1.4 The Audit Committee in the UK.
The Audit Committee is a committee of directors of a
company responsible for
facilitating and improving audits of its financial
statements and for dealings
with matters raised by auditors. It is an essential safeguard
of auditor independence
and objectivity. In particular, the audit committee should
have a key role where the
auditors also supply a substantial volume of non-
services to the client. An audit
committee also usually supervises internal auditing.
In modern company, the
information given in the directors' report relating
to the financial year must
be verified. Usually, to provide such third- party
control is the role of audit.
Companies Act 1981 introduced a three-tier size classification
of companies (Small,
Medium, and Large) and the option for small companies to
file `modified accounts'.
The size of small company that should be exempt from the
audit was an important
issue in the debate in the UK. In 1994 the EC fourth
Directive permitted national
Governments to dispense with the requirement for small
companies to undergo a
statutory audit.
The importance of audit committee was increased with the
major reports of 1990s
which had an impact on UK listed companies. The Code
of Best Practice of the
45
the Cadbury Committee stated that:
`The board should establish an audit committee of at
least three NEDs with written
of reference which deal clear with its authority and
duties'.
In 1992 only approximately two thirds of the top UK
listed companies had audit
46
committees. The Cadbury Code Provision had the indirect
`hidden agenda' impact
of virtually ensuring that the boards of listed
companies became balanced
47
through having a significant number of non
- executive directors.
45. Cadbury Code , provision 4.3.
46. Price Waterhouse Corporate Register , published by
Hamilton Scott .
47 . ibid
In 1998, the Hampel Committee on the financial aspects of
corporate governance
and directors' remuneration published its report and
the Combined Code which
replaced the Cadbury Code. The recommendations of
Hampel were along
similar lines and on similar issues to Cadbury; an
important contribution made by
the Hampel Report was the emphasis attributed to avoiding a
prescriptive approach to
48
corporate governance improvements and recommendations.
In 2003 a new version of the Combined Code was published,
so - called because it
combined the Cadbury (1992) and Greenbury (1995)Codes with the
modifications and
additions that the Hampel Committee had decided upon,
all of which the Stock
49
Exchange then adopted. The main principle of the
Combined Code regarding the
audit committee and auditors is that the board should
establish formal and transparent
arrangements for considering how they should apply
the financial reporting and
internal control principles and for maintaining an
appropriate relationship with the
the company' s auditors (C . 3).
The audit committee is responsible to the board, it
exists to assist the board to
discharge certain of its responsibilities, it should
satisfy that at least one member of
50
the audit committee has recent and relevant financial
experience. The main role and
responsibilities of the audit committee should be set out in
written terms of reference
51
and should include:
* to monitor the integrity of the financial statements of
the company and any formal
announcements relating to the company's financial
performance, to review the
company 's internal control and, risk management
systems ( para 3.2.);
* to monitor and review the effectiveness of the
company's internal audit function
(para 3.2.3);
48 . J . Solomon and A . Solomon , ' Corporate Governance
and Accountability ' , 2004.
49 . A . Chambers , ' Tolley ' s Corporate Governance'.
50.ibid
51.The 2003 Combined Code.
*to make recommendations to the board, for it to put
the shareholders for their
approval in general meeting, in relation to the
appointment, reappointment and
removal of the external auditor and to approve the
remuneration and terms of
engagement of the external auditor (para 3.2.4);
*to develop and implement policy on the engagement of
the external auditor to
supply non audit services, taking into account relevant
ethical guidance regarding
the provision of non-audit services by the external firm
(para 3.2.5).
On the other hand, the establishment of relations between the
audit committee and the
shareholders is essential for good corporate
governance. The Combined Code
provides that there should be a dialogue with
shareholders based on the mutual
understanding of objectives. The board as a whole has
responsibility for ensuring that
a satisfactory dialogue with shareholders takes
place (para. D.1).
However, the shareholder's contact is mostly with the
chief executive and finance
director, the chairman should maintain sufficient contact
with major shareholders
to understand their issues and concerns; the
board should keep in touch with
shareholder opinion in whatever ways are most practical and
efficient (para. D. 1).
Many UK companies already have an audit committee.
J . Charkham argued that in 1994, 53 % of the
top 250 industrial firms in
52
The Times 1000 have an established audit committee. In
addition, the impact of
the Combined Code on UK companies' directors and
industrial investors has
been far- reaching, especially in the area of investor
relations and shareholders'
53
activity. In a decade, corporate attitudes toward
their core investors have been
54
transformed from relative secrecy to
greater transparency. Similarly,
the attitudes of institutional investors have
been transformed from relative
55
apathy toward their investor companies
activities to an active interest.
52 .J . Chakham , ' Keeping Good Company'.
53.J.Solomon and A . Solomon, ' Corporate Governance and
Accountability'.
54.ibid
55.ibid
Even if the UK corporate governance does not provide a
requirement for a report
from the audit committee to appear in the annual
report of the company, the
Chairman of the audit committee should be available to
answer questions at the
56
annual general meeting of the company.
In addition to regular reporting through to the board
following each audit committee
meeting, it is good practice for the audit committee to
provide a special annual report
57
to the board. Some boards may consider this annual
report to be a satisfactory
alternative to regular reporting through to the board
following each audit committee
meeting, although there is an obvious need for the audit
committee to report to the
board on its scrutiny of interim and final financial results;
the annual report will cover
58
the committee's activities over the year.
Regarding the meeting of the audit committee, the
agenda plays an essential role.
Errors in minutes are usually errors of omission
rather than mistaken minutes;
it is important that the Chairman of the audit
committee is effectively in control
59
of both the agendas and the minutes of the committee.
On the other hand, the US Public Oversight Board's new
recommendation provides
that the committee should develop a formal calendar of
activities related to those
areas of responsibility prescribed in the committee
charter, including a meeting plan
60
that is reviewed and agreed to by the entire board. The
meeting plan should include
communications between the committee chair or full
committee and the auditors
61
before the release of interim or year end financial
data .
56 . J. Solomon and A . Solomon ,' Corporate Governance and
Accountability `.
57 . A . Chambers , ' Tolley 's Corporate Governance'.
58 .J .Baden ,'The Developing Role of Audit Committee ' ,
Internal Control(July 1998),
pp.3-6.ICAEW,London.
59.A.Chambers,'Tolley's Corporate Governance'.
60.J.Baden,'The Developing Role of Audit Committee ' ,
Internal Control (July 1998),
pp.3-6.ICAEW,London.
61.A.Chambers ,'Tolley `s ,Corporate Governance `.
However, the committee's relationship with internal audit is
quite crucial. One of
the responsibilities of the audit committee is to advise the
board on the effectiveness
of risk management and internal control and so the
committee needs to be able
62
to place reliance upon internal audit. A. Chambers
argued that it is best practice
that the appointment or removal of the head of
internal audit should have
the prior approval of the audit committee; the head of
internal audit should have
unrestricted access to the chair of the audit committee at all
times and the right to ask
63
for items to be placed on the agenda
of audit committee meetings.
In 1999 The Turnbull Committee was set up specifically
to address the issue of
internal control and to respond to those Provisions in
the Combined Code. The
Report provided an overview of the systems of internal
control in existence in
UK companies and made clear recommendations for improvements,
without taking
prescriptive approach. In addition, the Turnbull
Report represented an attempt to
64
formalize an explicit framework for internal control in
companies. Even though many
other countries are now focusing attention on the
systems of internal control and
65
corporate risk disclosure within their listed companies.
Even before Turnbull there
66
was a trend in this direction, as J. Baden reported :
`We believe that internal audit, as a separate discipline,
is no longer cost-effective or efficient. It is, instead, an essential element
of the overall corporate risk management system. Good internal auditors must be
risk and control consultants. Their job, in part ,is to help the business
make more accurate assessment as a basis for commercial
decisions'.
Moreover, the Turnbull Report requires that the board at
least annually reviews the
adequacy of the internal audit function or, whether there is
no internal audit, considers
67
whether internal audit should be set up.
62.A.Chambers,'Tolley's Corporate Governance'.
63. ibid
64.ibid
65. J. Solomon and A. Solomon ,'Corporate Governance and
Accountability `.
66.A. Chambers ,'Tolley `s Corporate governance `.
67.ibid
It is generally admitted that the effectiveness of
internal control is essential for
communication between the audit committees and the boards, the
audit committee's
68
responsibilities is to review the quality of information that
the board receives:
`One of the major requirements for good corporate governance
is that the board of the company receives the information it needs to take the
decisions it has to take; that this information is reported in a digestible
form and that it is accurate. This is something
the audit committee looks at on a regular basis, though it is
equally a concern of the whole board who take great interest in this
matter'.
The board should certainly be `in the know 'about this
whether or not the directors
intend to publish their opinion about it; some organisations
are establishing additional
committees of the board, for example, many UK hospital
boards of directors now
have clinical governance committees reporting to the
board on clinical risk and
69
control which, by and large, is their
equivalent of operational control.
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