Current issues for European audit committee chairs

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Current issues for European audit committee chairs

briefing for Vodafone

February 2011

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Topics in this briefing include:

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Increasing focus on risk

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Potential changes to audit committees and audit reports

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Improving audit committee effectiveness

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Taking a broader oversight of financial communication

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Examining the impact of the accounting standards convergence projects

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Comparing and contrasting US and European boards

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Additional materials

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About the EACLN

February 2011

This paper summarizes some of the issues that audit

committee chairs of leading European companies are

currently discussing with their advisors in Ernst & Young

and with each other through our European Audit Committee

Leadership Network (EACLN).

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Increasing focus on risk

Audit committees have historically had responsibility for financial and accounting risk oversight. As a result of the financial crisis, they are taking a broader perspective and, in many cases, are assuming a “default” risk committee role. Of course many companies, particularly those in financial services, have a separate risk committee at board level.

Criticism of corporate governance and risk oversight has dominated the media and leading companies are taking action.

Categories of risk within companies are increasingly being seen as more interconnected and audit committees are taking a more holistic view of risk, where financial performance is impacted.

Audit committees are looking at their level of understanding of their company’s risk management processes; whether they have sufficiently broad perspective on key risks and whether they have the skills necessary to improve risk oversight. They are questioning the risk management processes and judgments of management, and are diving into the detail to a greater degree.

Leading audit committee chairs agree that audit committees and boards should:

► Set aside specific time on the agenda for risk

► Prioritize risks by their potential impact on the bottom line

► Understand “gross risk” and “net risk” and evaluate the business’s mitigation strategies against both measures

► Explore key risk areas in detail where required

► Improve risk reporting to the board and encourage greater dialogue with management

A discussion of enterprise risk management leading practice is provided in a separate paper.

Potential changes to audit committees and audit reports

Audit committee chairs predict that the EU will explore

strengthening their role following the EU’s Green Paper on Audit Policy and the responses received.

European audit committee chairs who have reviewed the response to the first Green Paper are relieved that some of the more significant structural changes being considered — mandatory audit rotation and joint audit — have been rejected by many respondents. These are considered deeply inefficient by directors who must undertake them.

The second Green Paper on Corporate Governance is planned for release between March and May 2011 and will provide a rich platform for debate.

Many audit committee chairs consider that, in the turbulence resulting from the financial crisis, policy-makers, regulators and investors do not understand the difference in role between independent board directors and management.

The debate on whether to move from the principle of comply or explain to more prescriptive measures reflects their desire for stronger governance. There are real concerns that proposals to increase regulation on the “process” of corporate governance may have an opposite effect. By reducing the level of judgment boards and audit committees can exercise, accountability could be obscured.

It is clear there is no simple solution.

The EU Green Paper on Audit Policy touches on potential expansion of the auditor’s report, and this has been echoed by the UK’s Financial Reporting Council paper suggesting auditors could provide comment on the narrative reports, which should in turn be more aligned to financial statements. An additional audit committee report has also been suggested. The impact of this on the role of audit committees and auditors, and the corporate reporting process, needs to be explored.

At a minimum, the EU is likely to require greater disclosure on the selection of auditors, choice of accounting policy and the nature of audit itself, so companies should review their level of transparency regarding their relationship with their auditors.

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►Set aside time on the agenda for risk

►Prioritize risks by impact, and evaluate

►Improve communication on risk

►Assess your accounting and reporting practices against peers

►Review accounting close calls and learn from them

►Focus on the key issues — valuation, debt and funding — and

understand the assumptions behind the financial statements

►Keep updated on the changes to reporting standards

►Delegate subjects to specific members to tackle in detail

►Develop a training curriculum for board members using external audit, internal audit, risk and external business advisors

► Ask for better reporting on themes and issues, from specialists within the firm and external advisors

► Get to know management below board level (internal audit, head of risk, financial control) and use their insights

► Support the external auditor’s challenges to management’s assumptions

► Build a stable of advisors to call on

— legal, tax and market specialists

► Invite relevant guests to audit committee meetings

► Attend key business meetings

— for example, risk meetings

Improving audit committee effectiveness

Enhanced focus on risk management oversight, corporate governance and better protection of shareholder interests has led many audit committee chairs to examine the effectiveness of audit committees.

In response to enhanced scrutiny from investors and other stakeholders, our discussions with companies reveal audit committee chairs are making changes in these key areas:

fi nancial reporting

Use internal and Revie

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Improving audit committee effectiveness

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A summary of audit committee management in leading companies

While requirements vary depending on an organization’s sector, size and complexity, we identify the following trends in audit committee “operations”:

Frequency and length ►While four meetings are minimum, most leading companies hold between six to ten audit committee meetings a year

►Meetings are normally set for two to three hours

Preparation ►Papers are sent out a minimum of one week in advance. Many companies are providing directors with iPads to receive documents in electronic form

►Advisors (often the external auditors) are asked to refine the quality of information (and where possible reduce the volume) by providing executive summaries explicitly cross-referenced to risk

Agenda ►Agendas are prioritized with the most important issues that are material to financial reporting and risk

►Meeting attendance is tightly managed to match agenda items

►Diverse views are actively encouraged, but timing is controlled

►A standing calendar of agenda items can be used to plan the audit meetings through the year to ensure full consideration is given to all audit committee responsibilities

Example of a standing calendar for audit committee meetings

Q1 Q2 Q3 Q4

Annual statements Internal controls review Auditor engagement Accounting policies

Annual report completion Post-audit management letter and

auditor insight Significant business risks and

impact on financial statements Material judgments in the draft financial statements

Auditor reports Auditor performance review Complaint and whistle-blower

procedures External audit plan

Audit process review Audit committee terms of reference Internal audit plan for the next

financial year

Mid-year report Expenses of board, chair, CEO and

executives Resources in the finance function

Taking a broader oversight of financial communication

Financial stakeholders are increasingly demanding enhanced information about the financial statements, as well as a clearer picture of future performance, and a broader story on the organization’s challenges and strengths. As a consequence, the audit committee’s role in broader financial communication is being discussed.

The Institut Français des Administrateurs, the French Institute of Directors, is looking at board-shareholder communications as part of its 2011 work program. The aim is to close the gap in expectations about what boards do and to explore whether direct communication between the board chairman and shareholders on strategy and remuneration (as occurs in the UK) has merit.

Given the increased level of financial communications by companies, audit committees are looking at their level of involvement. While there isn’t an appetite for direct communication with stakeholders, many consider that the audit committee should increase its oversight of financial communication.

In particular, audit committees are concerned that a sufficient level of rigor is applied to ensure that management’s description of the company’s performance reflects their understanding. Some are already being consulted on communications to analysts and ratings agencies.

Crisis communication

Crisis communication is on audit committees’ minds given some recent high-profile cases where perceived poor communication has increased reputational damage.

In discussion, audit chairs recognize that significant unanticipated risk often accompanies the broad-scale adoption of new

technologies. There is a view that the audit committee has a role to play in ensuring the company is prepared and able to respond effectively to a catastrophic event.

Establishing early warning systems is key — ensuring the organization has invested in processes to identify problems early on to allow time to formulate a response.

Audit committees or board members should:

► Understand the magnitude of all major risks

► Ask “what-if” questions — how would the company respond in the event of a particular crisis?

► Ensure a crisis communications plan is built into the risk management framework to provide assurance to key stakeholders

► Review the succession plan for top management to allay any stakeholder fears on business continuity

► Seek external advice to test the robustness of their company’s crisis communications plan

Questions for the audit committee

► What steps has the company taken to ensure its financials are sufficiently comprehensible to investors?

► Do they accurately and appropriately represent the company’s underlying performance?

► Who at board level oversees management

communication of company performance to financial stakeholders and is their oversight sufficient?

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The impact of accounting standards convergence projects

The world’s main accounting standard setters (FASB and IASB) have an ambitious agenda of standards development, in an attempt to bring IFRS and US GAAP closer together and achieve substantial improvements in these standards. Their aim is to complete as many as possible in 2011, although the precise timetable is subject to change.

Top of the agenda are revised standards for financial instruments, revenue recognition, leases, the presentation of other

comprehensive income and fair value measurement. The boards have selected the standards they consider are most in need of improvement, and are at the root of accounting differences between the two reporting standards.

The projects that audit committee chairs are particularly concerned with are:

► Revenue recognition — and the impact on long-term contracts and accounting for warranties.

► Leases — bringing lease assets and obligations on to the balance sheet will have financial implications for most companies, and lead time will be needed to adapt financial systems to gather data.

► Financial instrument reporting — the use of fair value

measures for financial assets and liabilities will have significant implications.

The standard setters are working to balance the diverse interests of investors, preparers, regulators and auditors. There is concern that some stakeholders are not forthcoming in their views, and the boards are keen to increase the input they receive from preparers and analysts. Audit chairs are encouraged to comment on discussion papers which are released before exposure drafts, and actively participate in field testing and the consultation process.

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Comparing and contrasting US and European boards

Through our discussions with the audit committee chairs of large cap multinational companies in the US and Europe, we observe that US companies have mature audit committees with a distinct legal status and set of functions, often resulting in a broader and more influential role.

The supervisory board structure of several EACLN member companies (German, Dutch and some French companies) limits the role of the supervisory board and the audit committee in control and audit matters. This appears to be evolving, but slowly.

North American members of our networks tend to be more deeply involved in issues such as financial communications and non-financial risks (for example, information technology). They therefore engage more often and on a more substantial basis with management on these issues. European audit committees of companies listed in the US and most UK companies are more involved in these topics than many of their continental counterparts. Some of the more prominent differences are noted below.

US Europe

Anti-bribery and fraud US audit chairs are more focused on anti-bribery and corruption issues, as a response to the US Foreign Corrupt Practices Act.

European audit committees are expected to increase focus when the UK Bribery Act is passed.

The move to IFRS

On both sides of the Atlantic, audit committee chairs are fatigued by the lack of progress and politicization of the convergence process.

US audit committees express doubt over their eventual move to IFRS and are frustrated by accounting complexity.

European audit committees are enthusiastic about a US move to IFRS but are equally frustrated by accounting complexity.

Sustainability and sustainability reporting Both groups report no involvement or accountability for sustainability reporting.

European companies appear more advanced than the US on sustainability issues and environmental and social-issues reporting.

Most audit chairs in Europe are aware of reporting trends and the reputational and business risks to their companies.

Internal audit’s role and remit NYSE mandates that companies maintain an internal audit function.

Internal audit has a strong relationship with the audit committee chairman and plays a role in setting the audit committee agenda and preparing for the meeting with the chairman.

The structure and function of the audit profession and its role in capital markets stability

US audit committees have not yet discussed the issues raised in the European Commission’s Green Paper.

European chairs are engaged in discussion about how audits should be conducted in light of the recent publication of the European Commission’s Green Paper on Audit Policy. They are open to changes to the audit committee role and auditor’s report to shareholders.

Risk oversight US- and UK-based committees are including stronger risk reporting to the board, often due to the active involvement of the audit chair in shaping management presentations, and tools such as risk surveys that identify internal and external constituents’ views about key risks.

Insight into the treasury function Due to greater focus on capital markets financing in the US, committees tend to have

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Ernst & Young’s European Audit Committee Leaders Network

The EACLN is convened by Ernst & Young and orchestrated by Tapestry Networks. It brings together audit committee chairs from Europe’s leading companies who are committed to improving the performance of audit committees and enhancing trust in financial markets.

The network meets three times a year to discuss current issues and means of improving audit committee performance. The network facilitates private dialogues and the development of practical insights and recommendations.

Current members include:

Dr. Werner Brandt, Lufthansa

􀂃Mr Aldo Cardoso, GDF SUEZ

􀂃Mr Douglas Flint, BP

􀂃Mr Phil Hodkinson, BT

􀂃Dr. DeAnne Julius, Roche Holding

􀂃Mr Ewald Kist, Royal Philips Electronics

􀂃Mr Daniel Lebègue, SCOR

􀂃Mr Anders Nyrén, Sandvik and SCA

􀂃Mr Pierre Rodocanachi, Vivendi

Mr Hans-Joerg Rudloff, Rosneft, New World Resources Ms Guylaine Saucier, Areva and Danone

􀂃Mr Kees Storm, Anheuser-Busch, InBev and Unilever Mr Tom de Swaan, GlaxoSmithKline and Royal Ahold

􀂃Mr Jackson Tai, ING Dr. Bernd Voss, ABB

􀂃Mr Lars Westerberg, Volvo

􀂃Mr Mario Zibetti, Fiat Group

Recent materials

European audit committee leaders

► InSights for European Audit Committee Members (10):

Government intervention is driving audit committee agendas

► InSights for European Audit Committee Members (11): The sustainability journey — From compliance, to opportunity, to an integrated business strategy

► InSights for European Audit Committee Members (12): Crisis communications — Prepare to avert disaster; prepare to act when disaster strikes

► InSights for European Audit Committee Members (13):

Increasing contribution of audit committees — Providing oversight in M&A

► EACLN ViewPoints 20: The audit committee role in financial communication

► EACLN ViewPoints 21: The audit committee agenda in 2010

► EACLN ViewPoints 22: Corporate governance reform in Europe

► EACLN ViewPoints 23: The audit committee, the CFO and the finance organization

► EACLN ViewPoints 24: Enhancing audit committee effectiveness

► EACLN ViewPoints 25: Leading risk management practices

► EACLN ViewPoints 26: The challenge of overseeing IT governance and risks

Coming soon

February: InSights for European Audit Committee Members (14): Enhancing audit committee effectiveness in the aftermath of the financial crisis

May: European fraud survey

North American audit committee leaders

► ACLS ViewPoints 12: Convergence of accounting standards

► ACLS ViewPoints 13: Tax issues and the audit committee

► ACLS ViewPoints 14: Shareholder engagement

► BoardMatters Quarterly — January 2011: Financial reporting, tax and the board, health care, XBRL, whistle-blower bounty

► BoardMatters Quarterly — September 2010: Changes to the risk landscape — FASB and IASB, private equity investment, internal audit, catastrophic risk

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The contents of this paper are by their nature extremely abbreviated to give a flavor of the topic rather than a full balanced

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