Chapter 9 - Financial reporting to shareholders and external audit Flashcards
In what way is financial reporting connected to corporate governance?
Financial reporting falls within the context of corporate governance as it involves the concepts of accountability and transparency.
What is the purpose of financial reporting and how is that purpose different in listed companies?
Below is a list of users of a company’s financial reporting and why they find it of interest:
- Potential investors are interested in the ability of the company to generate net cash flows for dividends, distributable profits, or an increase in the share price, and to assist the decision to buy, hold or sell equities.
They are also interested in assessing the stewardship or accountability of management.
- Creditors are interested in the amounts, timing, and uncertainty of future cash flows that will give rise to interest, repayment of borrowings, and/or increases in the prices of debt securities. They are interested in the security of their debt.
- Suppliers are interested in the fact that the entity may be able to pay a debt, when it comes due, for goods or services provided to the entity.
- Employees are interested in the stability, profitability, and growth of their employer, which gives rise to the continuing ability to pay salaries, wages, and other employment-associated benefits.
- Customers are interested in ensuring the continued supply of goods or services, especially if these customers have a long-term association with or are dependent on the company
How can a company mislead the market in its financial reporting?
A company can misreport their financial numbers to improve its financial position through:
- The adoption of accounting policies that give a more flattering picture of the company’s position.
- Claiming that revenue or profits were earned earlier than they were. This can happen when a company has a contract for several years.
Revenue from the contract can be accounted for in the first year instead of being spread over the life of the contract.
- Taking debts off the company’s balance sheet. This can be achieved by transferring these debts to other companies (special purpose vehicles).
- Disguising money from loans as operating income so that the company’s reported cash flow from operating activities is increased.
- Over-valuing the company’s assets
What is the purpose of the audit committee?
The audit committee is key to ensuring that an organisation has robust and effective processes relating to financial reporting, internal controls, risk management and ethics. The committee is also the main oversight body for the internal and external auditors.
Briefly describe the four areas over which the audit committee would typically have responsibility?
The FRC in their ‘Guidance on Audit Committees’ provides information about the role and responsibilities of the audit
committee. These include:
- Annual reports and other periodic reports
- Internal control and risk management systems
- Internal audit
- External audit
Annual reports and other periodic reports:
The audit committee should review, and report to the board on, significant financial reporting issues and judgements made in connection with the preparation of the company’s financial statements, interim reports, preliminary announcements and related formal statements.
The guidance notes that it is the responsibility of management, and
not the audit committee, to prepare complete and accurate financial statements and disclosures in accordance with accounting standards and other regulations.
The audit committee should consider:
- whether the company has adopted appropriate accounting policies, and any changes to them;
- the methods used to account for significant or unusual transactions where the accounting treatment is open to different approaches and the judgements made as to the methods chosen;
- the clarity and completeness of disclosures in the financial statements and consider whether the disclosures made are set properly in context;
- the related information presented with the financial statements, including the strategic report, and corporate governance statements relating to the audit and to risk management; and
- the content of the annual report and accounts and advise the board on whether, taken as a whole, it is fair, balanced and understandable
Internal control and risk management systems
The audit committee should review the company’s internal financial controls, that is, the systems established to identify, assess, manage and monitor financial risks, as part of their expected roles and responsibilities in the UK Corporate Governance Code 2018.
If a separate risk committee has not been established, the audit committee should also review the company’s risk management system.
The company’s management has day-to-day responsibility for the risk management and internal control systems, including the financial controls, and these should form an integral part of the company’s day-to-day business processes.
The audit committee should receive reports from management on the effectiveness of the systems they have established, and the conclusions of any testing carried out by internal or external auditors.
It should consider whether the level of assurance it is receiving is enough to help the board in satisfying itself that the internal controls are operating effectively.
Internal audit
The audit committee should regularly review the need for establishing an internal audit function. More detail on internal audit is provided in Part 4.
In the absence of an internal audit function, the audit committee will need to assess whether other processes need to be put in place to provide sufficient and objective assurance that the system of internal control is functioning as intended.
Where there is an internal audit function, the audit committee should:
- review and approve the role and mandate of the internal audit function;
- approve the annual internal audit plan and budget ensuring that sufficient resources are available to permit internal audit to carry out its role effectively;
3 monitor and review the effectiveness of the work of the internal audit function;
- review and annually approve the internal audit charter to ensure that it is appropriate to the current needs of the organisation; and
- approve the appointment or termination of appointment of the head of internal audit.
External audit
The audit committee is responsible for overseeing the company’s relations with the external auditor. This role includes:
1.initiating a tender process, negotiating the fee and scope of the audit and making formal recommendations to the board on the appointment, reappointment and removal of the external auditors;
- annually assessing, and reporting to the board on, the qualification, expertise and resources, and independence of the external auditors and the effectiveness of the audit process, with a recommendation on whether to propose to the shareholders that the external auditor be reappointed;
- developing and recommending to the board for approval a policy in relation to the provision of non-audit services by the external auditor.
Once the policy is approved, the audit committee should be responsible for approving or recommending to the board for approval any non-audit services to be carried out by the external auditor within that policy;
- meeting with the external auditors prior to the start of each annual audit cycle, to ensure that appropriate plans and resources are in place for the audit.
The audit committee may also wish to hold an initial discussion without the auditor to consider factors that could affect audit quality and discuss these with the auditor;
- review the audit representation letters before signature and give particular consideration to matters where representation has been requested that relate to non-standard issues. These letters confirm that all the information provided to the auditors for during the audit process is complete and appropriate based on the board’s own knowledge.
What is the audit committee’s relationship with shareholders?
The FRC Guidance on Audit Committees states that the audit committee has a role in ensuring that shareholder interests are properly protected in relation to financial reporting and internal control. In carrying out this role the audit committee should:
- consider the clarity of its reporting and be prepared to meet investors; and
- develop for inclusion in the annual report, a separate report describing the work of the audit committee in discharging its responsibilities, which should be signed by the chair of the audit committee.
The chair of the audit committee should be present at the annual general meeting to answer questions on the separate section of the annual report describing the audit committee’s activities and matters within the scope of the audit committee’s responsibilities.
What matters should be included in the audit committee report?
The FRC Guidance on Audit Committees recommends that the audit committee report to be included in the annual report should include the following matters:
- a summary of the role and work of the audit committee;
- how the audit committee composition requirements have been addressed, and the names and qualifications of all members of the audit committee during the period, if not provided elsewhere;
- the number of audit committee meetings;
- how the audit committee’s performance evaluation has been conducted;
- an explanation of how the committee has assessed the effectiveness of the external audit process;
- the approach taken to the appointment or reappointment of the external auditor;
- the length of tenure of the current audit firm;
etc
What is the purpose of an external audit
and
what is the role of an external auditor?
The purpose of an independent audit of the company is to make sure that the financial statements of the company can
be relied upon.
The role of the external auditor
- To give an expert and independent opinion on whether the financial statements give a true and fair view of the financial position of the company
- To give an expert and independent opinion on whether the financial statements comply with the relevant laws.
- The external auditor of a listed company Is also required to review the company’s compliance with the 2018 Code, and to obtain evidence to support the company’s statement, included in the annual report and accounts, of its compliance with the 2018 Code.
- The external auditors’ report provides an opinion on compliance with the law and accounting standards and whether the accounts that have been prepared by the board present a true and (in some cases) fair picture of the financial reality of the company. They are not responsible for detecting fraud or errors in the organisation’s financial statements. This is the responsibility of the board of directors.
Who is responsible for detecting fraud in a company?
The external auditors’ report provides an opinion on compliance with the law and accounting standards, and whether the accounts that have been prepared by the board present a true and (in some cases) fair picture of the financial reality of the company.
They are not responsible for detecting fraud or errors in the organisation’s financial statements.
This is the responsibility of the board of directors
How does an audit report become modified?
If an external auditor has issued a modified audit report it is a serious issue, as it implies there are potentially grave concerns about the financial statements and the financial condition of the company.
It also implies that the external auditor and the board of the company could not agree on the application of accounting policies and hence the content of the financial statements. There are three types of modified audit opinion:
- A qualified audit opinion which is given when, in the opinion of the external auditor, the financial statements would
give a true and fair view except for a particular matter, which the external auditor explains. - An adverse opinion which is given when the external auditor considers that there are material mis-statements in the
accounts and that these are ‘pervasive’. In effect, the external auditor is stating that they believe that the information
in the financial statements is seriously incorrect. - A disclaimer of opinion which is given in cases where the external auditor has been unable to obtain the information that they need to give an audit opinion. The lack of information means that the auditor is unable to state that the financial statements give a true and fair view, and that there may possibly be serious mis-statements that the external auditor has been unable to check
How can a company protect an external auditor’s independence?
The UK Corporate Governance Code gives the audit committee the responsibility for reviewing and monitoring the independence and objectivity of the external auditors.
The UK FRC Guidance on Audit Committees suggests various measures an audit committee should take in carrying out this role. These include the following:
- The committee should seek reassurance that the auditors and their staff have no familial, financial, employment, investment or business relationship with the organisation that could adversely affect their independence or objectivity.
- The committee should seek information annually from the audit firm about its policies for maintaining independence and monitoring compliance with relevant requirements.
The company should consider, as another measure for protecting auditor independence, rotating auditors. This can be done in one of two ways: - rotation of audit partner; and
- rotation of audit firm.
The audit committee should also meet with the auditors at least one per year as part of the annual audit process without management present to ensure that the auditors are not being intimidated by management.
