FINANCIAL REPORTING COUNCIL

CHALLENGES FOR AUDIT COMMITTEES

ARISING FROM CURRENT ECONOMIC CONDITIONS

NOVEMBER 2009
Introduction

The current economic outlook appears to be less depressed than this time last year. However,
significant economic risks remain and will present challenges for many audit committees
during the 2009/10 reporting season. Past experience shows that insolvencies have increased
after the technical end of recessions as companies run out of working capital. Such conditions
mean that the next twelve months are likely to be particularly difficult for management and
may increase the risk that annual reports and accounts misreport facts and circumstances
and contain uncorrected errors and omissions.

The attached questions seek to identify issues that will be particularly relevant to the work of
many audit committees over the next few months. This publication does not establish any
new requirements.

Specific risks and uncertainties

All companies are likely to be experiencing the effects of the recession in one form or
another, but these conditions impact different companies in different ways. Useful insight
can often be gained by observing the strengths and weaknesses of competitors and
comparing their performance to that of the company.

Companies may have found it necessary to change their business models in order to improve
cash flow or to manage extreme competitive pressures. Such changes may have included
amendments to terms of trade and/or the way in which goods and services are processed and
delivered. There is also a higher likelihood of companies entering into innovative
transactions which require careful analysis to ensure that appropriate accounting policies
have been identified and applied. Where such changes are present, they are likely to
necessitate reconsideration of accounting policies and the effectiveness of the system of
internal control.

Reliance on assumptions and models for cash flow and valuation information
Whilst market conditions appear less volatile than last year, many companies will still need
to consider a wider‐than‐normal range of reasonably possible outcomes when performing
sensitivity and scenario analysis on the cash flow projections supporting both asset
valuations and impairment assessments.

The increase in the range of reasonably possible outcomes places additional pressure on the
judgments needed to evaluate illiquid asset values. Audit committees are likely to want a
clear understanding of these judgments and may require more detailed information and
analysis.

Principles‐based accounting and reporting standards rely on being applied in a constructive

and transparent way with a focus on useful communications, not just the minimum
necessary to comply with laws and regulations.

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Audit committees are likely to want to be convinced that key judgments are supported by a
greater degree of rigour and analysis than in more normal circumstances and to consider
how such matters have been explained in the annual report.

Liquidity risk and going concern

One aspect of this dependence on cash flow forecasts is the work necessary to assess going
concern. The Financial Reporting Council (FRC) has just published revised guidance for directors
on going concern and liquidity risk (http://www.frc.org.uk/publications/pub2140.html).

Heightened liquidity risk will necessitate greater attention to the key assumptions and
processes that lead to cash flow forecasts. In some cases, detailed consideration will need to
be given to determine whether there are material uncertainties leading to significant doubt
about whether the business is a going concern.

Many companies have responded to the FRC’s call for improved disclosures in 2008/9 and
linked their going concern statement required by the Listing Rules together with the liquidity
risk and supporting analysis required by International Financial Reporting Standard 7 ‐
Financial Instruments: Disclosures. The FRC continues to attach importance to the quality
and clarity of these disclosures.

Year‐end planning considerations

Given the increased economic pressures, audit committees may need to consider the possible
impact of an increased risk of error or omission or manipulation of the annual financial
information.

Effective systems are particularly vital in order to manage an increased risk of error,
omission and fraud when management and supporting finance teams are under abnormal
pressures. This may necessitate a re‐examination of systems and controls over key reporting
areas. Pending the outcome of the FRC’s recently announced review of market practices in
relation to the provision of internal audit services by external auditors
http://www.frc.org.uk/press/pub2157.html, audit committees should be cautious about the
engagement of auditors to provide services which may compromise the boundaries between
internal and external audit services.

External commentary is another key source of information to help alert the audit committee
to business issues. Examples include questions raised about prior period financial statements
which could indicate areas requiring attention in the current year.

Audit committees are likely to find it useful at the planning stage to have access to press
comments about prior period financial reports together with a briefing on any
correspondence with regulators such as the Financial Reporting Review Panel and a copy of
any comment letter provided by the Audit Inspection Unit to the company’s auditors.

2 Challenges for audit committees arising from current economic conditions (November 2009)
 2009/10 Corporate Reports
Key Questions for Audit Committees

Area of Key questions

consideration

Assessing and Has the audit committee considered whether the Board may need to amend the group strategic plan including expectations
communicating risk and of future growth and the group’s ability to sustain or modify its business model?
uncertainties
Is the committee satisfied that the group has monitored the effects on the business of the continued volatility in the financial
markets and reduced supply of credit, including its exposure to liquidity risk and customer and supplier default risk?

Has the Board set out in the annual report a fair review of the company’s business and how the business may have been
changed to address the effects of the recession?

Is the committee satisfied that the business review presents the principal risks and uncertainties that most concern the
Board in a fair and transparent way?

Has the committee considered whether the audited financial statements describe fairly all of the key judgments about the
application of accounting policies and the estimation uncertainties inherent in assets and liabilities?

Have all relevant issues that have concerned management during the year and that have been drawn to the attention of the
board and/or the audit committee been considered for disclosure?

Has the committee considered whether there is a need for additional disclosures about company circumstances, such as
going concern issues, in preliminary announcements or other regulatory reports before the annual report is published?

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 2009/10 Corporate Reports
Key Questions for Audit Committees

Reliance on models for Has the audit committee considered the processes in place to ensure that appropriate procedures and controls have been
cash flow and valuation applied to the group’s use of models to generate cash flow and accounting valuation information, including the choice and
information consistent use of key assumptions?

Has consideration been given to the changes in those assumptions made since last year and whether those changes are
consistent with external events and circumstances?

Do models adequately address low probability but high impact events? Has management considered which scenarios are
the most challenging for the company?

Is the audit committee satisfied that appropriate sensitivity analysis has been conducted, by flexing assumptions, to identify
how robust the model outputs are in practice and are the assumptions free from bias?

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?

Where models have been used to estimate the value of assets which must be tested for impairment, is the committee
satisfied by the procedures adopted to estimate cash flows and that the appropriate adjustments have been made for risk?

Are the assumptions that underlie any impairment tests consistent with internal budgets and forecasts and with how the
prospects for the business have been described elsewhere in the annual report?

4 Challenges for audit committees arising from current economic conditions (November 2009)
 2009/10 Corporate Reports
Key Questions for Audit Committees

Liquidity risk and going Is the audit committee satisfied by the process that the Board has conducted to conclude that the financial statements
concern should be prepared on a going concern basis? Was reference made to the revised guidance from the FRC: “Going Concern
and Liquidity Risk: Guidance for directors of UK companies 2009”?

Is the committee satisfied that proper consideration has been given to cash flow forecasts prepared for at least, but not
limited to, twelve months from the date of approval of the financial statements including an analysis of headroom against
available facilities and that all available information about the future has been taken into account?

Has the committee considered whether there is a need to extend the cash flow forecast exercise to evaluate issues that may
arise after the end of the period covered by the initial budgets and forecasts?

Is the committee satisfied that appropriate evidence has been obtained about the group’s ability to secure new or to renew
existing funding commitments?

Has the committee considered an analysis of the terms of current banking facilities and covenants, and has this analysis
identified risks that need to be addressed? If so, are plans in place to manage those risks?

Is the committee satisfied that full consideration has been given to guarantees, indemnities or liquidity facilities that have
been provided to other entities that the group may be called on to honour? Has management considered whether the group
has the resources to meet such obligations should they arise?

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 2009/10 Corporate Reports
Key Questions for Audit Committees

Year‐end planning Has the audit committee considered how it should respond to any heightened risk of errors, omissions or manipulation of
considerations reported financial results or balance sheet presentation? Has it assessed how these risks have been mitigated?

Is the committee satisfied that appropriate plans are in place to make a considered assessment about the use of the going
concern basis of accounting at the date of approval of the annual report and accounts?

Does the committee need further analysis of how the business has been affected by the recession? For example, if the terms
of trade have been changed has this resulted in a reconsideration of the system of internal control and how accounting
policies have been selected and applied? In particular, if sales terms and conditions have been changed has the company’s
revenue recognition policy been reviewed and does it need to be amended?

Has the company changed its business in a way that would increase the demands on the group finance function and its
need for specialist skills? If additional resources are required, has a plan to increase resources been made and implemented?

Where an internal audit function exists, has the committee considered whether it wishes internal audit to conduct
additional work up to or at the year end? Is the committee comfortable with the boundary between internal and external
audit ?

Has consideration been given to any recommendations for improvement arising from prior year annual reports from the
press or regulatory agencies, including the Financial Reporting Review Panel and the Audit Inspection Unit?

Has the committee considered whether the group audit plan has been updated to address current risks and any changes to
the business? Have the external auditors allocated sufficient additional and experienced resources to address heightened
risks and, if not, are negotiations scheduled to secure additional commitments?

6 Challenges for audit committees arising from current economic conditions (November 2009)
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