover external repairs, cleaning and building services.  These can be very significant costs to budget for. Consider limiting your liability at the outset by having a schedule of condition prepared. Get proper professional advice before you sign anything!

  1. Get your contract terms in order

Effective and enforceable contracts are the lifeblood of any successful enterprise. Contracts with customers, service users, suppliers, employees, landlords, business partners and insurers all make up the payment flows, risk allocation and risk management tools which allow an enterprise to manage its cash flow, generate surpluses and remain solvent. Properly drafted contracts which are clear and unambiguous are a vital protection for your organisation and can really help to avoid costly disputes if things go wrong. Consider getting your contracts reviewed and put into shape by a professional. Find out more.

  1. Are you up to date with regulations that apply to your business?

The scope and burden of regulations affecting business and non-profits just seems to grow exponentially, especially in highly regulated sectors like health and social care, education, financial and professional services. The default knee-jerk response of politicians to any problem or scandal, however isolated, seems to be to pass new laws, putting more responsibilities and penalties on managers for non-compliance. For example, last year saw the introduction of new laws affecting consumer contracts, a new minimum living wage starting in April 2016, new rules affecting zero hours contracts and tough new approach to data protection violations. It can be difficult for small and medium sized enterprises to keep up with all the developments and stay compliant. One solution is to sign up to a subscription service like ours, designed to provide peace of mind. We can help you to stay focused on running your business while we take care of the paperwork, updating policies, contracts and providing on-call support with cost certainty.

  1. Protect your business ideas and confirm ownership

Have you taken all the necessary steps to protect the names, logos and goodwill associated with your enterprise? These can be a real source of competitive advantage and enhance the value of your business. Patents (which protect mechanical devices, industrial processes and chemical compounds), trademarks (which protect distinctive slogans, logos, domain names and sounds) and designs, can all be registered with the UK Intellectual Property Office. The protection gives you the right to stop others from using them without permission. Other unregistered rights can arise automatically, such as copyright (which protects literary, dramatic, musical and artistic works, sound recordings, films and broadcasts), unregistered trademarks and confidential information (such as method statements or processes). If you are discussing confidential plans with a potential business partner, do you routinely get them to sign a non-disclosure agreement to stop them poaching your ideas? Is it clear in your contracts with staff and suppliers who will own the rights to any inventions or creations?

  1. Control your debts

Good cash flow management is essential to any business. It is important to know the precise identity of the customer with whom you are dealing and ideally perform a credit reference check on them. Mistakes in the name or address of a customer may prevent you from recovering a debt from them later. Get proper written terms of business in place and consider setting credit limits for individual customers. If the customer’s credit looks doubtful, consider taking additional security, such as payment in advance or a guarantee from a third party. Late Payment legislation was introduced in 1998 to encourage a culture of prompt payment. Evidence suggests that late payments are a major continuing problem. A survey by the Federation of Small Business in 2015 found that 43 per cent of firms have waited over 90 days beyond the agreed payment date before they got the money they were owed. New rules were brought in during 2013, but the level of awareness about how to use the rules still appears to be low. Businesses may fear upsetting their customers and jeopardising future business, but used wisely the rules can really help your business. Find out more.

  1. Understand your duties as an employer

It is vital to understand your responsibilities when taking on employees. Most problems in the workplace stem from poor communication, lack of clarity about roles or expectations of new recruits, or failing to tackle performance issues when they arise. With payroll costs typically averaging 60%-75% of total costs for most enterprises, this is a high risk area worthy of intensive attention. Time spent getting your documentation, contracts, policies and procedures in order will pay dividends in the long-run. Although the introduction of employment tribunal fees has deterred some legal claims, an employment dispute can be damaging for morale, costly in terms of time and resources and can have a very negative impact on an organisation’s reputation, including implications when bidding for external contracts. Time spent getting your paperwork in order could be a wise investment to avoid problems and expense further down the line. Don’t put off that appraisal meeting or employee paperwork any longer! See more on this.

  1. Manage disputes effectively

Disputes are almost inevitable at some point in a business relationship. Various techniques can be used to resolve them. The cost of taking a case to court has risen dramatically, not least because of the increase in court fees brought in during 2015. For disputes worth over £10,000 the court fee can be 5% of the value of the claim just to issue the claim form (for example a claim for a debt of £15,000 would incur a fee of £750, plus an additional fee of up to £1,000 payable for the hearing).  Not surprisingly this is prompting a strong interest in alternative forms of resolving disputes, such as ombudsmen, adjudication, expert determination and mediation. Many trade associations now offer a mediation scheme for their members, and we are seeing the growth of private online dispute resolution forums for resolving disputes, such as resolver.co.uk or modria.com. Consider amending your terms of business to require any disputes to be referred to a less costly swifter process, rather than the courts. Remember also that disputes are often won or lost by the quality of evidence available. Make sure you keep good records of contract documents, letters, emails and notes of phone calls and store them securely for at least six years after the relationship ends. Contemporaneous notes of meetings or calls can hold great weight with a judge.

  1. Be careful with your data

As we move inexorably into a digital world, the amount of data stored and transferred concerning operations, customers, suppliers and employees is increasing exponentially. The complexity of modern business relationships, multiple interfaces between networks, cloud-based applications and storage, social media platforms and electronic devices, as well increasingly sophisticated fraudsters and hackers, means the potential for personal data to be lost or misused is growing all the time. At the same time regulators are adopting a tougher enforcement approach towards data breaches and unauthorised use of data, such as unsolicited marketing calls, texts and emails. For example, the organisers of Parklife Festival in Manchester were last year fined £70,000 for sending unsolicited text messages.

In October 2015 TalkTalk suffered massive adverse publicity when it revealed that the data of up to 4 million customers may have been hacked. The charity British Pregnancy Advisory Service was fined £200,000 when it website was hacked and sensitive details of service users compromised. If you handle personal information, you will most likely need to register as a data controller with the ICO. Registration costs £35 per year and can be completed online. Failure to notify or renew a notification when you are not exempt from notifying is a criminal offence, punishable by a fine of up to £5,000. You also need to comply as a minimum with the eight data protection principles.

Take extra care if you are planning to sell or pass on your customer lists to third parties – Pharmacy2U Limited was fined £130,000 in 2015 for passing on its customer lists without consent from customers. It is important to get the right ‘opt in’ consent from customers and service users at the first point of contact with them, either through website forms, on paper or over the telephone.

10.  Get your policies in order

A full suite of policies may be your first line of defence against potential problems with employees or regulatory action. You cannot possibly have eyes and ears in very corner of your business, but you can set out clearly what is expected of your staff, suppliers and partners. Policies should cover every aspect of your business, such as health and safe