Saturday, November 20, 2010

UK Corporate Governance Regulator Updates Guidance for Audit Committees in Light of Financial Crisis

In light of the recent financial crisis and the ongoing economic climate, the UK corporate governance regulator, the Financial Reporting Council, has issued updated guidance for audit committees that focuses on accounting valuations and creating an environment in which the outside auditor can question management with professional skepticism. In that context, the audit committee should agree with the outside auditor on arrangements to ensure that the auditors can express any concerns they have about estimates, assumptions and forecasts without undue influence by management.

The audit committee must also refocus its oversight of risk management. In particular, the audit committee should discuss business and financial risks with the outside auditor and the committee should satisfy itself that the auditor has properly addressed risk in itsr audit strategy and plan. The audit committee must also be satisfied that the external auditor has allocated sufficient additional and experienced resources to address heightened risks. Another thing to watch for is whether company management has exerted undue pressure on the level of audit fees such that it creates a risk to audit work being conducted effectively.

In light of the issues of fair value accounting regarding illiquid securities in inactive markets, tghe FRC wants audit committtes to ensure that valuation processes are supported by appropriate internal controls and reasonableness checks and that key underlying assumptions are changes consistent with external events and circumstances. Last year’s valuations should be compared to actual outcomes. The audit commitee must also ensure tha models and key assumptions adequately address low probability but high impact events. The audit committee must make sure that management has considered which combination of scenarios could conspire to be the most challenging for the company.

The updated guidance also seeks to ensure that the audit committee is satisfied that appropriate sensitivity analysis has been conducted to flex assumptions to identify how robust the model outputs are in practice and that the assumptions are free from bias. Where assets are not traded, perhaps because markets are no longer active, the committee must be satisfied that appropriate additional procedures have been undertaken to estimate fair values through the selection of market‐based variables and the use of appropriate assumptions.

Further, a best practice is to determine if the assumptions that underlie valuations, including any impairment tests, are consistent with internal budgets and forecasts and with how the prospects for the business have been described in the narrative sections of the annual report and accounts. Importantly, the audit committee should ask the outside audit firm for a written summary of their views on the assumptions that underlie cash flow forecasts and other estimation techniques used to value assets and liabilities.