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The syllabus for P7 (INT), Advanced Audit and Assurance contains the following

learning outcome:
Outline and explain the need for the legal and professional framework
including:
i) public oversight of audit and assurance practice
ii) the role of audit committees and impact on audit and assurance
practice.
Candidates attempting P7 are expected therefore to be conversant with
corporate governance principles, many of which they will have seen in
previous exams F8, Audit and Assurance and P1, Governance, Risk and Ethics. The focus
in P7 is on the impact that corporate governance principles and practice
can have on the audit process, and this article explores some of these
issues.

BASIC PRINCIPLES OF CORPORATE


GOVERNANCE A REMINDER
Corporate governance is the system by which organisations are directed
and controlled. It encompasses the relationship between the board of
directors, shareholders and other stakeholders, and the effects on
corporate strategy and performance. Corporate governance is important
because it looks at how these decision makers act, how they can or
should be monitored, and how they can be held to account for their
decisions and actions.
The published audited financial statements and related information are
therefore of key importance. They will usually be the main information set
to which shareholders and other stakeholders have access and this is
why having credible financial statements supported by the auditors
opinion is crucial.

Many regulatory authorities, including the UK, use a code of best


practice, often termed a comply or explain approach to corporate
governance. Under this approach the regulatory authority issues a set of
principles with which company directors of listed companies are
expected to comply. In many jurisdictions disclosures are required in the
financial statements to demonstrate compliance. Non-compliance is not
expected, but in its event, the facts of the non-compliance must be
clearly disclosed and explained.
In some jurisdictions, such as the US, a more prescriptive approach is
used, whereby corporate governance requirements are set by legislation.
Both the principles and the legislative approaches are broadly similar in
the matters they address. They both deal with the importance of the
board of directors having a balanced structure, emphasising the need for
non-executive directors, and for robust procedures in relation to the
appointment of board members, and their remuneration. They both
describe the merits of audit committees and the need to monitor the
effectiveness of internal controls. They both demand disclosure about
these and other matters in the annual report.

THE MAIN PRINCIPLES OF THE UK CORPORATE


GOVERNANCE CODE
The content of the UK and Singapore Corporate Governance Codes are
very similar and for the purpose of this article the principles and
provisions of the UK Code will be used to highlight some of the key areas
that the board should consider when assessing their system of corporate
governance.
The Code comprises five sections, each containing main principles:
LEADERSHIP

Every company should be headed by an effective board which is


collectively responsible for the long-term success of the company, and
should lead and control the companys operations.
There should be a clear division of responsibilities at the head of the
company, which will ensure a balance of power and authority, such that
no one individual has unfettered powers of decision.
Non-executive directors should constructively challenge and help
develop proposals on strategy. The board should include a balance of
executive and non-executive directors such that no individual or small
group of individuals can dominate the boards decision taking.
EFFECTIVENESS

The board and its committees should have the appropriate balance of
skills, experience, independence and knowledge of the company to
enable them to discharge their respective duties and responsibilities
effectively.
There should be a formal, rigorous and transparent procedure for the
appointment of new directors to the board. All directors should receive
induction on joining the board and should regularly update and refresh
their skills and knowledge.
All directors should be submitted for re-election at regular intervals,
subject to continued satisfactory performance.
ACCOUNTABILITY

The board should present a balanced and understandable assessment


of the companys position and prospects. For UK companies, this is also
required by the Companies Act 2006, which requires that the directors
disclose a business review as part of the directors report to be included
in the financial statements.

The board should maintain sound risk management and internal control
systems. The board should establish formal and transparent
arrangements for considering how they should apply the corporate
reporting and risk management and internal control principles and for
maintaining an appropriate relationship with the companys auditor.
REMUNERATION

Levels of remuneration should be sufficient to attract, retain and motivate


directors of the quality required to run the company successfully, but a
company should avoid paying more than is necessary for this purpose. A
significant proportion of executive directors remuneration should be
structured so as to link rewards to corporate and individual performance.
RELATIONS WITH SHAREHOLDERS

There should be a dialogue with shareholders based on the mutual


understanding of objectives. The board as a whole has responsibility for
ensuring that a satisfactory dialogue with shareholders takes place. The
board should use the Annual General Meeting to communicate with
investors and to encourage their participation.

THE ROLE OF AUDIT COMMITTEES


The audit committee is such an important part of corporate governance
that it is the subject of its own guidance document in the UK, the
Financial Reporting CouncilsGuidance on Audit Committees. The audit committee
should be made up of at least three independent non-executive directors,
one of whom should have recent and relevant financial experience. The
committee has many roles, including several that are specifically related
to the external auditor, which are discussed below.

REVIEW OF PUBLISHED FINANCIAL INFORMATION

The audit committee should monitor the integrity of the companys


financial statements and any formal announcements relating to the
companys performance. Significant financial reporting judgements
should be specifically reviewed. This means that committee members
should scrutinise all published financial information, and question and be
ready to challenge the finance director and external auditors on any
contentious matters arising.
SYSTEMS AND CONTROLS

The audit committee members have responsibility to review the


companys internal financial controls and systems, and the risk
management systems, unless there is a separate risk committee.
Most large companies have an internal audit function, in which case the
audit committee should extend its monitoring role to include that function,
including the evaluation of the effectiveness of that function.
Where there is no internal audit function, the audit committee should
consider annually whether there is a need for internal audit and make a
recommendation to the board, and the reasons for the absence of such a
function should be explained in the relevant section of the annual report.
FRAUD PREVENTION AND DETECTION

Finally, the audit committee plays a part in fraud prevention and detection
in that whistleblowing arrangements should be made so that staff of the
company may raise concerns about possible improprieties in respect of
financial reporting matters.
EXTERNAL AUDITORS GENERAL PRINCIPLES

The audit committee has specific responsibilities in respect of the


external auditors, including recommending the appointment,
reappointment and removal of the external auditor, approving fees paid
for audit and non-audit services, and agreeing on the terms of
engagement with the external auditor. A point specific to the UK adapted
paper is that following a revision to the UK Corporate Governance Code
in 2012, there is now a requirement for FTSE 350 companies to put the
external audit out to tender every 10 years.
One of the key issues is that the audit committee should annually assess
the independence, objectivity and effectiveness of the external audit
process, considering of the ethical framework applicable in the
jurisdiction in which the organisation is operating. The audit committee
should report annually to the board on their assessment with a
recommendation on whether to propose to the shareholders that the
external auditor be reappointed. The audit committee section of the
annual report should also discuss the annual assessment of the external
audit process by the audit committee and also include information on the
length of tenure of the current audit firm, when a tender was last
conducted, and any contractual obligations that acted to restrict the audit
committees choice of external auditors.
In relation to potential threats to objectivity, the audit committee should
seek reassurance that the auditors and their staff have no financial,
business, employment or family and other personal relationship with the
company which could adversely affect the auditors independence and
objectivity. The audit committee should seek from the audit firm, on an
annual basis, information about policies and processes for maintaining
independence and monitoring compliance with relevant requirements,
including current requirements regarding the rotation of audit partners
and staff.

EXTERNAL AUDITORS THE ANNUAL AUDIT CYCLE

The audit committee should be involved at all stages of the audit, to


obtain comfort that a quality audit will be performed. The Guidance on Audit
Committee specifically requires the following to take place:
At the start of each annual audit cycle, the audit committee should
ensure that appropriate plans are in place for the audit. This includes
consideration of planned levels of materiality, and the proposed
resources to execute the plan, having regard also to the seniority,
expertise and experience of the audit team. In practice this means that
before any audit fieldwork takes place, the audit firm should meet with
the audit committee to discuss the audit strategy and audit plan,
demonstrating that auditing standards and quality control principles have
been adhered to in their development.
The audit committee should review, with the external auditors, the
findings of their work. In the course of its review, the audit committee
should discuss with the external auditor major issues that arose during
the course of the audit and have subsequently been resolved and those
issues that have been left unresolved; review key accounting and audit
judgements; and review levels of errors identified during the audit,
obtaining explanations from management and, where necessary, the
external auditors as to why certain errors might remain unadjusted. The
audit committee should review and monitor managements
responsiveness to the external auditors findings and recommendations.
Thus, all key audit findings should be shared with the audit committee
and discussed with them as the audit progresses.
At the end of the annual audit cycle, the audit committee should assess
the effectiveness of the audit process, by:

reviewing whether the auditor has met the agreed audit plan and understand the reasons for any changes,
including changes in perceived audit risks and the work undertaken by the external auditors to address those
risks

considering the robustness and perceptiveness of the auditors in their handling of the key accounting and
audit judgements identified and in responding to questions from the audit committee

obtaining feedback about the conduct of the audit from key people involved, for example the finance director
and the head of internal audit

reviewing and monitoring the content of the external auditors management letter (report to those charged
with governance), in order to assess whether it is based on a good understanding of the companys business
and establish whether recommendations have been acted upon and, if not, the reasons why they have not been
acted upon, and

reporting to the board on the effectiveness of the external audit process.

In summary, the audit committee carefully monitors the conduct of the


audit, and plays an important part in ensuring the quality and rigour of
the external audit of the financial statements.
EXTERNAL AUDITORS PROVISION OF NON-AUDIT SERVICES

Specifically, the audit committee should develop and implement a policy


on the engagement of the external auditor to supply non-audit services,
taking into account the relevant ethical principles and requirements. The
audit committees objective should be to ensure that the provision of
such services does not impair the external auditors independence or
objectivity. The audit committee should consider:

whether the skills and experience of the audit firm make it the most suitable supplier of the non-audit service
whether there are safeguards in place to eliminate or reduce to an acceptable level any threat to objectivity
and independence in the conduct of the audit resulting from the provision of such services by the external
auditor
the nature of the non-audit services
the fees incurred, or to be incurred, for non-audit services both for individual services and in aggregate,
relative to the audit fee, and
the criteria which govern the compensation of the individuals performing the audit.

The audit committee should set and apply a formal policy specifying the
types of non-audit service:

for which the use of the external auditor is pre-approved (i.e. approval has been given in advance as a matter
of policy, rather than the specific approval of an engagement being sought before it is contracted)

from which specific approval from the audit committee is required before they are contracted, and

from which the external auditor is excluded.

One of the non-audit services specifically referred to in the Guidance on Audit


Committees is the provision of internal audit by the external auditor. If the
external auditor is being considered to undertake aspects of the internal
audit function, the audit committee should consider the effect this may
have on the effectiveness of the companys overall arrangements for
internal control and investor perceptions in this regard.

CONCLUSION
Candidates preparing to attempt P7 should be familiar with the corporate
governance principles outlined in this article, and they are encouraged to
read the source documentation to obtain a full understanding of general
corporate governance principles and the role of audit committees in
particular. It is the impact of these matters on the audit process that is
particularly important to understand, and candidates should be ready to
include points relating to corporate governance in their answers where
appropriate.
Written by a member of the P7 examining team

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