Chapter 9 - Test yourself Q&A's - Financial Reporting to Shareholders and External Audit

Question 1

In what way is financial reporting connected to corporate governance?

Answer 1

Financial reporting fall within the context of corporate governance as it involves the concepts of accountability and transparency.

Question 2

What is the purpose of financial reporting and how is that purpose different in listed companies?

Answer 2

Various purposes include:

1. Potential investors - Interested in the ability of the company to generate net cash flow for dividends, distributable profits, increase in 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.
2. Creditors - Interested in the amounts, timings, 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.
3. Suppliers - 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.
4. Employees - 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.
5. Customers - Interested in ensuring the continued supply of goods or services especially if these customers have a long - terms association with or are dependent on the company.
6. Governments - Interested in the efficient allocation of economic resources, determining and applying taxation to the entity and / or for preparing national statistics.
7. Regulators - Interested in being able to assess that the company is complying with all of the laws, regulations, standards and codes applicable to it.
8. Public - Variable interests including assessment of the company’s prosperity, activities and ability to continue participating in the local economy and in local activities.

Question 3

How can a company mislead the market in its financial reporting?

Answer 3

A company can mislead the market in its financial reporting by:

1. The adoption of accounting practices that give a more flattering picture of the company’s position.
2. 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.
3. Taking debts off the company’s balance sheet. This can be achieved by transferring these debts to other companies (special purpose vehicles).
4. Disguising money from loans as operating income so that the company’s reported cash flow from operating activities is increased.
5. Over-valuing the company’s assets.

Question 4

What is the purpose of the audit committee?

Answer 4

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.

Question 5

Briefly describe the four areas over which the audit committee would typically have responsibilities?

Answer 5

The FRC Guidance on Audit Committees provides information about the roles and responsibilities of the audit committee. These include:

Annual Reports and other periodic reports
Internal controls and risk management systems
Internal Audit
External Audit

Question 6

What is the audit commitees relationship with shareholders?

Answer 6

The FRC Guidance on Audit Committees states that the audit committee has a role in ensuring that shareholders interests are properly protected in relation to financial reporting and internal control. In carrying out this role the audit committee should:

1. Consider the clarity of its reporting and be prepared to meet investors.
2. 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.

Question 7

What matters should be included in the audit committee report?

Answer 7

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;

the current audit partner name, and for how long the partner has held the role;

when a tender was last conducted and advance notice of any retendering plans;

if the external auditor provides non-audit services, the committee’s policy for approval of non-audit services;

how auditor objectivity and independence is safeguarded;

the audit fees for the statutory audit and for audit related services and other non-audit services, including the ratio of audit to non-audit work;

for each significant engagement, or category of engagements, explain what the services are and why the audit committee concluded that it

was in the interests of the company to purchase them from the external auditor;

an explanation of how the committee has assessed the effectiveness of internal audit and satisfied itself that the quality, experience and expertise of the function is appropriate for the business;

the significant issues that the committee considered, including: issues

in relation to the financial statements and how these were addressed, having regard to matters communicated to it by the auditors. The section need not repeat information disclosed elsewhere in the annual report and accounts, but
could provide signposts to that information;

the nature and extent of interaction (if any) with the FRC’s Corporate Reporting Review team.

Question 8

What is the purpose of an external audit?

Answer 8

The purpose of an independent audit of the company is to make sure that the financial statements of the company can be relied upon.

Question 9

Who is responsible for detecting fraud in a company?

Answer 9

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.

Question 10

How does an audit report become modified?

Answer 10

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.

Question 11

How can a company protect an external auditor’s independence?

Answer 11

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.