Smith report strikes at the heart of corporate governance

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As observers rushed to greet last week’s Higgs Report on non-executive directors, it went almost unnoticed that the Smith report on audit committees also emerged on the same day. Though perhaps less glamorous, Sir Robert Smith’s investigation of company audit committees is equally important.

The audit committee is a lynchpin of any board. It alone has the responsibility for monitoring and reviewing the way in which a company’s accounts are compiled, the treatments employed, the standards used and the work of external auditors. It is to them investors turn for reassurance that numbers are all above board.

Sir Robert was given a committee of wise men including Mark Armour, CFO at Reed Elsevier, Ted Awty, chairman of KPMG’s client services board and Glyn Barker, head of audit and business advisory services at PricewaterhouseCoopers.

It is clear that since the crisis at Enron, there has been a slow but certain movement among ministers and policymakers to the view that, in the UK at least, there is nowhere near the same risk of corporate meltdown, as has been seen in the US. The emphasis has been on reassurance but without fatally altering a system that is already believed to be pretty sound.

The Higgs report was therefore greeted as well measured and full of commonsense changes that do not threaten the basic structure of UK corporate governance.

The question will be whether the recommendations of the Smith report, to become part of the combined code on corporate governance, will provide the reassurance so urgently sought.

Its recommended additions include an audit committee of no less than three independent non-executive directors with at least one of them possessing ‘recent and relevant financial experience’.

Independence is a key word too and Sir Robert’s report recommends that NEDs comply to a new definition contained in last week’s Higgs Report.

Not everyone believes the definitions is as useful as it may seem on first reading. While it is rigorous and appears to back the demand from Smith that an audit committee owes its main duty to shareholders – the worry is when do the non-execs start worrying about the company.

While nearly everyone greeted the Higgs report warmly, many of those who did so spoke privately of a concern that the Higgs recipe could produce a board of robustly independently non-execs focused narrowly on shareholder interest and ignorant of the entrepreneurial needs of the company.

Exacerbating this is the fear that Higgs and Smith will build such an enormous need for non-execs that demand will outstrip supply, forcing companies to turn to poorer quality candidates, which may have to be found outside the private sector. They will therefore have even less understanding of the commercial needs of the company. Non-execs with little sympathy for business needs may prove a threat to shareholder interest.

Smith also provides us something to watch out for and perhaps an area where ‘reassurance’ appears noticeably absent. His recommendations include the belief that the audit committee should have principal responsibility for recommending an external auditor to the board and to shareholders.

If the committee disagrees with the board then a note should go in the annual report explaining the reasons.

Smith goes on to tackle the controversial issue of non-audit services, but only recommends that audit committees ‘develop and implement policy on the engagement of the external auditor to supply non audit services’.

Smith makes no effort to say what the policy should look like or which non-audit services present a risk to the objectivity of the external auditors.

Audit committees should ‘take into account relevant ethical guidance’ on the subject, but Smith remains silent on what that is or where it can be found.

Ministers at the Department of Trade & Industry may still have something to say in this area. When the department’s coordinating group on audit and accounting issues published its interim report in July, it said it had asked for ‘further work to identify the types of non-audit services which are incompatible with the principles underlying auditor independence’.

That group has now reached its conclusions. And it may be this report that finally changes the face of accountancy, the responsibilities of audit committees and UK corporate governance.


A governor for the BBC in Scotland, Sir Robert Smith comes to his role investigating audit committees after being president of ICAS.

At the moment he holds two non-executive positions himself. He is chairman at the Weir Group and vice chairman of Deutsche Asset Management.

His career in accountancy began in 1963 when was articled to Robb Ferguson & Co in Glasgow. He then moved to ICFC until 1982 and joined the Royal Bank of Scotland in 1983. From 1985 to 1989 he was managing director of Charterhouse Development.

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