Audit committees - Where to next?

Earlier this year the Higgs Report on non-executive directors drew a lot of flack, while the Smith Report on audit committees, published at the same time, came through the consultation period relatively unscathed.

So much so, that with very few changes it has now been turned into the Smith guidance and included as an attachment to the revised combined code that was published in late July.

Is this relative lack of public comment a reflection of the general acceptability of the new guidance? And, if so, what might be the long-term consequences of this?

I conducted more than 30 face-to-face interviews earlier this year with the group finance directors, audit committee chairmen, and lead external audit partners of 10 large UK listed companies and one large mutual building society.

The main focus of this research was on communication between the external auditors and the audit committee, but the comments made have put me in a good position to provide tentative answers to these questions. Is the Smith guidance generally acceptable?

The answer was a positive ‘yes’. All the companies I visited did almost all the things suggested by the guidance already, reflecting the fact that it is a codification of current best practice adopted by large UK listed companies.

But I am not sure that all smaller listed companies do all the guidance suggests. This is a pity. Recently published research by the Quoted Companies Alliance, representing companies outside the FTSE350, showed that there is a sustained downward trend in the numbers of pension funds, investment trusts and other institutional investors putting money into the shares of smaller listed companies outside the FTSE350. Good governance, including an effective audit committee, is essential if investors are to be encouraged to invest.

The way in which audit committees are operating is evolving. Before the 1992 Cadbury report very few UK listed companies had them at all. Since then, and particularly since the introduction of the combined code in 2000, companies have taken them more seriously with the final turn of the screw coming as a result of the perceived failures of the Enron audit committee. No one wants anyone to find fault with their audit committee so members are taking greater interest in what is expected of them. As a consequence, they are more rigorously and professionally run than they used to be.

There have also been increased demands on audit committees over the past five years. Responsibilities and the time needed to discharge them have grown. There used to be two or three audit committee meetings each year, now there are four or five with pressure for more.

The main job of audit committees used to be dealing with the auditors, the annual audit and financial reporting. Some now cover risk, ‘investor protection’ and pension scheme arrangements, too.

The role of the audit committee chairman has grown in importance. The last word about the agenda is now with him and not the finance director as might have been the case in the relatively recent past.

Internal audit is now taken more seriously and companies that have never had an internal audit function are considering having one. The work is often outsourced, usually to another of the big audit firms.

Evaluating external auditor effectiveness, both the process itself as well as its cost, are now of considerable interest. External auditor independence and non-audit services are key issues too.

Financial statements continue to grow in length and technical complexity.

Audit committees are adopting very different approaches to discharging their responsibilities – some read every line while others delegate to the finance director and the auditors almost entirely.

Not surprisingly, all this requires a bigger time commitment from audit committee members.

The long-term consequences of these developments, re-enforced by the Smith guidance, will inevitably be to increase the importance of the audit committee. In particular, audit committees will acquire more of the characteristics of ‘supervisory boards’ found elsewhere in the EU.

The chairman of the audit committee will be a much more significant figure on the board. The relationships between the chairman of the audit committee, finance director and lead external audit partner will be of great importance.

External auditors will have even less contact with the full board than they do at present. External auditors will do virtually no non-audit work, but they will work for other companies in a consultancy capacity.

Internal audit will be more a tool of the audit committee and less of management. And the demands on audit committee members will be much greater.

I believe that most of these consequences are to be welcomed and that if audit committees develop in this way, corporate governance in the UK will be better for it. But being part of an audit committee will be even more demanding. The roles may only be suited to retired people unless a new, younger version of ‘portfolio man’ emerges over the next few years.

Can such people be found? This problem hardly features in Dean Laura D’Andrea Tyson’s report on widening the ‘gene pool’ for the recruitment of non-executive directors. It is something board chairmen, executive search firms and the accountancy profession should look into.

• John Collier is an executive search consultant and former secretary general of the ICAEW.