VantagePoint. The audit committee s relationship with the external auditor

Transcription

1 November 29, 2011 TAPESTRY NETWORKS, INC The audit committee s relationship with the external auditor The Southeast Audit Committee Network (SEACN) held its 20th meeting on November 7, 2011, in Atlanta, where network members met to discuss their audit committees relationships with the external auditor. Members of the network serve on the boards of companies that are clients of all Big Four accounting firms. This document summarizes the key points raised during the meeting, along with selected perspectives that members shared before the meeting. 1 For a list of meeting participants, see Appendix 1 on page 10. Executive summary Reflecting on the theme of the meeting, one member said, I have always operated under the basis that you must have a great relationship with your auditor. There s always room for improvement, and we should focus on the opportunities to improve those relationships. Members discussed four broad issues, which are described below and discussed in more detail on the following pages: Audit committees ensure that the audit scope is appropriate and relevant. (Page 2) While the external audit firm is responsible for developing the scope of the audit plan, members said the audit committee has a key role in assessing that scope and ensuring that it covers key risk areas identified through the company s risk management processes. Members said the scope of the audit may change during the year to ensure that emergent risk areas, such as an acquisition, are adequately covered. Members said it is crucial when developing an audit plan to ensure that internal audit and the external audit firm collaborate so that duplicative efforts are avoided and nothing falls through the cracks. Audit chairs seek fair audit fees, but audit quality is the highest priority. (Page 3) The audit committee is ultimately responsible for agreeing on the audit fees. In some cases the audit chair conducts the negotiations on behalf of the committee, though it typically falls to financial executives to work with the audit firm to develop a proposal for the committee. Members said that while they make sure audit fees are fair to all parties, they are more concerned with ensuring a high-quality audit and retaining an audit team that views their company as a good, profitable client. Views vary on the appropriateness and extent to which companies should use their audit firms for non-audit-related services, such as tax advice. Many members restrict the work their auditor can do, but some audit chairs said the audit firm is often best placed to provide these services because of the institutional knowledge the firm possesses. Audit chairs seek strong working relationships with their audit firms. (Page 5) Members said the audit committee should have a strong, trusting relationship with the lead audit partner on the account, and that a great audit partner will possess sound judgment, integrity, and a willingness to 1 reflects the network s use of a modified version of the Chatham House Rule whereby names of members and their company affiliations are a matter of public record, but comments are not attributed to individuals or corporations. Quotes in italics are drawn directly from comments made by SEACN members before and during the meeting.

2 challenge management and proactively approach the audit committee with certain issues. Audit chairs said the audit committee should also ensure that the team supporting the lead audit partner complements the audit partner s skills and experience, and they recommended that the audit committee develop relationships with senior partners from the audit firm s national office. Audit committees employ multiple approaches to evaluate their audit firms. (Page 7) Members reported a variety of ways they assess their external audit firms, from formal surveys and checklists to informal discussions with management. Members said evaluations are most effective when they are followed up throughout the year to test where the audit firm is falling short of, meeting, or exceeding expectations. For a list of questions for audit committees to consider about their relationship with their external auditors, see Appendix 2 on page 11. Audit committees ensure that the audit scope is appropriate and relevant Although the external auditor is clearly responsible for developing the audit plan, the audit committee is responsible for approving the plan s scope. Members said the audit committee typically reviews the audit plan annually: We review the audit scope in detail and make sure that management does as well. Making sure key risk areas are covered Mmembers said they are primarily looking to ensure that the audit plan covers the key risk areas. As one member said, We ask the auditors to bring us a mapping of assets and revenue by risks areas. We make sure they have identified the risk areas and we look at the allocation of audit hours to see how they match up to the risk areas we are focused on. Our biggest problems tend to occur where we have small operations and there might be a minor legal problem that cascades, whereas in areas with larger operations, we typically have a lot of controls. Some members said the scope of the audit could change throughout the year because of a number of factors, including an acquisition, divestiture, or change in strategy, and the audit committee and external audit firm should be prepared to adapt. One member said, In a couple of cases, we increased the scope of the audit because of new risks that came up we were not comfortable doing a routine audit. Improving cooperation between internal and external audit Members said the audit committee should be aware of how internal and external audit work together, and oftentimes these discussions are made explicit in the audit plan. One member explained, We encourage internal audit and the external auditors to work together. We do a mapping of the internal audit and external audit plans, and we are mindful of overlaps and cracks in the plan. We plan this out against the overlay of the enterprise risk management program. Another member added, The operations people don t like to be audited twice. Members said they typically ask internal audit and the external auditors throughout the year how the relationship between the two parties can be improved. One member said, We hold separate executive The audit committee s relationship with the external auditor 2

3 sessions one with internal audit, one with the external auditor and ask both, How are you working with [the other party]? Being mindful of outdated activities Some audit committees challenge the continuation of certain activities. One member said the five-year changeover of lead audit partners does offer the opportunity to take a fresh look at the audit plan and consider a clean-slate approach How would you re-scope in light of changes to the business or broader context in which we operate? One member pointed out that the audit plan may include activities that are no longer necessary: Sometimes there are things being done for historical reasons that may cause scope creep. It might have been because of a certain situation that came up a few years ago. So I challenge the auditors: Are there some things you are doing that you don t have to do? Every once in a while I find some things that are in the audit plan for no good reason. Audit chairs seek fair audit fees, but audit quality is the highest priority The Sarbanes-Oxley Act of 2002 holds audit committees responsible for compensating the external auditor: The audit committee of each issuer, in its capacity as a committee of the board of directors, shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work, and each such registered public accounting firm shall report directly to the audit committee. 2 Members reported a variety of ways that they arrive at fees with their audit firms, but said that agreeing on a fee is ultimately the responsibility of the audit committee. One member negotiates directly with the external auditor on behalf of the audit committee. But more typically, financial management often the CFO or chief accounting officer conducts detailed negotiations with the external audit firm before a proposal is made to the audit committee. Members pointed out that the CEO and CFO have a lot at stake in demanding a thorough audit, as they have to sign the financial statements. Prioritizing audit quality Cheap audits produce bad results, said one audit chair. Members said that although they seek fair audit fees, their first priority is to ensure a quality audit. One member said, We always ask the audit firm if they are being fairly compensated, and if management is pressuring them on fees. I always make sure that the auditor is making money on our account. If not, good people will find a way to avoid that account. However, members are also looking for value and have no wish to overpay. Members also reported collaborating with their audit firm on how to make the audit more efficient, often through the use of automation and technology. One said, We ll ask our auditor, How can we make the 2 Sarbanes-Oxley Act of 2002, Pub. L. No , 116 Stat. 776 (2002). The audit committee s relationship with the external auditor 3

4 process better for you? One time, they asked us to put in a [software package]. We spent the money for that software and it has made the process much better. Using the auditor for permissible non-audit services Sarbanes-Oxley prohibits accounting firms from offering the following services to their audit clients: Bookkeeping or other services related to the accounting records or financial statements of the audit client Financial information systems design and implementation Appraisal or valuation services, fairness opinions, or contribution-in-kind reports Actuarial services Internal audit outsourcing services Management functions or human resources Broker or dealer, investment adviser, or investment banking services Legal services and expert services unrelated to the audit Any other service that the Board determines, by regulation, is impermissible 3 The act also stipulates the audit committee s obligation to preapprove non-audit services that are not specifically prohibited. 4 The PCAOB subsequently added additional rules related to preapproval for tax services. In addition, ISS lists excessive fees for non-audit services (defined as fees that are higher than the combined cost of audit fees, audit-related fees, and tax compliance and preparation fees) as one of four conditions that would prevent it from voting for proposals to ratify auditors. 5 The PCAOB recently criticized audit firms for certain activities that it believed could have potentially been a violation of the prohibition against compensating partners for the sale of non-audit services to audit clients. PCAOB Chairman James Doty said in a speech outlining the board s broad new agenda, PCAOB inspection reviews of partner evaluation and compensation processes find examples of seemingly unrestrained enthusiasm in partners self-evaluations, in their supervisors evaluations of their performance, and in agreed performance goals for selling services to audit clients. 6 Most members said they were conservative about using their outside auditor for permissible non-audit services. However, some members said they prefer to use their auditor for non-audit services in order to leverage the auditor s institutional knowledge of the company s business. One member said, I generally think it makes sense to have the same firm provide permissible services because that firm has more knowledge and insight into the company, and as an auditor, you want the most information possible to assess 3 Sarbanes-Oxley Act of 2002, 116 Stat Sarbanes-Oxley Act of 2002, 116 Stat Institutional Shareholder Services, 2011 US Proxy Voting Guidelines Concise Summary (Digest of Selected Key Guidelines) (ISS, 2011), 2. 6 James Doty, Rethinking the Relevancy, Credibility, and Transparency of Audits, (speech, SEC and Financial Reporting Institute 30th Annual Conference, Pasadena, CA, June 2, 2011). The audit committee s relationship with the external auditor 4

5 risks. Another remarked, We always use our auditors for due diligence. To me, it is not an independence issue. Companies should use the very best service provider, and the external auditor has in-depth knowledge of the company. I don t get hung up on this. Audit chairs seek strong working relationships with their audit firms Members said a great client-serving audit team, in addition to its core duties, will demonstrate a deep knowledge of the company s industry, including trends and emerging risks; ensure transparency on fees and scope; mobilize the firm s broader resources to assist the company in certain situations; adapt along with the company; and challenge the company when required. One member described the elements of a good working relationship between the audit committee and the audit team serving the account: Surfacing issues, resolving them early, making sure the staff is dealing with those issues properly, and not waiting until the 11th hour to take them to the national office. That s just good communications. Building proactive, courageous audit teams Members listed integrity, sound judgment, a willingness to be flexible, and deft communication skills as important qualities in an excellent lead audit partner. Perhaps most important, however, is the willingness to challenge management and proactively approach management and the audit committee with issues. One member said, I want the auditor to rock the boat. I don t like it when you ask the auditor, What s on your mind? and they don t say anything. I am looking for an audit partner that is not afraid to say what is on their mind. The mandatory five-year partner rotation presents an opportunity for audit committees and audit firms to step back and reflect on the quality of their relationships. As one member said, When the five-year rotation is up, we sit back with the audit firm and talk about the broader relationship. We might want them to take a fresh look at something, and we will ask them what they are going to do differently. During mandatory partner rotation, some members said they prefer that the audit firm prepare a shortlist of audit partner candidates from which to select. However, some members entrust the audit firm with the ultimate decision. One said, It s the audit firm s choice. They provide the service, and they have to deliver the product. In cases where the audit partner is not the right fit for an engagement, the audit chair handles sensitive discussions with the audit firm. One member, We had one candidate that came on the engagement and didn t work out. The member explained that he spoke with the CEO of the accounting firm to make clear that what didn t work out was not the result of a disagreement on accounting matters but rather concerns about the audit partner s fit with the company and its management team. Another member noted, The worst mistake you can make is when you change the audit partner and don t take into account any changes you have to make on the audit team. You have to make sure that you have the right team with the audit partner. If you change the audit partner whether to get a better relationship manager or a better technician you need to change the team underneath the partner to accommodate the change in leadership. The audit committee s relationship with the external auditor 5

6 Maintaining strong relations with the audit firm s national office The national offices of audit firms are staffed by senior-level accounting and auditing experts who spend much of their time reviewing complex client accounting issues. They are also the firm s primary interface with regulatory and rule-setting bodies, including the Financial Accounting Standards Board, the Securities and Exchange Commission, and the PCAOB. Members said the national office is an important resource when the company is dealing with a complex issue and wants access to the firm s expertise: I will press to have the engagement partner go to the national office. We had a major tax issue come up and I wanted some expertise that [the local partner] did not have, so I pushed them to go to the national office. I don t feel any discomfort if they ask the national office to drill down on something. Indeed, one member said, Sometimes there s not enough consulting with the national office The audit committee should be proactive about encouraging the audit partner to consult with the national office. However, members said that if the audit partner decides to go to the national office to seek a perspective on a certain issue, this should be communicated to the audit committee. One member said, I ask the question of the auditors, Have you gone to the national office with an issue in the last quarter? If the answer is yes, I want to know all about it. Members were also concerned that discussions with the national office are held in a timely manner: We had one instance where the partner went to the national office late, so the decision came down [from the national office] too late. Interacting informally with the external auditors Members said the audit committee can play an important role in developing relationships with external auditors, and they described two ways in which the audit chair can take the lead role: Meeting one-on-one with the audit partner between meetings. Audit chairs have long said that they derive significant value from regular, informal meetings with the lead audit partner between audit committee meetings. In a recent issue of InSights, an adviser noted, A good practice is to have a standing meeting between the audit committee chair and the audit partner in the 24 hours before the audit committee meeting takes place. They can decide what to focus on look at the financials, the press release [to help avoid surprises.] 7 In addition, members said that through these informal meetings, the audit committee chair could enhance the audit partner s confidence in dealing with management: It is important that the audit partner knows that he or she has the support of the audit committee. Encouraging the whole external audit team. One member reported meeting annually with the external audit team (as well as with the internal auditors at a separate meeting): I meet with the entire external audit team to let them know how much we appreciate what they do. The member added that this meeting also provides an opportunity to have the entire audit team understand the expectations of the audit committee. 7 Ernst & Young and Tapestry Networks, The Audit Committee Journey Continues to a Higher-Functioning Committee, InSights, January The audit committee s relationship with the external auditor 6

7 Potential points of tension between the audit committee and audit firm Members described several potential points of tension that could arise between the audit firm and the audit committee: Partner rotation. Members generally agreed that partner rotation could be a potential point of tension between the audit committee and the audit firm if the audit firm does not prepare the audit committee for a smooth transition. One member explained, There was one time when they just announced to us that we had a new partner, and I was furious. I went to the head of the firm because that is very bad practice. They didn t do that again. Personality conflicts. Members said their audit firms generally do a good job handling personality conflicts between audit partners and audit committees. One member said, I had an issue [with] the personality of the audit partner. We had to sit down with the firm and say, We have a personality conflict. They rotated him out in a prudent fashion, and the relationship [with the team] improved tremendously as a result. Lack of candid feedback about management. One member said, The audit committee asked for some insightful commentary on the management team, and we don t think we got enough on that. Another remarked, In general, the auditors tend to be less openly critical than they could be. They should be prepared to say, We could be wrong, but here are some issues [with management] that concern us. I think the external auditor needs to be more involved and trust the audit committee. Last-minute surprises. When the audit firms come up with an issue at the last minute and have to deal directly with the audit committee or management that always creates tension. Audit committees employ multiple approaches to evaluate their audit firms The National Association of Corporate Directors recommends that audit committees share with the external auditor in advance the performance objectives against which the committee will evaluate the auditor s performance in the coming year, and then evaluate the auditor accordingly. 8 Audit chairs can use these annual performance appraisals to help maximize the value they receive from the audit and the external auditor. 8 National Association of Corporate Directors, Report of the NACD Blue Ribbon Commission on the Audit Committee (NACD, 2010). The audit committee s relationship with the external auditor 7

8 Members described a variety of ways they assess their external audit firms: Formal evaluations. One member described using a 46-question evaluation form that is administered by the general counsel and completed by the audit committee and some members of management: They include questions such as, Are they proactive enough regarding accounting issues? Are they responsive enough? There are some issues that came out of the summary that were never discussed explicitly, so it was a good vehicle for discussion. Informal evaluations during audit committee executive sessions. One member said, We have a session with the external auditors by themselves at every meeting and in the minds of the audit committee, that s the place where we judge their performance more than any other part of the meeting. Explicitly setting expectations with the auditors. One member said, This year we have delivered a set of expectations to our auditors, and at every audit committee meeting we want an update on how they are meeting those expectations. Members said evaluations are only as effective as the audit firm makes them, and the best audit partners work hard to incorporate feedback into their work. One member said, The engagement partner takes it as a bit of a report card. He wants to get improving grades over the course of his time on the engagement. You give them the specifics of why they didn t get perfect grades, and it is up to them to do something about it. Conclusion Members said their relationships with their external audit firms have evolved significantly over the last several years. Members reported that their audit firms offer considerable value, challenging management, drawing on experience from their broader client base to generate insight into emergent industry trends, offering a unique perspective on the company s capabilities and resources, and leveraging their institutional knowledge to provide permissible non-audit-related services such as due diligence. One member said, There s a lot of trust in this relationship, and enhancing the relationship is really beneficial to both the audit committee and the audit firms. Better relationships help us make better judgment calls. The audit committee s relationship with the external auditor 8

9 About this document The Southeast Audit Committee Network is a group of audit committee chairs drawn from leading companies committed to improving the performance of audit committees and enhancing trust in financial markets. The network is convened by Ernst & Young and orchestrated by Tapestry Networks to access emerging best practices and share insights into issues that dominate the new audit committee environment. is produced by Tapestry Networks to stimulate timely, substantive board discussions about the choices confronting audit committee members, management, and their advisers as they endeavor to fulfill their respective responsibilities to the investing public. The ultimate value of lies in its power to help all constituencies develop their own informed points of view on these important issues. Anyone who receives may share it with those in their own network. The more board members, members of management, and advisers who become systematically engaged in this dialogue, the more value will be created for all. The views expressed in this document represent those of the Southeast Audit Committee Network. They do not reflect the views nor constitute the advice of network members, their companies, Ernst & Young, or Tapestry Networks. Please consult your advisers for specific advice. Ernst & Young refers to all members of the global Ernst & Young organization, including the US member firm of Ernst & Young LLP. This material is copyrighted by Ernst & Young and prepared by Tapestry Networks. It may be reproduced and redistributed, but only in its entirety, including all copyright and trademark legends. The audit committee s relationship with the external auditor 9

10 Appendix 1: meeting participants The following members participated in the meeting: Eddie Adair, Audit Committee Chair, Tech Data Denny Beresford, Audit Committee Chair, Fannie Mae and Legg Mason Jim Copeland, Audit Committee Chair, ConocoPhillips, Equifax, and Time Warner Cable Sherrill Hudson, Audit Committee Chair, Lennar and Publix Super Markets Claude Lilly, Audit Committee Chair, Erie Indemnity Dean O Hare, Audit Committee Chair, H.J. Heinz Company Steve Raymund, Audit Committee Chair, Jabil Circuit Jim Robbins, Audit Committee Chair, DSW Erik van der Kaay, Audit Committee Chair, RF Micro Devices Bunny Winter, Audit Committee Chair, Wellesley College Ernst & Young participants in the meeting included the following: Kurt Hohl, Partner and Director, Assurance Quality and Regulatory Matters Al Paulus, Director of Professional Practice - Auditing Brian Early, Southeast Assurance Business Development Leader Steve Konenkamp, Americas Chief Operating Officer - Assurance Services The audit committee s relationship with the external auditor 10

11 Appendix 2: questions for audit committees? What is the audit committee s role in reviewing and assessing the scope of the audit? What role does management play in assessing the audit plan?? How does the audit committee deal with differing views on audit scope?? How does the audit committee deal with changes in scope throughout the year?? What is the role of the audit committee in negotiating audit fees and protecting audit quality? What is management s role? Who in management conducts the negotiations?? Do you have a good understanding of the economics of the audit firms? What factors attract a premium price: brand or quality of partner, quality of service, or something else?? How do you determine what permissible services you want your audit firm to perform or not perform? How do you establish and monitor fees around those services? In what way do proxy advisory firms perspectives on non-audit services affect your views?? What is the impact on audit quality when non-audit services are delivered?? Are you satisfied with the amount of engagement from the national office of your external audit firm?? How does the engagement partner work with the national office to help resolve areas of dispute?? How can your company s interactions with the external audit firm s national office be improved?? How interested are you in the substance of the discussions that your lead audit partner has with his or her national office regarding your company? Do you ask your engagement partner to discuss these issues with the audit committee?? What are the characteristics of a great audit team?? What are the most significant areas for improvement in the relationship between the audit committee and the external audit team? What is your role in building that relationship?? How does the audit committee work with the external auditors to resolve areas of disagreement?? How do you evaluate the performance of your external auditor? How can the audit committee contribute to improving the performance of the external auditor? Does the external auditor provide feedback to the audit committee? The audit committee s relationship with the external auditor 11