Following publication of the Higgs and Smith Reports in January 2003, we now have much greater clarification of what is required of the audit committee and its members, and what qualifications (whether technical, commercial and interpersonal) will be sought by boards from prospective audit committee members.
The Smith Report proposes that “at least one member of the audit committee should have significant recent and relevant financial experience, for example as an auditor or a finance director of a listed company”.
The report also recommends that directors are offered appropriate training before and during their appointment to the committee, rather than prescribing the qualifications required by individuals before their consideration as audit committee members.
The effective audit committee member
One of the audit committee’s main responsibilities is evaluating the audit process – both internal and external audits. This includes the monitoring and advising the head of internal audit, reviewing the performance of the external auditors, and running the tender process for the appointment of new audit firms.
It is desirable that audit committee members have sound process management skills and the capacity to absorb a fair degree of detail. They must also be able to exercise subtlety in their judgement when reviewing the financial controls and procedures operating within the company. This is to ensure that an appropriate degree of pragmatism is shown when reviewing the appropriateness of financial controls, while continuing to look after shareholder interests. This is particularly applicable to those working for organisations that trade globally or have complex supplier or joint venture arrangements.
It is vital that any audit committee member has enough time to undertake the role effectively. In addition to regular board and audit committee meetings, it has been demonstrated that regular “one-on-one” meetings between the CFO and the audit committee chairman and/or members of the committee are increasingly common and mutually beneficial. Such meetings create far greater awareness on the part of the audit committee as to what is concerning the CFO on a tactical as well as strategic basis. They also provide an opportunity for audit committee members to advise and counsel the CFO. This kind of board behaviour and practises is what Higgs and more particularly Smith are trying to achieve in their reports.
Experience has shown that just as there is a natural link between the CEO and the board chairman, effective links have started to develop between CFOs and audit committee chairmen.
In addition, the effectiveness of an audit committee member is also fairly directly related to their ability and willingness to attend all offsite strategy days, as well as make themselves available to talk to the head of internal audit on an ad hoc basis. In our experience, the chairman of the audit committee is always directly involved in the recruitment of a new group head of internal audit. Similarly, heads of internal audit often seek the audit committee’s counsel when reviewing the scope and structure of their function.
There is some dislocation between the desire of most plc boards to appoint serving CEO/CFOs on to their audit committees, versus the enormous time commitment candidates must be prepared to make in order to be truly effective. Consequently, this should favour the appointment of audit committee members who are recently retired group finance directors. Such people may have decided to take on a portfolio of interests and can devote around one day a week - rather than one day a month - to serving as an effective audit committee member.
The composition of audit committees
The combination of sound judgement, good process management skills and pragmatism are qualities that any senior executive wishing to sit on the main board of a public company should possess. They are not restricted to requiring audit committee members to be drawn exclusively from the ranks of existing or recently retired group finance directors.
There is a natural tendency, reinforced by the Smith Report, that the chairman of the audit committee should be a serving or recently retired group finance director from another public company, or the chairman of another public company with a finance background. However, there are no restrictions on the other members having a general management background or functional expertise outside of finance.
High demand for audit committee members is forecast, given that the Smith Report proposes that the audit committee should comprise at least three independent non-executive directors, but not the chairman of the company. In many cases, particularly within the FTSE-250, audit committees comprise the chairman of the company plus two non-executive directors.
While the primary target market will be serving or recently retired group finance directors, there is no reason why a committee that has a financially qualified chairman should not take on additional members from outside the group finance director community - serving CEOs, for example. However, given the limited number of serving FTSE CEOs who have not yet already taken up one non-executive position (most plc boards restrict executive directors to one additional board), another potential source of candidates will be those divisional chief executives or group accountants from large, complex international businesses.
Such divisional executives would bring operational expertise to complement the chairman’s financial expertise, and hopefully enthusiasm. Consequently if the role of audit committee member is clearly set out in terms of time commitment and overall remit, there should be a good number of senior executives who would be qualified and willing to serve.
Due diligence
Ten or so years ago when the phrase “due diligence” was mentioned in senior recruitment exercises, it almost exclusively referred to the assessment and referencing of potential candidates in terms of whether they would be suitable for the company (whether they were joining as an executive or non-executive). Now it is very much a two-way process, shifting, if anything, more towards individuals carrying out greater due diligence on companies. This is encouraged by Higgs who suggests prospective non-executives be better informed prior to making a decision over an appointment.
Before considering a non-executive position, best practice in carrying out due diligence encompasses the following issues:
- Is the company in question both genuinely interested in and seen to be interested in best practice in corporate governance?
- Has the chairman, CEO, CFO and existing non-executives been available for consultation?
- Making contact with shareholders (or ex-shareholders), advisors and former employees should provide a good sense of the company’s attitude towards governance.
- Does the company run an induction programme for new non-executive directors?
- How qualified in terms of financial literacy are the existing non-executive committee members?
- Although it is unusual to request a meeting with the head of internal audit before taking up an appointment, this may change in the medium term.
Prospective audit committee members should also ask themselves the very simple question: “Why am I being hired? They are increasingly requesting the opportunity to view company broking reports, management accounts or any other financial projections of the business to ensure that they are comfortable with the prospects for the organisation.
Conclusion
The role and the requirements of the audit committee may soon be clarified yet further by the Government in light of the Smith Report. A number of quoted companies, particularly in the FTSE-250, will need to increase the size of their audit committee. Given the modest numbers of serving group finance directors who are able and willing to take up a second board position, we anticipate that there will be significant demand for individuals who are not financially qualified. Consequently it is imperative that those executives bring with them the necessary maturity, pragmatism, judgement and process management skills.