Audit Committees

• 1: The role of directors, audit committees and management in improving audit quality

1 - The role of directors, audit committees and management in improving audit quality

In its 2021 audit inspection report ASIC set out that company directors, audit committees and management have roles in supporting quality audits. Among other matters ASIC suggested that, directors and audit committees should consider:

• non-executive directors recommending audit firm appointments and setting audit fees;

• assessing the commitment of the auditors to audit quality;

• reviewing the resources devoted to the audit, including the amount of partner time, the need for the auditor to use experts and the appropriate use of other auditors;

• accountability of the lead audit partner, the review partner, specialists and audit team members for audit quality;

• facilitating the audit process, including support by entity management for the audit process;

• two-way communication with the auditor on concerns and risk areas;

• assessing the auditor’s professional scepticism in challenging accounting treatments and estimates;

• ensuring independence of the auditor; and

• asking for the results of any ASIC review of the audit files and asking the auditor how they have responded to any ASIC findings.

ASIC set out that directors and audit committees should ensure the company’s internal governance and risk frameworks are robust and support the preparation of financial statements free of material misstatements.

Following on from each of these points, Audit Committees should consider

Who recommends the audit firm appointment and the setting of fees?

In many cases it is executive management that both recommend the appointment and retention of the auditor, particular the CFO, with justification of selection including low fees or value for money.

Clearly such an arrangement can reduce audit quality and increase the risk that the audit is not performed in accordance with Australian Auditing standards:

• Would the CFO choose the auditor most likely to question particular accounting treatment? or instead recommend an auditor that takes a more “pragmatic: “commercial” stance?

• Would the CFO choose to pay an auditor high fee so the auditor can perform a thorough job and identify misstatements? or would the CFO prefer the audit to be performed “efficiently” so as to reduce the risk of the auditor detecting material misstatements?

• If the auditor is dependent upon keeping the CFO happy, so as to retain the audit and negotiate audit fees, is the auditor motivated to keep the CFO happy and to avoid challenging the CFO’s judgement?

For audit quality to be maintained, the appointment of auditors and the determination of audit fees, should be determined by the audit committee, not the CFO.

How does the audit committee assess the commitment of the auditors to audit quality?

When engaging any supplier or service provider the purchaser of those goods and services should take steps to ensure that service provided is fit for purpose and of the appropriate quality, this basic requirement also applies to the purchase of audit services.

• What steps does the audit committee take to ensure the quality of the audit services they are being provided with?

• How well does the audit firm perform in audit inspections?

• Is it appropriate for the CFO to be the sole judge of the quality of the audit being provided?

Does the audit committee consider whether appropriate resources are devoted to the audit?

Again when purchasing a service the purchaser should evaluate whether the service provided was appropriately resourced, this should apply to the assessment of the audit service received:

• How involved was the audit partner?

• How many hours did the audit partner spend on the audit?

• What was the experience and qualifications of the audit team?

• Did the auditor use experts in the audit (IFRS experts, valuers etc)?

• Did the auditor appropriately supervise component auditors?

Were the lead audit partner, the review partner, specialists and audit team members accountable for audit quality?

It is important for the audit committee to understand how audit quality was applied to their audit considering:

• How did the audit partner ensure appropriate quality was applied?

• Does the auditor believe they delivered a quality audit?

• Were adequate resources given to the audit?

• Was the time allowed conducive to performing a quality audit?

Did the Directors and the Company facilitate a quality audit?

If an audit committee wants a quality audit, then they need to determine if the company and its management facilitated the audit process:

• Was the fee realistic?

• Was the audit timeframe realistic?

• Were deadlines realistic?

• Was the auditor supplied with the appropriate information in a timely manner?

• Does the CFO have adequate resources to produce a financial report free of material misstatement?

• Does the CFO and the finance team have sufficient resource to spend sufficient time with the auditors?

Was there two-way communication with the auditor on concerns and risk areas?

Many auditors promise a ‘no surprises’ audit, but fail to properly communicate the audit process and the audit risks with the audit committee.

• Was there an audit planning meeting?

• Was the audit committee involved or consulted in the development of the audit plan?

• Was an audit plan presented to the audit committee?

• Did the audit committee have concerns as to the application of financial reporting, that required to be discussed with the auditor?

• Does the audit involve auditing key judgements and estimates?

• Is there a communications process between the auditor and the audit committee?

Did the audit committee assess the auditor’s professional scepticism in challenging accounting treatments and estimates?

Many accounting failures arise from management being too aggressive and optimistic in making estimate, that are neither realistic or supportable, such judgements leading to material misstatements of:

• Impairment of goodwill;

• Impairment of non-current assets;

• Inadequate bad debt provisions;

• Overvalued inventory;

• Overvalued property;

• Overvalued financial assets; and

• Too early recognition of revenue.

It is imperative that an audit committee:

• Understand the key judgements used in preparing the financial report;

• Are satisfied that the estimates are based on reasonable and supportable assumptions;

• Understand how the auditor planned to obtain sufficient and appropriate audit evidence to determine if the key assumptions in the estimates were on reasonable and supportable;

• Understand what evidence the auditor obtained to determine whether or not the key assumptions in the estimates were on reasonable and supportable; and

• Understand whether the auditor challenged the assumptions in the estimates.

Did the audit committee ensure the independence of the auditor?

Auditors are obliged under law, ethical standards and auditing standards to be independent and will provide confirmation to the board to that effect prior to issuing their audit opinion.

However independence is a subjective area requiring both actual threats to independence and perceived threats to independence.

Audit committees need to consider actual or perceived:

• Self interest threats to their independence; and

• Self review threats threats to their independence.

Self-interest threats may include:

• Consideration whether the audit partner is overly financially exposed should the audit be lost;

• Whether the audit firm has been involved in the due diligence of assets acquired that may be impaired;

• Whether the firm has given tax advice that may prove to be incorrect;

• Whether the firm has given accounting advice that may be incorrect; and

• Whether the firm has failed to identify material errors in past financial reports and is incentivised to overlook them in the current year audit fearing litigation.

Self-review threats may include:

• Tax advice;

• Accounting advice;

• Performing due diligence; and

• Performing valuation services.

Has the audit committee asked for the results of any ASIC review of the audit files and asked the auditor how they have responded to any ASIC findings?

Perhaps the easiest way for an audit committee to gauge the quality of their audit is to request the auditor to provide them with the results of any ASIC review of the audit files.