Audit committees, very gradually, have become the unsung success of the UK corporate governance system. They were first proposed by the Cadbury Report on corporate governance back in 1992 and became part of the Listing Rules, under the principle of ‘comply or explain’ in 1994.  A newly published book* by academics Laura Spira and Judy Slinn explains the context with delightful clarity.

And at the end of last week a report from the Financial Reporting Lab at the Financial Reporting Council suggested that, in the words of the Lab’s Director: ‘Audit committee reports should form part of the conversation between companies and investors building confidence in this important area of governance and showing how it contributes to good financial reporting’. That sentence alone shows how far the concept of the audit committee has come since it first appeared as an idea during the creation of the Cadbury Code back in the 1990s.

Then the idea was that such a committee could forge a channel of communication with the company’s auditor and enable the discussion of issues of concern on both sides. This would, it was thought, provide both the audit committee and the auditor, with enhanced independence. Now, as the recent report on audit services by the Competition Commission also shows, the concept of the audit committee has become ever more important. 

The Commission’s report said that, amongst other points: ‘Measures should be introduced to strengthen the accountability of the external auditor to the audit committee, including a stipulation that only the audit committee is permitted to negotiate and agree audit fees and the scope of audit work, initiate tender processes and make recommendations for appointment of auditors and authorize the external audit firm to carry out non-audit services. The audit committee may receive submissions from executive management regarding these matters. It may establish a materiality threshold below which executive management may instruct the audit firm to conduct non-audit services’. But that is as far as they should go. The Commission also aims to strengthen the audit committee’s importance by suggesting larger companies should be required to hold an advisory vote on the sufficiency of the disclosures in the audit committee’s report. 

And days later the FRC’s Financial Reporting Lab came up with its recommendations. Within its confidential environment some 19 companies and 25 investor and analyst organisations took part in a project which was intended to provide insight into how audit committee reporting could be made more effective. And it was intended to be timely. The FRC’s revisions to the UK Corporate Governance Code which require audit committees to provide more detail about the focus of their specific work during the year have now come into force. 

What the Lab’s findings show is that what investors and companies really want is more specific detail, insight and understanding from audit committees generally. ‘Investors’, they say, ‘are keen to gain an understanding of what issues have been the subject of the audit committee’s focus for the year’. They don’t want a standard report. In particular they want a report which provides details of the actions it has taken, rather than talk about the functions they serve. 

They want a report which has been tailored to their needs. ‘Investors  want audit committee reporting to move away from boilerplate disclosure’, says the report, ‘and to be bespoke and company specific’. Audit committee chairmen should demonstrate their ownership and accountability by personalising their report; they need to ensure that reports are specific to their company and the current year’s activities; they want an account of specific activities undertaken and why they took them, all couched in active and descriptive language, in short, narrative reporting. They want the reports to disclose the judgements made during the year and the source of assurance and other evidence which they used to satisfy themselves that what they had done had produced appropriate conclusions. ‘Many investors’, says the report, ‘believe that the audit committee should not place an undue level of reliance on the external auditors or management’. And they also needed to show that they had taken their audience into account throughout that process.  

What all this amounts to is a further, and very important, notch in the evolution of the audit committee from an idea to that of a serious player. As Spira and Slinn say in their book: ‘All the issues identified at the time of the Cadbury Report – directors’ pay and the role of responsibilities of institutional investors, as well as reporting on internal control and going concern – remain a focus of continuing concern and the guidance provided is subject to regular review by the FRC, as is the Code itself. None of the subsequent groups charged with considering these ongoing issues has provided conclusive answers: this reflects the need, which the Cadbury Committee had emphasised, for continual review of the issues in the light of the practical experience of company boards and investors and the current business environment. The arena for debate opened up by the Committee’s work has enabled discussions to continue, moving forward on the basis of the conclusions of each group and review, even though resolution of these problems remains elusive’.

Or, in the words of one anonymous investor quoted in the Financial Reporting Lab’s report: ‘Current audit committee reporting has a lot “in the letter”, not much “in the spirit”. The evolution of the role of the audit committee continues.

Click for:

• Our news story on the Financial Reporting Lab project report on effective approaches to Audit Committee reporting  
• Our news story on the Competition Commission final decision on remedies 

*‘The Cadbury Committee: A History’. By Laura F Spira and Judy Slinn. Published by Oxford University Press at £35