Financial reporting to shareholders and external audit

Question 1

In what way is financial reporting connected to corporate governance?

Which companies must make public disclosures?

Why?

Which companies are subject to additional reporting requirements?

Why?

Answer 1

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

All companies = books or accounts and records must be kept to prepare the annual accounts = filed with CH and available for public inspection.

= allow those dealing with the company to see the company is financially stable.

• Financial reporting requirements for listed companies are more rigorous than those for private companies = listed companies have to be accountable and transparent to their shareholders

= Separation of ownership between shareholders and board of directors

Question 2

Who are the 8 users of a company’s financial reporting and why are they interested?

Answer 2

1. Potential investors – interested in the ability of the company to generate net cash flows
2. Creditors – interested in the amounts, timing and uncertainty of cash flows
3. Suppliers – interested in the entity’s ability to pay a debt for goods or services
4. Employees – interested in sustainability and profitability (to pay wages)
5. Customers - interested in ensuring the continued supply of goods or service
6. Governments - interested in determining and applying taxation
7. Regulators - interested in whether company is complying with all of the laws, regulations, standards and codes applicable to it.
8. Public - interested in company’s ability to continue participating in the local economy

Question 3

What are the CA2006 requirements for financial reporting? (3)

Whose responsibility is it to sign off on the accounts that they give a true and fair view?

Answer 3

1. Requires every company to keep adequate accounting records which are sufficient to:
   a. show and explain the company’s transactions;
   b. disclose with reasonable accuracy the financial position of the company at that time;
   c. enable the directors to ensure accounts prepared comply with the requirements of the CA2006 and IAS
2. Requires directors to prepare accounts for each financial year = accounts should comply with IAS
3. Accounts must comprise a balance sheet as at the last day of the financial year, and a profit and loss account:
   a. Both should give a true and fair view of the company’s financial affairs
   b. Must be approved by the board and signed on behalf of the board by a director

• Directors = must not approve and sign off accounts unless they are satisfied they give a ‘true and fair’ view = To do so is a criminal offence

Question 4

What are the Listing Rules financial reporting requirements required by the FCA and LSE for listed companies to maintain their listing? (3)

What are the Disclosure, Guidance and Transparency Rules for financial reporting? (2) (auditors)

Answer 4

1. LR 9.7 = voluntary preliminary statements and dividend accounts
2. LR 9.8 = annual report disclosures
3. Viability statement = included in annual report on the appropriateness of adopting the going concern basis of accounting and the directors’ assessment of the prospects of the company

Chapter 4 DTRs = requires financial reports to be audited and for the auditors to be registered with the FRC’s Professional Oversight Board

Question 5

What do the International Financial Reporting Standards provide?

What are the 5 required components of financial statements under IFRS?

What does UK accounting standards require directors to do and what does this mean for how the accounts will then be prepared?

Answer 5

= provide a common global language for business affairs so company accounts are understandable and comparable across international boundaries

1. Statement of comprehensive income (P&L)
2. Statement of financial position (balance sheet)
3. Cash flow statement.
4. Statement of changes in equity
5. The notes to the accounts – cosec may be involved in the drafting these

directors must satisfy themselves that is it is reasonable to conclude the company is a going concern
= Accounts then prepared on a going concern basis rather than a break-up basis

Question 6

What does Principle M UK CG Code require boards to do via their AC for financial reporting?

What does provision 27 UK CG Code require directors to do in the annual report?

What are the 4 things listed companies must state in their annual and half-yearly financial statements under provision 30 and provision 31 UK CG Code?

Answer 6

• Principle M = requires boards via their AC to establish formal and transparent policies and procedures to satisfy themselves on the integrity of their company’s financial statements

• Provision 27 = Directors required to explain their responsibility for preparing the annual report and accounts and make a statement regarding their review

1. Provision 30 = Whether it considers it appropriate for the company to adopt a going concern basis of accounting when preparing the financial statements.
2. Provision 30 = Whether there are any material uncertainties, and if so, to identify them over the last 12 months
3. Provision 31 = Taking into account the company’s current position and principal risks, how it has assessed the prospects of the company
4. Provision 31 = Whether it has a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due

Question 7

Name 4 ways a company can misreport their financial numbers to improve its financial position.

Answer 7

1. Adoption of accounting policies that give a more flattering picture of the company’s position.
2. Claiming that revenue or profits were earned earlier than it should have.
3. Taking debts off the company’s balance sheet (Enron)
4. Over-valuing the company’s assets

Question 8

What 4 things does the FRC’s Review of Corporate Reporting November 2020 recommend companies should do to improve investor confidence in financial reporting?

Answer 8

1. provide clear and meaningful explanations as to how they achieve good governance standards
2. clearly show the impact of engagement with stakeholders on decision making, strategy and long-term success
3. better assess and monitor culture
4. demonstrate their commitment to diversity and inclusion through improved succession planning

Question 9

In 2021 Sir James Wates’ articles provided insight into reporting trends.

Name 3 positive trends identified.

Name 2 negative trends identified.

Answer 9

• Positive trends:
1. Many companies have provided good explanations as to how their governance arrangements work (Jaguar Land Rover)

2. Wholly owned subsidiaries (Northern Bank) reported on how they were applying the Wates Principles and their parent’s governance standards
3. Examples of issues that their boards were dealing with were provided (Chanel)

• Negative trends:
1. Companies state what their purpose is but do not show how their purpose guided board-level discussions and decision-making

2. Access to the Corporate Governance Report on company websites is not easy

Question 10

What is the board’s role in financial reporting / how should the board satisfy itself about the integrity of the financial reports of the organisation? (5)

Answer 10

By ensuring:
1. Compliance with financial reporting standards.

2. Effective arrangements for oversight over the auditors.
3. Periodically assessing independence and objectivity of the auditor
4. Disclosure of significant audit matters and how these were addressed
5. They respond to any issues raised in the Auditor’s report to the shareholders (usually at AGM)

Question 11

Why does the cosec have to be competent in financial accounting and reporting?

What is the role of the cosec in financial reporting? (5)

Answer 11

• they need to understand the significance and relevance of accounting information and the process by which it is acquired

1. Ensuring the board complies with the legal, regulatory, standards and codes relating to financial reporting
2. Interpreting in non-financial terms the financial performance and disclosures for the board, shareholders and other stakeholders.
3. Reading the notes to the financial statements to ensure that they clearly and transparently explain the figures in the financial statemen.
4. Providing advice and oversight, on behalf of the board, for the preparation of financial reporting documentation, annual and half yearly reports
5. Overseeing the distribution/circulation of the documentation/disclosures.

Question 12

Which companies must have an AC?

What does the UK CG Code require boards to do in relation to internal and external audit?

Which UK CG provision lists the main roles and responsibilities of the AC?

Under the UK CG Code, where must the AC describe its work?

Where does the FRC Guidance on Audit Committees say the main role and responsibilities of the AC should be set out?

What does the FRC Guidance on Audit Committees say the AC and board should review annually?

Answer 12

• DTR 7.1 = listed companies are required to establish an audit committee
(DTRs are mandatory = not comply or explain)

• Principle M = requires board to establish formal and transparent policies and procedures to ensure the independence and effectiveness of internal and external audit functions

• Provision 25 lists the main roles and responsibilities of the AC

• Provision 26 = describe its work in the annual report

main role and responsibilities of AC should be set out in written terms of reference tailored to the particular circumstances of the company

AC and board should review annually the effectiveness of the AC

Question 13

What are the DTR composition requirements of an AC? (3)

What are the UK CG Code composition requirements of an AC? (4)

What does the FRC Guidance on Audit Committees say regarding appointments to the AC?

Answer 13

• DTR 7.1 = requires AC of listed companies be comprised of:
1. a majority of independent members, including the chair;
2. at least one member with accounting and/or auditing experience;
3. members who have the competencies relevant to the sector in which the listed company is operating in

• UK CG Code = stricter requirements:
1. Provision 24 = minimum of 3 independent directors, 2 for companies below FTSE350;
2. one member should have recent and relevant financial experience;
3. members have relevant competencies to the sector in which the company operates
4. Board chair should not be a member

FRC Guidance on Audit Committees provides that appointments to AC should be made by the board on the recommendation of the NC, in consultation with the AC chair

Question 14

In the FRC Guidance on Audit Committees, what are the 4 sub-headings of Section 3: The role and responsibilities of the AC?

Answer 14

1. Annual report and other periodic reports
2. Internal control and risk management systems
3. Internal audit
4. External audit

Question 15

What 3 things should the AC consider under the ‘Annual report and other period reports’ sub-heading in the FRC Guidance on Audit Committees?

Answer 15

1. whether the company has adopted appropriate accounting policies;
2. the clarity and completeness of disclosures in the financial statements
3. the content of the annual report and accounts and advise the board on whether it is fair, balanced and understandable

Question 16

What 3 things should the AC consider under the ‘Internal control and risk management system’ sub-heading in the FRC Guidance on Audit Committees?

Answer 16

1. the company’s internal financial controls
2. If a separate risk committee have not been established = AC should review the company’s risk management system
3. reports from management on the effectiveness of the systems established and the conclusions of any testing carried out

Question 17

What 3 things should the AC do under the ‘Internal audit’ sub-heading in the FRC Guidance on Audit Committees?

Answer 17

1. AC should regularly review the need for establishing an internal audit function
   • Where there is an internal audit function, the AC should:
2. approve the annual internal audit plan and budget;
3. monitor and review the effectiveness of the work of the internal audit function;

Question 18

What 3 things should the AC do under the ‘External audit’ sub-heading in the FRC Guidance on Audit Committees?

Answer 18

1. Initiate a tender process, negotiating the fee and scope of the audit
2. make formal recommendations to the board on appointment/reappointment/removal of external auditors
3. Develop and recommend to the board a policy in relation to the provision of non-audit services by the external auditor

Question 19

How often should the AC meet in a year according to the FRC Guidance on Audit Committees?

Who should be present at the meeting?

Should management always be present?

Answer 19

• at least 3 meetings during the year, held to coincide with key dates within the financial reporting and audit cycle

• Only AC chair and its members should be present at its meeting, others should be in attendance when invited by AC

• AC should meet the external and internal auditors, without management, at least annually, to discuss any issues arising from the audits

Question 20

Who should the AC report to and on what according to the FRC Guidance on Audit Committees?

Name 3 issues that should be raised to the board.

Answer 20

• FRC Guidance on Audit Committees = AC should report to the board on how it has discharged its responsibilities

1. the AC’s assessment of the effectiveness of the external audit process and its recommendation on the appointment/reappointment of the external auditor;
2. the AC’s assessment of the effectiveness of the internal audit function;
3. any other issues on which the board has requested the committee’s opinion

Question 21

What is the AC’s relationship with shareholders according to the FRC Guidance on Audit Committee?

In carrying out this role, what 2 things should the AC do?

Answer 21

• AC has a role in ensuring that shareholder interests are properly protected in relation to financial reporting and internal control.

1. consider the clarity of its reporting
2. develop for inclusion in the annual report a separate report describing the work of the AC in discharging its responsibilities, signed by the AC chair

Question 22

Name 5 matters that should be included in the AC report as recommended by The FRC Guidance on Audit Committees.

Answer 22

1. summary of AC role and work
2. No. of AC meetings
3. Explanation of how AC assessed the effectiveness of the external audit process;
4. Name of external firm, partner and length of tenure
5. how auditor objectivity and independence is safeguarded;

Question 23

Name 5 things the cosec would typically be involved in in relation to the AC.

Answer 23

1. advising the board on whether it was appropriate to have an AC
2. developing the terms of reference for the AC to comply with FRC requirements and international best practice
3. ensuring that the committee has sufficient resources to carry out its role e.g., access to external independent professional advice
4. organising annual evaluation of the performance AC members
5. drafting the AC report to be included in the annual report;

Question 24

Which companies must have an external auditor?

What are the board responsible for regarding the resolutions of appointing the external auditor?

Do shareholders have the power to remove the external auditor if they are dissatisfied with them?

Answer 24

• S.489 CA2006 = Every plc except dormant companies must have an independent external auditors who carries out the annual audit of the company

• Board are responsible for ensuring that resolutions appointing the external auditor are placed before shareholders at the GM at which the annual financial statements are laid

Yes

Question 25

Who do auditors owe a duty of care to and when? (Case)

Can auditors be liable to 3rd parties? (Case)

What recommendation came from this case?

Answer 25

Owe a duty of care to their client company and its shareholders when conducting the audit and issuing their opinion
• Caparo Industries plc v Dickman (1990) = duty is owed to shareholders as a body and not to any individual shareholder or the public at large

• RBS v Bannerman Johnstone Maclay (2002) = 3rd parties can assume a duty was accepted because it was not denied. It was open to the auditors to disclaim, however they chose not to do so.

• ICAEW recommended the inclusion of a disclaimer in audit reports = ‘Bannerman disclaimer’

Question 26

How can auditors limit their liability?

What does the CA2006 require in relation to this?

Do auditors only face civil liability?

Answer 26

Enter into liability limitation agreements with the companies they are auditing.

• CA2006 requires companies to disclose in the notes to the annual accounts any liability limitation agreements they make with their external auditors

• Criminal offence = to knowingly or recklessly ‘include any matter that is misleading, false or deceptive’ or to omit a statement that is required by the CA2006.
Offence is punishable by a fine.

Question 27

Who does the external auditor make a report to?

What is the audit reports 2 main purposes?

Are auditors responsible for detecting fraud or errors in the organisations financial statements?

What are the 2 types of audit report?

What 2 things does the 2nd type imply?

Answer 27

• s.495 CA2006 = external auditor must make a report to the company’s members

1. 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
2. to give an expert and independent opinion on whether the financial statements comply with the relevant laws and accountancy standards

• no = board’s responsibility

1. unmodified = auditors state the financial statements give a true and fair view
2. modified = serious issue and implies
   a. there are potentially grave concerns about the financial statements and the financial condition of the company
   b. auditor and board couldn’t agree on the application of accounting policies and hence the content of the financial statements

Question 28

What are the 3 types of modified audit opinion?

Answer 28

1. A qualified audit opinion = the financial statements would give a true and fair view except for a particular matter, which the external auditor explains.
2. An adverse opinion = there are material mis-statements in the accounts and that these are ‘pervasive’.
3. A disclaimer of opinion = external auditor has been unable to obtain the information that they need to give an audit opinion

Question 29

What are the 5 possible threats to auditor independence identified by the International Federation of Accountants (IFAC)?

Answer 29

1. Self-interest threat = an auditor or audit firm is earning such a large amount of fee income from the audit and non-audit work that its judgement will be affected by a desire to protect this income stream
2. Self-review threat = Audit firm conducts non-audit work for company and has to check the firm’s own employees work
3. Advocacy threat = Audit firm is asked to give its formal support to the company by providing public statements or supporting the company as part of litigation
4. Familiarity threat = Auditor becomes familiar with a company or one of its directors through a working association over time (= too trusting and don’t check)
5. Intimidation threat = An auditor may feel threatened by the directors or senior management of a company

Question 30

What are the 6 measures to protect auditor independence against the possible threats?

Answer 30

1. Appointment by shareholders =CA2006 provides appointment of auditor and their remuneration should be approved by shareholders at GM
2. Restricting or prohibiting non-audit services
3. Assessment of independence of audit firm employees = AC has responsibility for reviewing and monitoring the independence and objectivity of the external auditors
4. Rotation of audit partner or audit firm
5. Requesting that the auditor make public statements on behalf of the company = AC should monitor what statements they are being asked to make to avoid the audit firm carrying out an advocacy role on behalf of the company
6. Management intimidation = AC should meet with external auditors at least annually without management

Question 31

What 2 things does the 2014 EU Audit Directive and Regulations do in relation to non-audit services?

Answer 31

1. restrict the amount of non-audit work that audit firms can undertake from clients to no more than 70% of the average fees from audit work over the previous 3 years
2. impose a ban by audit firms on certain types of non-audit work, including: tax advice, book-keeping, payroll, legal services, internal audit, and HR services

Question 32

What is the objective of operational separation?

Who has agreed to the FRC’s principles of operational seperation?

Answer 32

= to ensure audit practices are primarily focused on delivering high-quality audits in the public interest, and do not rely on non-audit fees from the rest of the firm

Big Four firms have agreed to operational separation of their audit practices on the basis of the Principles by September 2024

Question 33

What does the FRC Guidance on Audit Committees say the AC’s objective should be in relation to non-audit services?

How should the AC do this?

What is the AC required to explain if the external auditor provides non-audit services?

Answer 33

• AC’s objective should be to ensure that the provision of non-audit services does not impair the external auditor’s independence or objectivity

• AC should set and apply a formal policy specifying the types of non-audit service for which use of the external auditor is pre-approved

• Provision 25 requires an explanation in the annual report of how auditor independence and objectivity are safeguarded, if the external auditor provides non-audit services

Question 34

What does the FRC Guidance on Audit Committees say on the rotation of audit partners?

Can this be longer?

What is the EU Audit Directive and Regulation requirement for the rotation of the audit firm?

What is the benefit?

What is the disadvantage?

Answer 34

• recommends normal rotation period for the audit engagement partner and key audit partners is 5 years

• AC can decide that it’s necessary to safeguard the quality of the audit without compromising the independence and objectivity of the external auditor, to extend the period = 2 more years

• EU Audit Directive and Regulation = requires EU PIEs to change their audit firm at least every 10 years

• Benefit = new auditor brings greater scepticism and a fresh perspective that may be lacking in long-standing auditor–client relationships

• Disadvantage = audit quality may suffer because the auditor would lack familiarity with the client and its industry

Question 35

What were 5 key recommendations from The Report of the Independent Review into the Quality and Effectiveness of Audit 2019 (the Brydon Review)?

Answer 35

1. A redefinition of audit and its purpose.
2. The introduction of suspicion into the qualities of auditing
3. Mechanisms to encourage greater engagement of shareholders with audit and auditors.
4. A change to the language of the opinion given by auditors
5. The increased use of technology

Question 36

Following collapse of Carillion and BHS, the UK Government confirmed FRC would be replaced by a new independent regulator, known as what?

What are the 3 core objectives?

How will this new regulator be better than the FRC?

Answer 36

• = the Audit, Reporting and Governance Authority (ARGA) by 2023

1. To set high standards in CG and stewardship, corporate reporting, and audit and assess the effectiveness of the application of those standards, enforcing them proportionally in the public interest
2. To promote improvements and innovation in these areas exploring good practice with a wide range of stakeholders
3. To transform the organisation Into a fit-for-purpose, independent regulator

• Will have stronger powers = able to intervene directly and make changes to company accounts and issue sanctions

Question 37

In 2021, gov proposed reforms to address the findings in Kingman, Brydon and CMA reports.

What was the name of the white paper?

Name the 4 stakeholders the reforms are aimed at and an example of each.

Answer 37

• ‘Restoring trust in audit and corporate governance’
1. Directors
= Ensure regulators have effective civil enforcement powers to hold directors to account for breaches of duty

2. Audit, Auditors, and Audit Firms
   = New requirements for audit firms to separate their audit and non-audit practices
3. Shareholders
   = Companies to publish an audit and assurance policy setting out their approach to audit subject to an advisory shareholder vote
4. The Audit Regulator
   = Regulator to have responsibility for deciding which individuals and firms should be approved to audit PIEs

Question 38

What is the role of the cosec in relation to external audits? (3)

Answer 38

Typically involved in:
1. The appointment and remuneration of the external auditor

2. Ensuring external auditor attends AGM and is briefed about potential questions
3. Advising the board and/or AC on any auditor rotation requirements