Audit Committee and the External Auditors:

The audit committee and Financial reporting:

As a committee of the board of directors,the audit committee's main responsibilities are to:

• ensure the integrity of financial reporting by the company;and

• ensure the integrity of external auditing.It should do this by making sure that the external auditors are independent and objective and that they perform their auditing function properly.

 

The smith report suggested how this should be done.

• It is the responsibility of management to prepare complete and accurate financial statements.This is not a responsibility of the audit committee.

• However,the audit committee should monitor the preparation of the financial statements.It should consider the significant accounting policies used by the company(and any changes in policy that have been made) and also any significant estimates and judgements that have a material effect on the figures in the financial statments.

• When transactions can be accounted for in two or more different ways management should explain to the audit committee which method of accounting they have selected.

• The audit committee should compare the information received from management with the views of the external auditor and decide whether the accounting policies estimates and judgements used in the financial statments are appropriate.

 

Disagreements between the audit committee and management:

A problem will arise whenever the audit committee is not satisfied with any accounting policy,estimate or judgement.When it cannot reach a satisfactory agreement with the management(and external auditors) the audit committee should report the disagreement to the board.The smith report suggested that the audit committee should be strong-minded if necessary.The audit committee has a role to ensure that if things go wrong,they are put right.Audit committee must be capable of tackling the worst situations,for example if an audit failure seems to lead to poor ,or even deliberately misleading,financial reporting decisions.The report goes on to state that an adversarial relationship between the audit committee and the company's management is of course not typical.When it happens there has been a failure in corporate governance.When corporate governance is good the relationship between the audit committee and the company's management should be based on openness and mutual respect.

 

The audit committee and the external auditors:

The audit committee should be responsible for monitoring the company's relations with its external auditors,including their appointment and remuneration.The operational relationship between a company and its external auditors is the responsibility of management but the audit committee needs to ensure that:

• the auditors do their job properly.

• the auditors remain independent,so that they can provide independent views to the company.

 

Appointment of External Auditors:

The smith report stand that the audit committee should have the main responsibility for making a recommendation to appoint,re-appoint or remove the external auditors.

• The recommendation should be made to the board of directors.

• If the board doesnot agree with the recommendation of the audit committee,the committee should make a statement in the directors report to shareholders explaining its recommendations and why the board as a whole has disagreed.

• In many countries the board makes a recommendation about the appointment 0r re-appointment of the auditors to the shareholders.The final decision is taken by the shareholders although they almost always agree with the recommendation of the board.

 

The smith report also recommend that each year the audit committee should assess the qualifications,expertise resources and independence of the external auditors to satisfy itself that these remain adequate.

 

Terms of appointment and remuneration:

When the external auditors are appointed or re-appointed each year the company's management and the auditors discuss the terms of engagement for the auditors for the next annual audit cycle.The smith report recommended that the audit committee should review and agree these terms of engagement at the start of each audit.The scope of the audit should be discussed by the committee with the auditor and if the committee is not satisfied that the audit work is adequate,it should ask for additional work to be undertaken.The audit fee is negotiated between management and the auditors.The audit committee should satisfy itself that this  fee is appropriate and that an effective audit can be performed for such a fee.

 

Monitoring the independence of the external auditors:

It is essential that the external auditors should be independent of the company and its management.They provide a report to the shareholders of the company and the shareholders rely on the professional independence of the auditors,to confirm that the financial statements present a true and fair view.

 

Threats to auditor independence:

There are several ways in which the independence of an auditors opinion may be threatened.

• Familiarity Threat:An auditor who carries out the audit for the same company for many years may become very familiar with the company and its management and may even become friendly with some senior managers or directors.When the auditor becomes familiar with the company's management,he may be less inclined to doubt what they are telling him.After several years of providing clean audit reports he may think that there will never be any reason to write a qualified audit report,because nothing materially wrong will ever happen with the clients accounts.When this happens his judgement will no longer be independent and so cannot be trusted.

• Self-Interest Threat:An audit firm may avoid asking awkward questions and challenging the company's management when they think that by annoying the client they will lose audit work(and non-audit work) in the future.The auditor may therefore decide to accept what management tells him,and avoid asking too many questions in order to obtain more work from the client.

• Intimidation Threat:The management of a client company may threaten to more the audit (and non-audit work) to another firm of accountants,unless the auditors are less challenging with their questions and get on with completing the audit as quickly as possible.

• Self-Review Threat:A firm of auditor may be engaged to check the work that has been done by other employees of the audit firm.This would happen,for example if an audit firm is engaged to provide its staff to do bookkeeping and accounts work for the client,or to act in a managerial capacity in the clients accounts department.If this happens,the auditor would have to review the work done by the firm itself when it comes to doing the annual audit.The auditors may believe that the accounts work doesn't need to be investigated in depth,since it has been done by the firms own staff.This would seriously undermine the independence of the auditors(and is the reason why professional accountancy bodies donot permit members or member firm to carry out certain types of non audit work for clients).

• Advocacy Threat:A threat to an auditors independence would also occur if the audit firm is engaged to defend the companys position in a legal dispute.The auditor should provide a fair and independence opinion.If he is engaged to take the side of the client in a dispute he could not possibly be independent.

 

The audit committee is responsible for monitoring the independence of the external auditors and ensuring that the external that the external auditors are independent of the company and its management.If evidence of a loss of independence has occured  or is suspected the audit committee may recommend a change of auditor.An assessment of the auditors independence should take into consideration the non-audit work performed for the company by the audit firm as well as the audit work.The annual assessment by the audit committee should take into consideration any ethical standards or guidances issued by the professional accounting body/bodies.

 

Assessing auditor Independence:

The independence of the external auditors should be assessed in several ways.

• When auditors are appointed for the first time,the audit committee should ask for a statment from the audit firm that the auditors and their staff have no family,financial,employment,investment or business relationship with the company other than in the normal course of business.

• The audit committe should check periodically that the policy on the recruitment of former auditors is complied with by the company.

• The audit committee should check that the audit firm complies with ethical guidelines issued by the accountancy bodies and regulatory issues such as:

       -The rotation of audit partmers.

       -The amount of fee income of(1) the audit firm or(2)a regional office of the audit firm or(3)an individual audit partner.

• The audit committee should agree with the board the company's policy on the appointment to its full-time staff of individuals who were previously a part of the audit team and are now moving directly from audit firm to the company.Recruitmg former auditors could affect the relationship of the company with the audit firm and damage the independence of the auditors.This policy on recruitment should take account of ethical guidelines to auditors from the accountancy bodies.

The risk that the external auditors might lose their independence from a company is sometimes called the hazards of auditor capture. 

 

Auditor independence and non-audit work:

The independence of the external auditors might be affected by non-audit work that the firm performs for the company.There are two main reasons why independence might be affected.

• The total fee income for the audit firm from the company,from audit work and non-audit work,might be a large proportion of the firms total annual income.When this situation occurs the audit firm might be reluctant to annoy the company's management because it doesnot want to lose any work-and income from the company.

• The audit firm might be required to audit the (non audit) work done by other employees of the firm.The audit team might be reluctant to question or criticize their colleagues because this might damage the reputation of the audit firm in the opinion of the company's management.

 

The smith report recommended that the audit committee should be responsible for developing and recommending to the board the company's policy on going non-audit work to its external audit firm.The chosen policy should ensure that by giving non-audit work to the auditor,the auditors independence will not be affected.A part of this policy should specify three categories of non-audit work and allocate each type of non-audit work to one of these categories:

• Non-audit work that should not be given to the audit firm.The general principle should be that the audit firm should not be given any non audit work where:

       -employees of the audit firm have to make management decisions for the company,or

       -employees of the audit firm have to act as advocates for the company,or

       -the audit team will have to audit the work done by other employees of the audit firm(for example,bookkeeping services).

•  Non-audit work that can be given to the audit firm without the need to refer the matter to the audit committee.

• Non-audit work where a case-by-case decision is necessary and the matter should be reffered to the audit committee for a decision.

 

The UK Combined code states that it is a responsibility of the board to ensure auditor independence and the annual report should explain to shareholders how if the auditor provides non-audit services auditor b=objectivity and independence is safeguarded.

 

The audit committee and the external audit process:

The audit committee should review the audit plans and audit work of the external auditor to make sure that these are satisfactory.

• Audit Plan

   At the start of the annual audit cycle,the audit committee should ensure that an appropriate audit plan has been prepared.It should also check whether the resources that the audit firm proposes to use for the audit are sufficient and that the audit team will have the required seniority,experience and expertise.

 

• Review of the findings of the auditors

        At the end of the audit,the audit committee should carry out a review.As a part of this review,the audit committee should:

​        -discuss with the auditors any major issues that arose during the audit.These may be issues that have been resolved with management,or issues that still remain unresolved.

        -review the key accounting judgements and audit judgements that have been made

        -review the level of errors identified by the auditors and should obtain from management an explanation of why any of these errors remain unadjusted.

        -review the response of management to the recommendations made by the auditors(in the auditors management letter).

Assess the effectiveness of the audit:

Each year the audit committee should assess the effectiveness of the audit and assess whether the auditors did their work to a satisfactory standard.The committee should:

• review whether the auditor met the requirement of the agreed audit plan (and if there were any charges in the plan,the reasons for the changes).

• Consider how'robust' the auditors were in discussing accounting and audit issues with management,and how perceptive the auditors appear to have been in making their judgements.

• obtain feedback about the conduct of the audit firm key people inside the company such as finance director and the head of internal audit.

• review the contents of the auditors management letter(to management) in order to:

       -assess whether the recommendations in the letter are based on a good understanding of the company and its business and

       -establish whether management has acted upon the recommendations of the auditors and if not the reasons why management has taken no action.