An audit committee and an Austrian cat may not initially have any obvious connection. However, the revisions to the UK Corporate Governance Code recommending disclosure in the annual report of the significant issues considered by audit committees in relation to financial statements, and how such issues are addressed, has more in common with Schrödinger’s famous feline than you might think.
Not up to speed with quantum physics? Back in 1935, Austrian physicist Erwin Schrödinger composed a thought experiment involving a cat, a steel box, an atom and some rather nasty poison. The experiment aimed to shed light on the fluctuating nature of atoms. The conclusion drawn was that the cat was both alive and dead inside the box until it was opened and the cat was observed. This is what is known as the observer’s paradox: observation or measurement itself affects an outcome and the outcome as such does not exist unless the measurement is made.
The concept may have come from quantum physics, and seem like science fiction, but similar things could be said to be happening all around us – even about how audit committees’ exert oversight over the external audit relationship and the integrity of financial statements.
It’s in investors’ interests for companies to be well-governed. In an ideal world, boards and investors would welcome a demonstration of the Audit Committees’ effectiveness. But how to deliver this?
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.
Most would accept that good governance is not only about structures and process, but also about behaviour. What is the audit committee doing in practice? What is it doing to ensure the integrity of the financial statements and how is it satisfying itself that the audit process is robust? This is unlikely to be demonstrated by ticking a checklist of organisational criteria.
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?
Openness and transparency
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 (say) 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.
Will the new audit committee reporting requirements deliver this enhanced disclosure? Early practice is mixed, and I fear there is a significant danger that boiler plate and minimal disclosure will win out over useful reporting. Unless, of course, investors engage with audit committees and articulate what they like and what they don’t like.
If audit committee disclosures lapse into boiler-plate – a Terms of Reference summary or list of accounting issues that most readers could guess from the nature of the company and industry – then the opportunity to drive audit committee effectiveness through enhanced disclosure will have been lost.
And if we can see clearly what a particular audit committee has done, at least we’ll know the state of health of this important aspect of corporate governance. That’s in everyone’s interest, including the cat’s.
Tim Copnell is an Associate Partner at KPMG in the UK