The new minimum standard for audit committees applies to all premium listed companies on the London Stock Exchange, which are also on the FTSE 350. It will be compulsory, and the exact date it comes in to effect depends on when primary legislation is passed for the new Audit, Reporting and Governance Authority (ARGA) to replace the FRC. In the meantime, the FRC urges all firms to adopt the standard as good practice and to maintain effective governance processes.
Understanding the audit committee’s responsibilities
Designed in conjunction with the revised UK Corporate Governance Code, the new minimum standard for audit committees focuses on its relationship with external audit. Its role includes:
- ensuring the company has a good range of options for external audit by carefully managing non-audit relationships
- making recommendations to the Board for external auditor appointments or removal, including carrying out the tender process, approving remuneration and setting terms of engagement
- engaging with shareholders on the scope of the external audit, where appropriate
- ensuring that the external auditor has full access to company staff and records
- inviting challenge from external audit, making sure the points raised are properly considered and fed into the financial statements as needed
- monitoring external audit’s independence and objectivity, and effectiveness – taking professional and regulatory requirements into account
- establishing and implementing a policy on engaging an external auditor on non-audit services, considering the potential impact on independence; and regulatory and ethical considerations
- reporting to the Board on how the Audit Committee has met these obligations.
The new minimum standard for audit committees set out new guidelines for the tendering process. Ultimately, this responsibility needs to move from Executive Management to the Audit Committee, and includes initiating the process, negotiating scope and fee, and influencing the appointment of the engagement partner.
This involves making formal recommendations to the Board over external audit appointments or removals. All members of the Audit Committee should be involved at every step of the process, not just the final selection stage.
When tendering for a new external auditor, it’s important to have a range of options available and Audit Committees shouldn’t discount challenger audit firms without good reason. Independence is crucial, and tenders should be carried out far enough ahead to allow potential auditors to resolve any potential conflicts of interest and broaden the range of viable auditors.
If eligible firms are reticent to tender, the new minimum standard for audit committees requires the Audit Committee to ask why, and potentially remind firms that external audit is in the public interest, and they may become ineligible to tender for non-audit services.
Similarly, if excluding firms from tendering, the Audit Committee should have good reason to believe the audit would not be of high-quality. Quality is the key selection criteria, including technical competence, independence and challenge. To assess quality, firms can look at reports by the FRC or other regulators on the quality of the potential audit firm’s work. The FRC is keen to highlight that price or perceived cultural fit are not appropriate criteria, and the minimum standard for audit committees suggests that Audit Committee’s consider prince-blind tenders.
UK Corporate Governance Code – the key changes proposed
Oversight of auditors and audit
The Audit Committee must provide effective oversight of the external audit function, recognising the importance of that work and promoting a culture that encourages challenge by the auditors. It should review the effectiveness of external audit, and its objectivity and independence.
To assess effectiveness under the minimum standard for audit committees, firms can consider the auditor’s mindset and culture, quality control, skills, knowledge and judgment. This includes the auditors’ response to Audit Committee questions, their ability to communicate key judgements and the quality of their commentary on internal controls. The Audit Committee can:
- ask the auditor about key risks to audit quality and how they’ve been addressed
- consider key internal controls and findings of their own internal and external audit teams
- assess if the audit plan has been completed and any changes
- review feedback on auditors conduct
- review and monitor the external auditor’s management letter and other communications.
Evidence of effectiveness includes examples of effective challenge, auditor response to Audit Committee concerns, and engagement level Audit Quality Indicators, among others. Audit Committees should also document how effective oversight has been achieved over the year, and consider how audit plan and tendering commitments have been fulfilled.
The annual reports in an integral element of the UK Corporate Governance Code, and must include details on the Audit Committee including any significant issues relating to the financial statements, and an explanation of the accounting policies. It must also explain how the Audit Committee has determined external audit effectiveness and independence, and details of any regulatory inspections and remedial actions.
The report should also cover details of the appointment and any plans for retender; and if the Board didn’t follow the Audit Committee’s recommendations for appointment, details of why not. Similarly, if stakeholders requested for specific items to be covered in the audit report and they weren’t, the Audit Committee must explain why.
Finally, the Audit Committee must report on how it has met the requirements of the minimum standard for audit committees.
Meeting the new requirements
While the new minimum standard for audit committees will be mandatory for premium listed firms that are also on the FTSE 350, it is a benchmark of best practice and early adoption will support good governance processes.
While many of these practices are already in place, albeit by disparate teams across the organisation, some are new. Centralising them into the Audit Committee is pivotal to the revised UK Corporate Governance Code.
To get started, firms should consider the current role of the Audit Committee and review existing processes across the wider business regarding external auditor appointment and oversight. A gap analysis will help firms identify what controls are in place and map responsibility for them. Moving these responsibilities to the Audit Committee and re-establishing the necessary governance processes will take time, and require significant input from across the organisation.
Starting early will give firms the necessary time to achieve regulatory compliance, and help smaller firms stay competitive by aligning with broader governance expectations.
Contact Paul Young for further information.