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Comments from The Association of Chartered Certified Accountants
October 2002.

1. Terms of reference for Audit Committees including guidance on Committee activities and proceedings
   
   Q1 Should there be standard terms and conditions for Audit Committee activities and proceedings? If so, what should be included?
   
   We are against standard terms and conditions for Audit Committees. Different companies have different ways of achieving their objectives. For example, the board may choose to undertake a thorough assessment of risk management itself or delegate this to an Audit Committee or to another committee. It would be wrong, therefore, to impose standard terms and conditions as this may hamper flexibility and efficiency with no real gain in control.
   
   There are, however, certain core functions which should be fulfilled. Guidance should be developed to set out the main purpose of Audit Committees, their general objectives and the principles to be applied throughout their activities and proceedings. An illustrative list of core activities might contain the following:
   
   
   • making recommendations to the board on auditor appointment, remuneration and dismissal
   • reviewing the scope and focus of audit activity (both internal and external, financial and non-financial)
   • developing objective criteria for the procurement of non-audit services from the external audit firm
   • monitoring and assessing the independence of the external auditor (using the IFAC independence guidance as a benchmark)
   • appointing the Head of Internal Audit
   • receiving the output of the internal and external audit activities and identifying priority areas for remedial action
   • reviewing the financial and operating control and risk reviews undertaken by management and ascertaining whether or not policy changes are required
   • reviewing the performance of the company in meeting (a) its legal obligations and (b) legitimate stakeholder expectations in non-financial areas such as environmental performance, corporate social responsibility and sustainable activities (see 10 below)
   • reviewing draft financial statements (including quarterlies) from the perspectives of acceptability of accounting policy choice, transparency and understandability
     and
   • reporting to shareholders on the activities of the Committee (frequency of meetings, issues discussed, etc.) and providing a public assessment of the independence of the external auditor.
     
     
   It may also be appropriate to issue best practice guidance on the depth of involvement of Audit Committees as well as the scope of their involvement
   
   
2. The composition of the Audit Committee, paying due regard to the characteristics which members would need to have to ensure independence from the executive, to avoid conflicts of interest and to achieve a suitable balance of skills and experience. The competencies required for the proper exercise by individual Audit Committee members of their responsibilities; including any training needs, and the time required to discharge those responsibilities
   
   Q2.1 Who should serve on Audit Committees?
   
   Three or more NEDs, preferably independent and in the majority, and definitely with an independent chairman.
   
   Q2.2 What skills and experience is required?
   
   It is hard to prescribe particular skills requirements for NEDs but, in the current climate, when accountability and transparency issues are dominating the agenda, it would be reasonable to suppose that all NEDs should have a broad awareness of financial reporting issues and related assurance/corporate governance mechanisms. In terms of specifics, companies must be free to determine the particular skills and knowledge required from each NED. Not every NED will serve exactly the same role on the board.
   
   Expectations of companies are increasing and the boundaries of accountability are widening. Elsewhere in this response (see 1 above and 10 below), we suggest that consideration of non-financial issues, such as corporate social responsibility and environmental compliance, should be a standard feature of the work of the Audit Committee. It follows that Audit Committee members should have an awareness of such accountability issues and should be able to recognise the significant risks which can arise if such issues are mismanaged.
   
   Q2.3 What training should be provided to members of Audit Committees, and how can it be ensured that they receive it?
   
   We support the view that board members should receive some formal training regarding their roles and responsibilities. Such training should include an induction into the company's strategies, structures, values and policies and financial and operating controls. NEDs should not be exempt from this innovation - especially given the sensitivity of their role in the expanded accountability debate. Insistence on formal qualifications for all directors would not, in our view, be appropriate.
   
   
3. The relationship between the Audit Committee and the full Board Q3.1 What form should the interaction between Committee and Board take?
   
   ACCA supports the present unitary board structure. Board members should work as a team. The interaction between EDs and NEDs should therefore be constructive yet challenging. It is important that both EDs and NEDs understand that independence means independence of mind (i.e. objectivity) and that NEDs are encouraged say it "as it is" rather than how they think the EDs would like to hear it.
   
   Q3.2 How should conflict between the Committee and Board be resolved?
   
   If EDs understand the role of the Audit Committee, appreciate what is meant by independence and accept that, as a consequence of being independent, NEDs will ask challenging questions, conflict should be avoided. It is up to the board chairman to create the culture where decisions can be challenged and discussed without conflict. Where conflict does arise, perhaps over the organisational appetite for risk or the effectiveness of the CEO, it is realistic to recognise that confrontation, possibly leading to the resignation of one of the parties, may be the only way forward.
   
   
4. Safeguarding the interest of shareholders, including for example any report from the Audit Committee directly to shareholders
   
   Q4.1 What form should the interaction between Audit Committee and shareholders take?
   
   ACCA believes that NEDs should have a responsibility to make governance reports to shareholders and to be available to answer questions on governance at general meetings. As part of this report, the Audit Committee should disclose its assessment of the independence of the auditors, and the criteria used for awarding any non-audit work to the auditors. Audit and non-audit fees should be disclosed by category and significant changes fully explained.
   
   Q4.2 Should Audit Committees report direct to shareholders?
   
   Yes, as part of the NEDs' governance reports.
   
   
5. Monitoring the company's financial controls and financial policies
   
   Q5.1 Should the Audit Committee monitor financial controls and policies, and the company's exposure to financial risk? If so, how?
   
   Yes. It should also monitor internal control and risk as a whole rather than just from a financial aspect (see 1 above and 10 below - non-financial issues). It should do this partly through consideration of reports from internal and external auditors. It should also have access to other information such as the results of control self-assessment programmes, and through asking appropriate questions and making its own inquiries. If it has any cause to doubt the reliability of any of the information which it receives, or if information from different sources is inconsistent, it should make further inquiry to obtain necessary assurance on internal control or call for the board to take appropriate action.
   
   Q5.2 Should the Audit Committee be prepared to challenge the substance of the executives' financial reporting decisions?
   
   Yes. When the Audit Committee has serious concerns relating to the financial reporting policies adopted, for example in respect of long-term contracts, financial instruments, pensions costs, stock options, goodwill or revenue recognition, it should have the right to employ specialist advice.
   
   
6. Establishing an effective working relationship with the auditors Q6. How is the best way to form an effective working relationship between the Audit Committee and external auditors?
   
   The relationship should be based upon the agreed principle of protecting and promoting the public interest against the possibility of self-interested actions by highly placed individuals. Promoting the role of the Audit Committee should serve to place a necessary distance between the auditors and the CFO and thus protect the independent status of the former.
   
   An effective working relationship can be helped by the Audit Committee focusing on the overall objective of ensuring the integrity of financial reporting and demonstrating a sound understanding of both the financial reporting and the assurance issues pertinent to the company.
   
   It should be common practice to have clear terms of reference and to forward-plan the Audit Committee agenda so that the Committee meets at the right times to consider key stages of the audit cycle. It is particularly important that the Committee is involved in the planning stage of the audit.
   
   
7. Criteria for reviewing the effectiveness of the audit and its value to shareholders and other stakeholders
   
   Q7. How can the effectiveness of the audit be evaluated by the Audit Committee?
   
   This is a question which is often asked but to which no satisfactory answer seems available. However Enron and WorldCom have now provided many questions which can be asked to help judge effectiveness.
   
   The effectiveness of the audit can best be assessed if the objectives have been agreed and outputs are transparent and related to appropriate external benchmarks. When necessary, Audit Committee members should consider information from other sources and so have a basis from which to assess the information which they receive from the auditors.
   
   Although the primary aim of the audit will be to maintain confidence in the integrity of the company's external financial reporting, the results of an effective audit will also be observable in terms of the practical recommendations made as a result of the audit. These recommendations might include:
   
   
   • improvements to control systems to cover weaknesses or prevent fraud
   • changes to the system of data collection and/or presentation to improve the efficiency of the audit process
   • suggestions for the better documentation of balance sheet estimates
   • changes in the nature and scope of internal audit work
   • clearer explanation of forward looking assumptions and justification of projections
     and
   • alternative presentations for items in the annual report and accounts.
     
     
8. Recommending to shareholders the auditors' appointment and reappointment, approving the auditors' remuneration, the use of the auditors for non-audit work, including the purchasing policy for any such use, the policy for tendering for audit services and the means of reporting on these activities
   
   Q8. Should the Audit Committee deal with the above issues regarding external auditors? If so, what procedures should be put in place?
   
   Within the unitary board structure, it is most appropriate for the Audit Committee to make recommendations to the board on auditor appointment and dismissal and for the board then to make recommendations to shareholders. If the board does not follow the recommendation of the Audit Committee, this should be reported to shareholders in the NEDs governance report.
   
   The Audit Committee should consider and approve the purchase of any non-audit services prior to their provision. As stated in our answer to 4.1 above, the Committee should report to shareholders, as part of the governance report, on the use of the auditors for any non-audit services and should justify such use.
   
   Using the recently published IFAC independence framework, the Audit Committee should review the potential that exists for threats to the independence and objectivity of the external auditors. These threats include: self-interest; self-review; advocacy; familiarity; and intimidation. At the same time, the Committee should ensure that, from the company's perspective, the appropriate safeguards are in place to ensure that such threats do not materialise.
   
   
9. The relationship with the company's head of internal audit and the internal audit team
   
   Q9.1 Should the Audit Committee monitor the work of Internal Audit? If so, how?
   
   Yes. Internal audit should be regarded as one of the main sources of information on internal control. To monitor the work of internal audit (as is the case with monitoring the effectiveness of external audit), it is important to consider information from various sources. In addition, the chief internal auditor should have access to the Audit Committee and the Committee should have a regular meeting with the internal auditors without the presence of management. The Committee should be able to satisfy itself that the work, scope and reports of internal audit are free from any undue and inappropriate management influence.
   
   Q9.2 Should the Audit Committee approve appointment and dismissal of the head of internal audit?
   
   Ideally, yes.
   
   
10. Are there any other relevant matters which you consider should be drawn to the FRC Group's attention in the course of their review?
    
    Disclosure of compliance and performance
    
    As it is now responsible for the Combined Code, the FRC should look at audit committees in the context of corporate governance as a whole. We recommend that, in any review of the Combined Code, the opportunity should be taken to improve disclosure of corporate governance processes and, where objective measures can be identified, of performance.
    
    Performance is more important than compliance. At present, companies report on how they have applied the principles in the Code and if they have not followed any best practice provisions. Although this was certainly not the intention of the authors of the Code, we believe that this has encouraged a 'tick box' approach to assessing governance. To counter this, and to encourage companies and analysts to assess corporate governance performance rather than just compliance, we urge that companies be required to disclose how they have followed the best practice provisions in addition to justifying where they have not.
    
    Social and environmental responsibility
    
    The scope of corporate governance has expanded over the last decade from the exclusively financial remit of Cadbury to the broader risk management approach advocated by Turnbull and subsequently integrated into the Combined Code. Recent developments, for example in South Africa, have seen the span of corporate governance expanded still further to include social and environmental responsibilities. In the UK, the Association of British Insurers has issued guidelines for the separate disclosure of social and environmental policies and progress in the annual report and accounts. 2002 marks the first year of application of these new reporting guidelines.
    
    ACCA believes that no review of UK corporate governance in general and audit committees in particular should omit consideration of these broader societal responsibilities. The Audit Committee is particularly well placed to remind the board of its social and environmental responsibility. Consideration of the board's effectiveness in discharging its legal and societal responsibilities and in meeting stakeholders' legitimate expectations should become a standard element in the work programme of all audit committees.

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