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Auditing Viewpoints

The Audit Committee and Corporate Governance

by Richard Wilson

Audit committees in large public companies have an essential role as part of the corporate governance regime. How would you sum up the main tasks of the audit committee?

The main role of the audit committee comes down to providing delegated board oversight over financial reporting and financial risk management. Maintaining a continuing dialog with the internal and external auditors is very much a central part of the audit committee’s activities, as is its relationship with the finance director and the finance team. Understanding the way risk is identified and managed within the organization is also central. Basically, everything that that is financial in nature that goes to the sustainability of the organization is part of the brief.

In some companies this may go beyond financial. There are a tremendous number of moving parts that define the viability of the organization, with many drivers and a great deal of complexity and interaction between them. The quality of the people involved, the quality of the systems that a company has, and the sector the company is in all play a role and have a bearing on the degree of effort that the audit committee has to put in to satisfy itself that it is on top of the brief assigned to it by the board. It is important to remember that the audit committee is, in one sense, simply a specialist subcommittee of the main board, with its members appointed by the chairman of the board.

The interaction with external auditors is a very interesting and critical part of the brief. The external auditors are there to provide assurance to investors/shareholders that they are receiving the appropriate financial information, free from material error, to allow them to judge whether their money is being well protected and well managed by the directors.

The standards governing the audit process are constantly evolving and being refined. How technically aware does the audit committee need to be?

There is absolutely no doubt that audit standards have been and are evolving. When I look at the audit world today by comparison to, say, 30 years ago, it is quite clear that we now have more clearly defined audit standards and there is a great deal to help auditors to determine how they should go about their work. However, in many areas the quality of the financial information available to the auditor will be dependent on judgments taken by the board in key areas. In these cases, the auditor’s role is to judge whether the reported output on those board judgments is clear and understandable.

A great deal of the audit, in other words, is about routine processes, and there is another element that is about exercising sound commercial business and financial judgment in the execution of the annual audit. The external audit firm needs to understand the risk profile of the company and it needs to form judgments on the integrity of management and whether the company has the quality of management to manage the risks that the company, at the direction of the board, is taking on and that this is presented in the financial statements in a way that is true and fair.

There are some important distinctions here that the press and the public often get into a muddle over. It may be very clear in a particular company what its business model is and you can see very clearly what it is setting out to do. The execution of that model might not turn out well in practice, but this is not the same thing as misleading shareholders and creditors as to what the company is doing, or what its aims and objectives are. What is key here is getting some definition and transparency over the risks that are being run. Investors need to be able to form a view about the risks that a company is running in its attempt to make a certain level of returns.

If you invest in an exploration and production (E&P) oil company, for example, you know that the company explores for oil and gas, and you know from the outset that you run the risk as an investor that the company might fail to find reserves. What you need—assuming that you have some confidence in the management team to achieve the company’s goals—in order to make your investment decision is some indication or guidance as to the probability of them finding oil. So the financial statements produced by the E&P company should include sufficient information for investors to form a clear view as to the chances of success and the risks associated with achieving that success.

Before signing the audit report the auditors will need to work with the company to see whether it has got it right or not. If not, then since this could go, for example, directly to whether the E&P company can claim to be a going concern or not, the audit firm might well need to revisit its “going concern” opinion. In any event, the external auditor needs to enable shareholders to form a view as to whether they are comfortable or not with the stewardship of the company through the completion of the audit report. The audit committee is there to ensure that the auditors get the level of cooperation from management that they require. So you can see that the audit committee’s role is fundamental in ensuring that external auditors can do their job unhindered.

You can extrapolate from this to every shade of enterprise. In any set of financial statements there is an element that is historical, which reports on past numbers, and there is an element that is forward-looking. Everyone knows that the financial statements are struck at a particular point in time, and all the auditor can do is to ensure that the information being included in the report is reasonable and that it complies with the relevant laws, standards, and regulations.

But what we are also seeing is rather more disclosure on business models and on the key risks and uncertainties facing the company. It cannot be the role of the external auditor to second-guess management’s judgment of those risks and uncertainties. However, the auditor will challenge management on their assertions and will need to review this information to ensure that it reflects the auditors’ knowledge of how the board and management are running the enterprise when it comes to including this information in the financial statements.

The audit committee also has a brief to challenge the financial statements. This is where the audit committee chairperson plays a hugely important role. The committee chair will want to engage in continuing dialog with the finance director and the external and internal auditors. It is therefore very important that the chair of the committee has a strong financial background.

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