Audit Committees face the challenge of understanding the key judgements about the application of accounting policies and the estimation uncertainties inherent in the value of assets and liabilities, due to the level of knowledge they possess and the complexity of operations of companies. Economic uncertainties coupled with management’s intention to misrepresent facts significantly increases the risk that annual reports and accounts misreport facts and circumstances and contain uncorrected errors and omissions.
The following questions – reproduced from the Financial Reporting Council’s publication “Update for audit committees: Issues arising from current economic conditions (November 2010)” – seek to identify issues that will be particularly relevant to the work of audit committees.
#1 Has the audit committee considered the processes in place to generate forecasts of cash flow and accounting valuation information, including the choice and consistent use of key assumptions?
#2 Are the forecasts and valuation processes supported by appropriate internal controls and reasonableness checks and have those internal controls been tested by internal and/or external audit?
#3 Has consideration been given to the need for changes in the approach to valuations and key assumptions underlying forecasts since last year and are those changes consistent with external events and circumstances?
#4 Have last year’s key forecasts and valuations been compared to actual outcomes and have any lessons been fed into the current year process?
#5 Do models and key assumptions adequately address low probability but high impact events? Has management considered which combination of scenarios could conspire to be the most challenging for the company?
#6 Is the audit committee 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?
#7 Where assets are not traded, perhaps because markets are no longer active, is the committee satisfied that appropriate additional procedures have been undertaken to estimate fair values through the selection of market-based variables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?
#8 Are the assumptions that underlie valuations, including any impairment tests, 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?
#9 Have the auditors been asked 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? Is the committee satisfied that any material concerns have been properly addressed by management?
This covers practically all aspects that should be covered by management, reviewed by auditors and to be considered by audit committees. Please ask these questions and increase effectiveness of your audit committee.