Smiths Group plc – Annual report – 31 July 2018
AUDIT COMMITTEE (extract 1)
The Committee places great importance on the quality, effectiveness and independence of the external audit process. In respect of the period, the Committee:
- considered PwC’s audit report on its review of the FY2018 half yearly results announcements; and its ‘early warnings’ report on the FY2018 audit;
- approved and monitored PwC’s execution of the audit plan;
- discussed any significant issues identified by PwC during the course of the audit, including the key accounting and audit judgements taken by management and management’s responses to the audit findings;
- agreed materiality and de minimis levels with PwC; and
- considered the draft letter of representation from the Company to PwC in connection with the audit of the FY2018 financial statements.
The Committee confirms that the Company has complied with the provisions of the Competition and Markets Authority Order 2014 relating to the UK audit market for large companies throughout the year under review and as at the date of this report.
External auditor independence, effectiveness and reappointment
The Committee is responsible for the development, implementation and monitoring of the Group’s policies on external audit, which are designed to maintain the objectivity and safeguard the independence of the external auditor. These policies, which are reviewed annually, include the engagement of PwC for non-audit work and regulate the appointment by the Group of former employees of PwC.
The non-audit services policy corresponds with the European Commission’s recommendations on the auditor’s independence and with the Revised Ethical Standards issued by the Audit Practices Board in the UK.
The Committee recognises that certain non-audit services can be completed more efficiently by, and be purchased more cost-effectively from, the incumbent auditor due to the audit firm’s existing knowledge of the Group and its systems. Under the policy the Committee has delegated its responsibility for authorising non-audit services from PwC to the Chair of the Committee and the Chief Financial Officer, within set limits:
- the Chief Financial Officer may approve any service costing less than £10,000 if it complies with the objectivity and independence principles set out in the policy.
- any permitted service costing more than £10,000 in aggregate and less than £100,000 must be approved by the Chair of the Committee.
- where the estimated total cost is expected to exceed £100,000 then the service must be subject to a competitive tender unless agreed by the Chief Financial Officer and the Chair of the Audit Committee.
The Committee is satisfied that the non-audit work performed by PwC during the financial year had been properly assessed and authorised in accordance with the Group policy.
In addition to monitoring compliance with the Group’s policies on the employment of former employees of PwC and the use of PwC for non-audit work, the Committee’s review of PwC’s independence included:
- examining written confirmation from PwC that they remained independent and objective within the context of applicable professional standards;
- considering the tenure of the audit engagement partner, who is required to rotate every five years in line with ethical standards; and
- monitoring the ratio between the fees for audit work and non-audit services.
Details of the fees paid to PwC for the year ended 31 July 2018 can be found in note 2 on page 138. Non-audit fees as a percentage of audit fees totalled 5% (FY2017: 8%). The Company would not expect in the ordinary course of business for non-audit fees to exceed 20% of the average of the previous three years’ total Group audit fees unless exceptional circumstances existed.
Audit effectiveness is assessed continually throughout the year using a number of measures including: reviewing the quality and scope of the proposed audit plan and progress against the plan; responsiveness to changes in our businesses; and monitoring the independence and transparency of the audit.
The Committee also reviews the performance of PwC and the effectiveness of the external audit process by conducting a survey of the Board, senior management and divisional finance teams. The survey included questions on PwC’s independence and objectivity, audit strategy and planning, conduct and communication, audit findings and feedback, and expertise and resourcing. The results were positive and confirmed that PwC and its audit process were appropriate and effective; and that the relationships between the audit teams and the Company’s businesses continued to provide effective and objective challenge. Areas identified for improvement were agreed with PwC. The Committee also noted the findings in the FRC’s June 2018 Audit Quality Inspection report on PwC.
Subsequent to its assessment of PwC’s independence and performance, the Committee satisfied itself that the quality of the work exhibited by the firm and its commitment to improvements were of a high standard. The Committee therefore agreed that it was appropriate to recommend to the Board that the reappointment of PwC as the Company’s auditor for a further year be proposed to shareholders at the 2018 AGM.
PwC or a predecessor firm has been the Company’s external auditor since 1997, and there has been no previous external audit tender since their appointment. Smiths is required to replace PwC as its statutory auditor by 2023. However, as reported in the FY2017 Annual Report, the Committee concluded that it was in the best interests of the Company to tender for the rotation of the external auditor for the FY2020 audit. This coincides with the end of tenure for the current lead engagement partner Andrew Kemp who, having been the lead engagement partner for five years, in accordance with ethical standards, will be required to rotate off the Smiths account.
During FY2018, the Committee initiated a tender process designed to be transparent, effective and efficient and give each participating firm an equal opportunity to successfully tender. Prior to the tender, participating firms were provided opportunities to engage with Smiths through the placement of non-audit services. This enabled participating firms to develop their understanding of the business, and its systems and controls. Procedures for managing access to employees and Board members and potential conflicts of interest, including gifts and hospitality, were implemented.
Except for PwC, no other firms were prevented from participating in the tender. However, the Committee agreed that only Deloitte, EY and KPMG should be issued with the Request For Proposal (RFP) following consultation with several “second tier” firms who confirmed that due to their size they would be unable to respond effectively to an RFP. There are no contractual obligations restricting the Group’s choice of external auditor.
To help support the Committee in developing and implementing its planned approach, the Committee approved the formation of a Steering Group, comprised of the Chair of the Committee Mark Seligman, Sir Kevin Tebbit, Bill Seeger and John Shipsey to oversee the work of management. The Chair of the Committee and the Steering Group each met with the tender project team and received and commented on the main materials prior to them being issued to the Committee and/or the participating firms.
In line with FRC guidance the evaluation criteria for the process was agreed as:
- Organisation and capability
- Audit approach and delivery
- Audit quality and value-add
- Resourcing and engagement team
- Fees and contracts.
In order to evaluate each of the firms against the criteria the Committee is in the process of overseeing a number of activities including:
- Analysis of RFP responses
- Presentations to Group and divisional finance teams and corporate functions
- Assessment of performance on non-audit services previously provided
- Due diligence including reviewing Audit Quality Review Team reports published by the FRC and references
- Presentations to the Steering Group and the Committee.
The tender process is ongoing and the Committee hopes to make a recommendation to the Board during the 2018 calendar year following which a detailed transition plan will be developed. The implementation of the transition plan will be overseen by the Committee through FY2019.
Risk management and internal control
During the year, the Committee, on behalf of the Board, carried out a robust assessment of the principal risks facing the Group, including those that would threaten its business model, future performance, solvency and liquidity. A description of the principal risks facing the Company and how these were reviewed to assess the Group’s viability can be found on pages 50–59 and 68.
The Board is also responsible for ensuring that there are sound risk management and internal control systems in place to safeguard shareholders’ investments and the Group’s assets.
The internal control system is a framework to manage risks and monitor compliance with procedures. The Group’s internal control systems are designed to meet Smiths’ particular needs and the risks to which it is exposed. However, they can provide only reasonable, not absolute, assurance against material loss to the Group or material misstatement in the financial statements. The Executive Committee is responsible for designing the Enterprise Risk Management (ERM) system and ensuring it is effectively deployed throughout the Group. More detail can be found on pages 50 and 51.
In FY2018, the Committee, on behalf of the Board and with the assistance of the Internal Audit function, monitored, reviewed and assessed the effectiveness of the Group’s risk management and internal control systems in the context of the Group’s strategy and business model.
In fulfilling its responsibilities, the Committee:
- Received reports to enable an evaluation of the Group’s control environment and risk assurance framework and embedded risk management processes. This included a report commissioned by the Committee from an independent third-party provider to complete a limited scope review of the Group’s ERM framework. The report confirmed that the existing ERM process addressed all of the expected elements. In particular, stakeholders had reported that the risk process had proportionate focus and consistency across the business. Enhancement opportunities were identified based on stakeholder feedback and leading practice witnessed at other organisations. Although none of the opportunities were considered material, the Committee provided oversight of the enhancements adopted;
- Received reports from each of the divisions on the ERM process and an analysis of their own risk registers. This enabled the Committee to understand the risks and opportunities and assurance processes throughout the business and the potential impact on the Group. The Committee also considered two principal risk deep-dive reviews into enterprise and product cyber risk and the risk of a significant ethical breach with a focus on third-party agents and distributors; and
- Reviewed management’s plans to enhance controls in the Group’s internal financial and risk controls and monitored their effectiveness. The Committee did not view any of the issues identified as significant.
Internal Audit is independent of the business, and as such has no responsibility for operational business management. This ensures the integrity and objectivity of its annual Audit Plan work, which is approved by the Committee. The authority of the Internal Audit function is derived from the Committee. The Director of Internal Audit is accountable to the Board through the Chair of the Committee. Administratively, the Director of Internal Audit reports to the Chief Financial Officer. In order to carry out the responsibilities, as set out in a charter approved by the Committee, the Internal Audit function has:
- full and unrestricted access to all Smiths records, property and personnel;
- independent access to the Chair and members of the Committee;
- the right to request meetings with the Committee; and
- the authority and obligation to report significant findings or other concerns to the Committee.
During the period the Committee:
- received progress reports on the execution of the 2018 Internal Audit Plan;
- discussed recommendations made by the internal auditors;
- considered the remit of Internal Audit, its budget and resources and the nature and extent of any outsourcing to specialist co-source providers; and
- approved the 2019 Internal Audit Plan, including the proposed audit scope, approach, coverage and allocation of resources.
The Committee oversees the performance of the Internal Audit function through the Director of Internal Audit’s attendance at Committee meetings and a review of agreed KPIs which are reported
to the Committee. In addition, the Committee oversaw the appointment of an independent third party to conduct an effectiveness review of the Internal Audit function. The review assessed the Internal Audit function’s conformance with the International Standards for the Professional Practice of Internal
Auditing (Standards) and benchmarked the function’s operation against other functions in listed companies, as well as identifying any opportunities for improvement. The findings from the review, which were presented to the Committee, were positive. Internal Audit is seen as a valued assurance function throughout the Group, it is appropriately resourced and conforms with the Standards. There were some opportunities for improvement, including enhancements to audit documentation and agreeing the correct level of coverage for future internal audits.
Treasury and Tax
During the financial year, the Committee reviewed reports from the Treasury department on financial risk and treasury management, noting the Group’s borrowing position and debt capacity and its impact on the Group’s viability. The Committee also received status reports on tax risk from the Tax department, noting the assessments of compliance, tax audit risk, tax provisions and international tax rates. The Group’s assessment of its appetite for tax risk was also reviewed. The Group’s tax strategy is available on our website.
Ethics and Compliance
During the financial year, the Committee reviewed the work programme of the Smiths Ethics and Compliance Office, whose activities included the launch of a new Code of Business Ethics; investigations into allegations of noncompliance with the Code of Business Ethics and any matters raised through the Group’s anonymous ethics reporting procedures. In respect of anonymous ethics reporting the Committee considered that the Group’s processes and arrangements for employees to report concerns about any improprieties and any subsequent investigation as necessary, were both appropriate and effective. No issues were raised that required the Committee’s action. More information can be found on page 63.
The Committee also commissioned an audit from a third party on the effectiveness of certain Group policies and processes supporting Ethics and Compliance. The review covered the ethics and compliance framework; distributors and agents; international trade compliance; gifts and entertainment and modern slavery (direct labour and supply chain). The report concluded that there has been significant progress in strengthening the overall compliance framework and compliance processes around the in-scope policy areas from its previous audit conducted in 2016. The report also identified some areas for further focus which will be overseen by the Committee. The third party has recently audited Smiths’ antitrust and labour standards compliance programme. The audit report is due by the end of September and will be reviewed by the Committee.
The Committee also received regular reports on the Group’s preparedness for the implementation of the General Data Protection Regulation (GDPR). The obligations under GDPR build on those in existing law already applicable to Smiths. Smiths has revised and updated its policies and procedures to reflect these obligations.
The annual evaluation of the performance of the Committee was conducted as part of the overall annual evaluation of the performance of the Board conducted by Independent Audit. The findings relating to the Committee were discussed with the Committee Chair. Overall, the Committee is considered to be performing well, and is rigorous and effective in discharging its responsibilities.
Committee’s assessment of internal control and risk management arrangements
In light of its work, the Committee was content with the effectiveness of the Group’s processes governing financial reporting and controls, its culture, ethical standards and its relationships with stakeholders. The Committee was also satisfied with the appropriateness and adequacy of the Group’s risk management arrangements, internal control framework and three lines of defence model.
AUDIT COMMITTEE (extract 2)
SIGNIFICANT JUDGEMENTS AND ISSUES
An important responsibility of the Committee is to review and agree the most significant management judgements and issues which impact the financial statements. The key areas of judgement in the year were as follows:
The Committee reviewed progress toward the adoption of IFRS 15 ‘Revenue from Contracts with Customers’ including the interpretation judgements made in drafting the Group’s revenue recognition policies. Attention was also given to the weighting of profits toward the final quarter of the year and in particular the timing of shipments to distributors and customers. The Committee oversaw the implementation of a new control process designed to ensure revenue was accounted for correctly. The treatment of one-off items generating non-recurring profit was also considered.
The intangible assets and the assumptions used to justify their carrying values, including ‘fair value less costs to sell’ were reviewed. Following the integration of Morpho Detection and Smiths Detection, particular attention was given to the combined business being treated as a single cash generating unit (CGU). The Smiths Interconnect – Subsystems CGU was also considered, along with the proposal to consolidate Interconnect’s Microwave Subsystems and Connectors & Components CGUs into a single CGU for impairment testing. The carrying value of capitalised development expenditure was reviewed and the treatment was considered reasonable due to the planned timing of new product launches and projected future cash-flows. The Committee agreed a change to the evaluation of the useful life used to amortise capitalised R&D which resulted in a change from a standard five years to between three and eight years, depending on whether the product is a new platform or derivative, and whether it is hardware or software. See note 11 of the financial statements.
Acquisitions and divestments
The Committee reviewed the final fair value adjustments to the acquisition balance sheet for Morpho Detection and agreed the treatment for deferred consideration which has been recognised in the income statement. The accounting treatment of the disposal of John Crane’s Bearings business included the judgement that, due to the immaterial scale of the transaction, the disposal did not meet the criteria to be classified as a discontinued operation. The acquisitions of the heating element division of Osram Sylvania Inc. and Seebach GmbH were also considered and particular attention was paid to the fair value of assets and liabilities acquired and the resulting goodwill. The Committee also considered the treatment of costs between headline and non-headline.
Judgements within working capital, including the level of inventory and provisions and overdue receivables particularly in emerging markets were reviewed. The Committee reviewed progress toward adoption of IFRS 9 ‘Financial instruments’ including the impact of adopting an expected credit loss model for receivables provisioning. See the Accounting Policies section of the financial statements.
Provisions for liabilities and charges
The Committee continued to monitor expert assessments on the Group’s exposure to the John Crane, Inc. asbestos litigation and to the Titeflex Corporation CSST claims. In particular, the Committee considered the treatment of potential liabilities and the changes to the assumptions made in calculating the provisions, including the reassessment of the time period for the Titeflex Corporation CSST provision and the continued appropriateness of the ten-year time period for John Crane, Inc. asbestos litigation. In the case of the John Crane, Inc. asbestos litigation, the Committee also agreed with the judgement that, whilst large numbers of claims are made against John Crane, Inc. and other defendants every year, trials are extremely rare such that a sufficiently reliable estimate cannot be made to cover the full period over which it is expected that costs will be incurred. In both these cases, it was determined that the assumptions fairly reflect the position. See note 22 of the financial statements.
The assets and liabilities recognised in income and deferred tax, as well as the treatment of losses in the UK were assessed. Particular focus was given to the recognition of UK deferred tax assets which are judged to be recoverable; deferred tax assets relating to the John Crane, Inc. asbestos provision; and the Titeflex Corporation CSST provision. In reviewing projected profit streams the Committee was satisfied that, where appropriate, the relevant entities will generate sufficient future taxable profits to utilise the assets recognised. See note 6 of the financial statements.
The Committee reviewed and agreed the methods, assumptions and benchmarks used by the actuaries to calculate the position of the UK and US schemes at 31 July 2018, which have continued to show a net accounting surplus position. The Committee agreed the treatment and the corresponding disclosures on these matters. See note 8 of the financial statements.
The Committee, after receiving the reports on the significant issues and areas of judgement, was content that the judgements made were appropriate and are correctly reflected in the Annual Report.
NOTES TO THE ACCOUNTS (extract)
2 OPERATING PROFIT IS STATED AFTER CHARGING
Other services comprise audit-related assurance services £0.2m (FY2017: £0.2m), other services £0.1m (FY2017: £0.1m), tax advisory services £nil (FY2017: £0.1m) and one-off IT and consulting projects £nil (FY2017: £0.2m). Total fees for non-audit services comprise 5% (FY2017: 8%) of audit fees. Audit-related assurance services include the review of the Interim Report.