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Regulator to clarify audit role

The UK’s corporate governance regulator, the Financial Reporting Council, is
proposing to water down some aspects of the Smith guidance on audit committees
to make compliance less onerous.

The first major proposed revision of the Smith guidance says that the audit
committee should annually “assess” – rather than have “procedures to ensure” –
the independence and objectivity of the external auditor. The FRC says “the
existing guidance to ensure independence and objectivity could be interpreted as
setting a high barrier for relationships between the company and the audit
firm.”

The FRC also proposes to change the Smith guidance’s recommendation that the
audit committee should consider whether there are safeguards in place to “ensure
that there is no threat to objectivity” when an audit firm provides non-audit
services, to “reducing” such potential threats “to an acceptable level”.

The Smith guidance was published in 2003 to help company boards implement the
sections of the Combined Code that deal with audit committees and to help audit
committees carry out their role.

But the FRC is recommending a number of changes as part of its review into
auditor choice and its effect on corporate governance and risk assurance should
one or more of the Big Four audit firms “leave the market”, as the euphemism
goes.

As a result, the FRC’s Market Participants Group – which is leading the
review – is trying to get audit committees to make public the reasoning behind
their choice of external auditor and why it may be providing non-audit services.
It also proposes that company boards should disclose any contractual obligations
to appoint, say, a Big Four audit firm as a result of a loan covenant, for
example.

The FRC has proposed inserting a new requirement that an audit committee
should not agree to an auditor providing additional non-audit services if “the
external auditor develops close personal relationships with the company’s
personnel”. This is because the FRC believes that a familiarity or trust threat
could be created or worsened through the delivery of non-audit services, such as
recruitment services.

Appointments explained
The regulator is also proposing that in the annual report audit committees
should include – along with a summary of the role of the audit committee and the
number of meetings – a summary of the audit committee’s policy on non-audit
work, as well as “an explanation of the audit committee’s recommendation on the
appointment, reappointment and removal of the external auditors”.

The FRC admits that providing shareholders with this information could incur
extra – though largely negligible – costs, particularly with regards to possibly
putting the audit out to tender. However, the MPG says that companies only need
to do this “when they judge that a change of auditor would be beneficial”.

Paul George, the FRC’s director of auditing, says that “greater information
disclosure always helps the market function more effectively. Communicating the
way that the audit committee reaches its conclusions about the choice of auditor
and whether there is any conflict of interest is always going to be helpful.”

The FRC has also made suggestions to change parts of the Combined Code which
would impact the Smith guidance if implemented. Last December, the FRC invited
comments on two proposed changes to the Combined Code on Corporate Governance,
one of which was relevant to audit committees. The FRC proposed that for listed
companies outside of the FTSE-350, company chairmen would be allowed to be a
member of – but not chair – the audit committee, provided they were considered
independent on appointment. The FRC is also suggesting that “the board should
satisfy itself that at least one member of the audit committee has recent and
relevant financial experience”.

FSA on internal controls
The Financial Services Authority says that financial institutions should
consider carrying out reviews of their front and back office operations to make
sure that the chance of a rogue trader putting the organisation at risk is kept
as low as possible.

Following rogue trader Jérôme Kerviel’s actions at Société Générale, the
regulator has issued its Market Watch commentary to highlight the measures firms
should consider when reviewing the systems and controls which protect them
against such risks.

FSA supervisors have spoken informally to 50 of the largest trading banks in
London. Many have already put in place reviews to identify and correct gaps that
may exist in their trading controls.

Among the areas for review suggested by the FSA are:
• Front office culture and governance – in particular, are traders encouraged to
take two-week continuous holidays, and is there appropriate segregation of front
office staff from middle and back office functions;
• The use of suspense accounts;
• The quality of management information, both routine and outside normal
parameters; and
• Elementary IT precautions, such as whether access to systems is password
dependent or protected.

Useful links
The consultation can be found at
www.frc.org.uk/about/auditchoice.cfm
and closes on 6 June 2008.

The Smith Guidance can also be found on the FRC website at
www.frc.org.uk.

To read further guidance on audit committees, visit the library section of
the Institute of Chartered Accountants of England and Wales’ website at
http://tinyurl.com/33yjef.

To read the FSA’s Market Watch, go to
www.fsa.gov.uk/pubs/newsletters/mw_newsletter25.pdf.

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