Audit Committees Effectiveness – Self assessment versus External Assessment

By Amanda Peters – Amanda.Peters@EthicalBoardroom.com

Until recently, there has been no standard in Anglo-Saxon practice for the external assessment of audit committees. The best-practice standard for audit committee assessment has always been based on self-assessment.

This practice is now being reconsidered. In the South African Code for Corporate Governance, King III (referred to as “King I, II, III”) was established when the Institute of Directors in South Africa asked retired Supreme Court of South Africa Judge Mervyn E. King to chair a committee on corporate governance resulting in the issue of the first Code in July 1993. This specifies that the board, its committees and individual members should be evaluated regularly; previously not a requirement in previous versions of the code. Similarly, the Financial Reporting Council in the UK has recently issued guidance making changes to the UK Corporate Governance Code that calls for the Board to formally evaluate the work of the audit committee. 

There is still no proposal in place by regulatory authorities for the use of an external examiner of some type to evaluate the performance of audit committees. There is, however, the proposal in King III (which calls for evaluation without specifying that whether it should be by the Board or by another type of examiner), and there is the call in the UK Governance Code, and these indicate that pressure is building for a more formal approach to evaluating the performance of both the committee and individual auditors. 

Typically, the language in Anglo-Saxon corporate governance regarding the evaluation of the audit committee runs as follows: (The following is taken from the New York Stock Exchange Listing Requirements) 

• THE ANNUAL AUDIT COMMITTEE EVALUATION

“New York Stock Exchange Listed Company Manual §303A.07 requires the audit committee of each company listed on the Exchange to conduct an annual performance evaluation. Annual self-evaluation should be suggested for all public company audit committees, and should be considered by audit committees of reasonably large non-profit entities and private companies.

Prudent audit committee make-up and conduct are important to reduce both audit committee and overall company liability and damages risk. At the audit committee level, audit committee members can be held liable for the failure to exercise sufficient diligence, and for the failure to spot and respond to red flags. Thus, a structured and formal evaluation of an Audit Committee’s performance can help ensure the committee delivers on its charter and can help the committee continuously enhance its contribution to the Chief Executive/Board. The evaluation may be a self-assessment, with input from key stakeholders, or involve facilitation or review by an external party. Self-assessment is generally considered to be a sufficient method of evaluation for governance committees. The performance assessment process should involve an assessment of the committee as a whole and may extend to an assessment of the performance of individual members.[1]” (Emphasis is ours).

Similarly, the same manual of guidance indicates that the chair of the audit committee should formally assess members’ performance annually. 

Repeated studies by the Audit Committee Institute in the UK have, however, raised issues with the self-assessment process.[2] There are numerous “guides to audit committee self-assessment” available, and almost all of these consist of lists with boxes to check off. As the ACI studies note, the self-assessment process has a tendency to degenerate into a box-checking exercise. There have been serious questions raised about its effectiveness. 

The argument for formal evaluation was made by R.S. Wilkinson at the Pretoria Institute of Directors in 2006, and then developed by the Institute of Directors in Southern Africa in 2009.[3] The argument runs that, “although conducting board, committee and director performance assessments is generally considered to be difficult, the process of performance assessment has the benefit of being the most effective way of  making performance expectations clear, and clarifies whether board or committee composition is appropriate and whether members should be reappointed. This suggests that individual assessments should be conducted. It also improves relations between the board, committees and management and prevents powerful personalities from exercising overall control and evading checks and balances. Performance assessments identify not only strengths and weaknesses but also shortcomings in the professional development and education of audit committee members. It is therefore evident that performance assessment is a vital factor in enhancing the performance of individual members and the audit committee as a whole.”[4] 

According to Ernst & Young,[5]adequate global benchmarks and measures are available for measuring audit committee performance and progress. However, regulatory bodies have provided little guidance on how these assessments should be performed. KPMG’s Audit Committee Forum suggests that a structured and formal assessment can help to ensure that the audit committee delivers on its mandate or charter and continuously enhances its contribution to the functioning of the board. Performance assessment methods, singly or in combination, could be used to evaluate audit committee performance, say, to obtain formal feedback from the board, the chief executive officer (CEO), the chief financial officer (CFO), the compliance officer, as well as internal and external auditors.[6] 

Specifics on the application of this approach are not provided, and, while some companies have begun to make formal evaluations of audit committees, no data is yet available on their effectiveness. 

The argument against such evaluations is made by Tim Copnell of the Audit Committee Institute at KPMG.

  “You might benchmark an audit committee against a list of perceived good governance criteria. Is the committee comprised of at least three independent directors? Does it monitor the integrity of the financial statements, and does it review the effectiveness of the audit process? Ultimately, however, these criteria are either organisational or process matters – and that doesn’t really answer the question of effectiveness. ” 

In fact, much audit committee self-assessment consists of checking off boxes in this way. 

“Short of observing the audit committee ‘in action’, how would an investor assess if their activities were proportional and focussed on areas of greatest risk? How could they tell if the committee had taken appropriate steps to ensure auditor objectivity, and that independence is safeguarded? How could they tell if the committee have exercised what some might call professional scepticism?”

In fact, without an external assessment, there is no way for an investor to obtain a judgement on these issues. But Copnell maintains that such a judgement would not, in fact, be objective:

“I believe the answer lies in openness and transparency regarding what the audit committee has done, how they did it, what they concluded, and how they reached their conclusion. With that information, investors can assess the rigour of the audit committee’s oversight activities, or at least start a meaningful dialogue with the company on these important issues. This brings us back to Schrödinger’s cat and the paradox that observation itself affects the outcome. In this case, the very act of disclosing how the significant issues considered by the audit committee in relation to the financial statements were addressed may well affect how the audit committee exerts oversight over such issues. Open and transparent communications with investors may itself improve audit committee effectiveness. ”

 Or, as Copnell points out, it may not. The new disclosure could simply become the same kind of “boiler plate” that is currently coming out of self-assessment. Formal evaluation may not result in better practice, unless the quality of the evaluation is high, driven by investor need. Much work still remains to be done.