Do Audit Committees understand Intangible Assets?

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Understanding Intangible assets has become more relevant in modern business due to digital/technology companies and goodwill recognition raising concerns around valuation and impairment calculations. Goodwill has got in the news following the liquidation of a number of entities.

Earlier this year it was reported, one of the UK government’s biggest contractors, filed for liquidation. At the date of its liquidation, the company had goodwill valued at £1.57bn on its statement of financial position. This was listed as the single biggest asset in the books, representing more than a third of the company’s total assets. This goodwill had initially been correctly calculated and had arisen from the acquisition of numerous entities over many years.

The following story is familiar to many companies in Sri Lanka! The intangible assets note in the financial statements shows an annual impairment review had been performed and there was deemed to be no impairment in goodwill. However, in the above instance an insolvent entity ends up with £1.57bn of goodwill, which is unimpaired?

On the other hand, does a large goodwill balance simply represent overpaying for an entity as opposed to an actual asset? How do minority shareholders establish fraudulent intent in such situations? In most cases, the CFO in collusion with majority shareholder Directors develops beautiful cash flows to justify higher recoverable amounts and hood wink the auditor and the audit committee. We of course know impairment tests involve subjective inputs that are too easy for management to manipulate.

Therefore, an impairment review of goodwill is an important task rather than simply preparing an excel worksheet. Depending on its size internal auditors should review this process and confirm appropriateness with IFRS and challenging sensitivity analysis based on relevance to the business. Audit committees should make it their business to understand why goodwill was not impaired or else when it is impaired it did not relate to an overpayment due to fraud.

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Key Audit Matters for Better Governance

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From 2018 auditor reporting standards in Sri Lanka have changed to disclose many aspects of an audit on the face of the audit report. For listed companies, disclosure of key audit matters explaining significant matters on the report was made mandatory by the auditing standard ISA 701. This not only improved the quality of information available to investors, but also has positive effects on the elements of financial reporting, including governance and corporate reporting.

The concept of the key audit matte (KAM) was borne out of investor demand for more detail on the audit process: more contextual information to help investors differentiate between the large number of companies that receive ‘clean’ – unqualified audit reports. The KAM requires the auditor to set out, in a separately identified section of the audit report, those matters that:

‘…in the auditor’s professional judgement, were of most significance in the audit of the financial statements of the current period…selected from matters communicated with those charged with governance’

So far based on discussions with audit committees a mixed bag of feelings are noted. Some members think it’s a good thing to clarify the most important areas of judgement on the report to showcase management is in control of those areas. There’s another lot who think the disclosures may raise too many unwarranted questions that will eat into management time providing explanations.

An ACCA UK report issued recently noted the following hidden benefits of KAMs, which I tend to agree with:

1. KAMs encourage better conversations between the auditor and those charged with governance; this in turn contributes to better governance
2. KAMs help the auditor to focus on the areas of the audit requiring the most careful judgement; this in turn contributes to higher audit quality
3. KAMs give preparers incentives to revisit financial reporting and disclosures in areas related to those KAMs; this in turn contributes to higher quality financial reporting.

The jury is out on the matter whether this will reduce the “expectation gap” of an audit. The auditing expectation gap refers to the difference between what the public and other financial statement users perceive auditors’ responsibilities to be and what auditors believe their responsibilities entail.

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My Top 10 quotes to inspire a Board of Directors

The Board of Directors provides leadership to a company. The Board needs to demonstrate leadership characteristics and inspire teams to exceed their potential. These selected quotes are meaningful, inspirational and communicate specific leadership characteristics that are important to succeed as a group of Directors and as individuals.

1. “The key to successful leadership today is influence, not authority.” –Ken Blanchard. (Board members should wield influence.)

2. “Group Thinking” or lack of courage to ask the tough and strategic questions is the chief weakness on Boards today.” – Pearl Zhu, Digitizing Boardroom: The Multifaceted Aspects of Digital Ready Boards.

3. “What you do has far greater impact than what you say.” –Steven Covey. (The Board should lead by example)

4. “Delegating work works, provided the one delegating works, too.” – Robert Half. (The Board should lead by example)

5. “Good leaders organize and align people around what the team needs to do. Great leaders motivate and inspire people with why they’re doing it. That’s purpose. And that’s the key to achieving something truly transformational.” – Marillyn Hewson

6. “The challenge of leadership is to be strong, but not rude; be kind, but not weak; be bold, but not bully; be thoughtful, but not lazy; be humble, but not timid; be proud, but not arrogant; have humor, but without folly.” –Jim Rohn

7. “Too many companies believe people are interchangeable. Truly gifted people never are. They have unique talents. Such people cannot be forced into roles they are not suited for, nor should they be. Effective leaders allow great people to do the work they were born to do.” ~ Warren  Bennis

8. A Board through individual Directors can provide leadership to achieve what is quoted below in reference to a person:
“The best executive is the one who has sense enough to pick good men to do what he wants done, and self-restraint to keep from meddling with them while they do it.” -Theodore Roosevelt

“My job is not to be easy on people. My job is to take these great people we have and to push them and make them even better.” –Steve Jobs

9. “Before you are a leader, success is all about growing yourself. When you become a leader, success is all about growing others.” ~ Jack Welch. ( The Board should invest time in growing more leaders for succession)

10. In a world of well-defined problems, directors are required to exercise influence over volatility, manage uncertainty, simplify complexity, and resolve ambiguity in the 21st-century digital environment. – Pearl Zhu, Digitizing Boardroom: The Multifaceted Aspects of Digital Ready Boards

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Usefulness of Independent Directors

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This post is not titled ‘benefits’ of an ID because there are many benefits that are anticipated by the requirements for appointing IDs to public interest entities and many understand them. But it’s important that the benefits accrue to the entities that appoint IDs. Hence, IDs need to make themselves useful to ensure their skills, experience, acumen and objectivity contribute to the governance of the public entity.

“What’s important is, if more and more of the decision-making in public interest entities is in the hands of independent directors, those independent directors require the information that they need to make it work”

Does your ID ask for more relevant information without fearing management displeasure over additional efforts? Can your ID ask the most difficult or obvious question without feeling uncomfortable? Is your ID able to make management think of alternatives and mitigate a wider range of risk factors than the normal risks that have been discussed in the past? Reliance on IDs are on the increase in public interest entities due to regulatory pressure. We need those IDs to perform their task to the best of their abilities with the due care and diligence expected of them.

Some ways of how IDs can demonstrate their usefulness and independence to contribute to the overall governance in the boardroom are:

1. Be free of bias: Human beings have relationships and are biased. If robots with AI were employed they would be free of bias! Despite this IDs must ensure their advice is not tainted by conflicts of interest or existing corporate politics.
2. Bring to bear out of the box thinking: This does not mean some earth shattering matter but bring in a different view or perspective to business issues as an outsider not constrained with internal processes.
3. Bring credibility to decisions: Objective impartial decision making can add that all important boost of credibility focused on the well being of the entity and putting shareholder interests first.
4. Contribute with the specialist knowledge: IDs are appointed to fill a gap in skill and experience in a specialist area. Therefore, ensure that specific knowledge is used to bring a different view to issues and discussions. For example the audit committee chair should use his/her prior experience to identify risks, anticipate weaknesses and mitigating controls when responding to issues.
5. Be a sounding board to the CEO: The ID should be approachable and offering the CEO a sounding board to test ideas, concerns, etc.  Because the CEO may need to discuss strategies with a person who is somewhat removed from the day-to-day activities, to bring a fresh but applicable perspective.

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EI for Board of Directors

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What distinguishes great leaders from merely good ones? It isn’t IQ or technical skills, says Daniel Goleman. It’s emotional intelligence (EI): a group of five skills that enable the best leaders to maximize their own and their followers’ performance. The chief components of emotional intelligence identified as —self-awareness, self-regulation, motivation, empathy, and social skill—can sound unbusinesslike, but Goleman, cochair of the Consortium for Research on Emotional Intelligence in Organizations, found direct ties between emotional intelligence and measurable business results. In his HBR article he noted when senior managers at one company had a critical mass of EI capabilities, their divisions outperformed yearly earnings goals by 20%.

I borrowed Goleman’s descriptions of these skills to understand how these EI skills benefit directors and audit committees.
• Self-awareness—knowing one’s strengths, weaknesses, drives, values, and impact on others
• Self-regulation—controlling or redirecting disruptive impulses and moods
• Motivation—relishing achievement for its own sake
• Empathy—understanding other people’s emotional makeup
• Social skill—building rapport with others to move them in desired directions.

We are all born with certain levels of EI skills. But we can strengthen these abilities through persistence, practice, and feedback from subordinates, colleagues or coaches. Empathy doesn’t mean adopting other people’s emotions and trying to please everybody. Rather, empathy means thoughtfully considering employees’ feelings in making intelligent decisions. To do this directors should demonstrate some of the following behaviors to achieve better business results, retain good talent and for better transparency & governance.

* Self-confidence coupled with realistic self- assessment. Don’t take the “I know everything” approach.
* Thirst for constructive criticism. Listen and act on others’ ideas.
* Trustworthiness & Integrity. This is required for any leader, though some may argue that politicians generally won’t demonstrate such behaviors, though they’re eternally optimistic of misleading the public.
* A passion for the work itself and for new challenges.
* Ability to attract and retain talent. Good people love to work for bosses with empathy and an ability to challenge them to exceed their potential and develop.
* Persuasiveness – for example the audit committee chair will have to persuade the CEO or the Board to act on a contentious issue that is unpleasant.
* Expertise in building and leading high performance teams. High performers cannot be retained with money only.

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Earnings management – Legal or Unethical

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It is difficult to explain if Earnings management is legal or not, but it is the creative methods of using different accounting techniques to make financial statements look better. Now that doesn’t exactly sound like a legal thing to do, does it? But a host of companies succeed in making it look acceptable through means of provisions, accruals, impairment adjustments, revenue recognition and deferrals. On the other hand the intention of doing so may be to meet budgetary/incentive targets and earnings expectations of the market or income smoothing to show a rising trend.

Intention and state of mind are difficult to prove in a court of law. Nor can we legislate for fraudulent intent. Therefore, earnings management techniques may follow the letter of the rules of standard accounting practices, however they certainly deviate from the spirit of those standards. Continuing to redraft or introduce new standards will not stop the ill-intentioned executives from earnings management. It has only complicated accounting and created more avenues for manipulation.

Every accountant understands that accounting for business operations requires judgment and estimates. For example, you can’t measure revenue without estimating when customers will pay and how many will return goods for refund; you can’t estimate asset values on a bank balance sheet without estimating how many will not repay loans; you can’t estimate claims liabilities in a life insurance company without estimating how many will die during their lifetime!

For this reason, audit committee members must be aware of the ways in which management’s accounting-related choices provide opportunities to manage earnings. These choices can be simplified through timing of transactions or what is called ‘cut-off’ and making estimates.

Audit committee should take serious note of what are called critical accounting policies and estimates. If you’re not familiar talk to your auditor to understand them. In addition audit committees can address the following minimal aspects:

▶️ Understand that your primary role is to ensure integrity of financial reporting and not to assist in window dressing the financial statements.
▶️ Understand all the transactions that require management to make judgments or estimates.
▶️ Understand the choices available to management in each instance and ask them to justify their selection.
▶️ Understand the potential a given choice provides for earnings management and request the CFO to confirm the intention for each selection.

Companies should be in a position where no one can say that some other number gives an accurate picture. It should be considered unethical for a company’s management to condone the use of accounting techniques to misrepresent the quality of earnings to users of financial statements.

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Audit Committee best practices

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There are certain audit committee chairpersons and audit committees who demonstrate good practices to improve governance and ensure the integrity of financial reporting. These can be put down as easy habits that could be implemented by all members of audit committees. I have noted the following 5 basic habits that are practiced by members of audit committees to increase their effectiveness;

1. They Understand the business and are also Skeptical


Make an effort to understand the business of the entity. For example, 70 percent of the General Electric audit committee’s time is spent on the job—and this is not just the chair, it’s the full committee’s time—is spent outside the building, visiting GE locations, going out and seeing things and talking to people on their own, in their own offices and workplaces. The good directors ask questions to verify inconsistencies and challenge management on risks and outliers, based on their understanding. They’re skeptical about management not reporting any matters of concern or defending their position against findings by internal or external auditors. They ask incisive questions.By exercising their right to seek explanations and constructively challenging the CFO, the audit committee and its chair are instrumental in enhancing the effectiveness of governance.
2. They Support the Internal Auditor

Making the head of internal audit to report directly to the audit committee chairperson gives it the right recognition and independence. Good audit committees are responsible to evaluate the performance of the internal auditor and to provide appropriate resources for them to function effectively. They are extremely attentive to internal audit findings and to any corrective measures and action plans implemented by management. In certain companies the audit committee chair is actively engaged to see what the internal audit is working on, what they’re finding, and trends they’re observing and help in the probing.
3. They have a Non negotiable Culture around non compliance
Control consciousness and implementation are much better when the audit committee chair and members take serious note of non compliances. When the accountants know that financial misrepresentation is not tolerated then they try less to justify misreporting and therefore integrity of the financial reporting process improves.
4. They are alert for Fraud Indicators
When management is defensive or unable to provide plausible explanations good audit committee members probe to understand why. They’re alert to external information about life style changes or previous employment references or unethical behaviors of key management persons. When insufficient time is given for audit committee activities, alert directors challenge management to get the right attention.
5. They hold management Accountable.


Effective audit committee chairs actively follow up with management and the CFO about quarterly financials and challenge them on earnings management and inconsistency of accounting estimates and judgment. They monitor management’s action plans and question on delayed implementation of remediation plans. Any feedback from the audit committee is considered in performance appraisals to further enhance the non negotiable stance taken by the audit committee.

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