Audit committee report, significant issues, external audit assessment, FRC audit inspection, tenure, non-audit fees, objectivity, independence

Smiths Group plc – Annual report – 31 July 2020

Industry: manufacturing

GOVERNANCE (extract)

AUDIT & RISK COMMITTEE REPORT (extract 1)

External audit

The Committee places great importance on the quality, effectiveness and independence of the external audit process. Further to a tender process described in last year’s Annual Report, KPMG was appointed as the Company’s external auditor at the 2019 Annual General Meeting, replacing PwC which had been the Company’s auditor since 1997. Michael Maloney, KPMG’s audit partner, has led the engagement during the year and since their first appointment at the 2019 AGM. In line with ethical standards it is expected he will rotate off the Smiths audit within five years and no later than the conclusion of the FY2024 audit. In respect of the period, the Committee approved and monitored KPMG’s execution of the audit plan.

The Committee also considered KPMG’s report on its review of the FY2020 half yearly results announcement and its report on the FY2020 audit. It also discussed all significant matters identified in KPMG’s final report on the FY2020 audit including the key accounting judgements taken by management and management’s responses to any audit findings.

Due to PwC’s understanding of Smiths Medical’s financial reporting and internal control environment and the work necessary to support the separation of that business, the Committee agreed it was more efficient for PwC to continue to act as the auditor for those companies which comprise the Smiths Medical division and to report to KPMG.

The Committee confirms that the Company has complied with the provisions of the Statutory Audit Services Order 2014 relating to the UK audit market for large companies throughout the year under review and as at the date of this report.

Independence and effectiveness

The Committee is responsible for the 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 are reviewed annually. They cover the engagement of the external auditor for non-audit services and the appointment by the Group of former employees of the external auditor. The policies correspond with the European Commission’s recommendations on the auditor’s independence and with the Revised Ethical Standard issued by the FRC in the UK.

Notwithstanding developing practice being adopted by audit firms not to provide non-audit services to audit clients, the Committee recognises that certain permissible 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 approved by the Committee, it has delegated its responsibility for authorising the purchase of non-audit services from the external auditor to the Chair of the Committee and/or the Chief Financial Officer within specific limits.

Details of the fees paid to KPMG for the year ended 31 July 2020 can be found in note 2 of the financial statements on page 162. Non-audit fees as a percentage of audit fees totalled 9% (FY2019: 4% – this was in respect of fees paid to the Group’s previous external auditor PwC). The Group 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. The Committee confirms that the non-audit work performed by KPMG, which included some supplementary audit work and work in preparation for the separation of Smiths Medical during the year, was properly assessed and authorised in accordance with the Group’s policy.

In addition to monitoring compliance with Group policies, the Committee’s review of KPMG’s independence included examining written confirmation from KPMG that they remained independent and objective within the context of applicable professional standards, and considering the performance of the audit engagement partner.

Audit effectiveness is assessed continually 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; appropriate scepticism and challenge of management; and monitoring the independence, professionalism and transparency of the audit. In addition, the Committee discussed the findings in the FRC’s 2020 Audit Quality Inspection Report with KPMG to understand those activities being undertaken to address the findings; and KPMG’s position regarding the various areas of audit reform which is currently under review. The processes whereby KPMG sought assurance on the audit work completed by PwC in respect of those companies forming the Smiths Medical division was also reviewed. The Committee concluded that KPMG and its audit process were effective, and that audit teams had provided effective and objective challenge. The Committee therefore agreed that it was appropriate to recommend to the Board that the reappointment of KPMG as the Company’s auditor for a further year be proposed to shareholders at the 2020 AGM. As this was KPMG’s first year as auditor a further in-depth review of their performance will be conducted ahead of their review of the FY2021 half year results.

Risk management and internal control

The Board is responsible for ensuring that sound risk management and internal control systems are in place. The Executive Committee is responsible for designing the risk management and internal control systems and ensuring they are effectively deployed throughout the Group. The internal control system is a framework to manage risks and monitor compliance with procedures. It is designed to meet the Group’s particular needs and the risks to which it is exposed. However, it can provide only reasonable, not absolute, assurance against material loss to the Group or material misstatement in the financial statements. More detail can be found on pages 67-76.

In FY2020, 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, business model and risk appetite. The Committee also 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, notably in the light of COVID-19. A description of the principal risks facing the Group and how these were reviewed to assess the Group’s viability can be found on pages 69-76 and 77-78.

In fulfilling its responsibilities, the Committee received reports to enable an evaluation of the control environment and risk assurance framework and processes. No significant failings or weaknesses were identified. The Committee also received reports from the divisions on their risk management processes and a presentation on the risk registers and associated controls. The Committee undertakes deep-dive reviews on a rolling basis of the Group’s principal risks. During FY2020, deep-dives were carried out on: Integrated supply chain with a focus on the potential impact of COVID-19 and Product quality within John Crane. Product quality deep dives for the other divisions are scheduled to be held during FY2021. Separately, the full Board considered the People and Cyber security principal risks and due to COVID-19 a report on financial controls in respect of those risks deemed heightened during the pandemic. Consideration of the risk registers alongside the principal risk deep dives enables the Committee and full Board to understand the culture, risks and opportunities and assurance processes throughout the business and the potential impact on the Group.

Internal Audit

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, 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 Committee Chair, although 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 records, property and personnel;
  • independent access to the Committee 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 FY2020 Internal Audit Plan, notably how the plan would be completed due to site and system access and travel restrictions imposed as a result of COVID-19. This was largely addressed by the increased use of technology and reviews being completed remotely.

Review findings and recommendations made by the Internal Audit function were discussed as well as the pace at which control enhancements were addressed by the business. The Committee also considered the remit of Internal Audit, its budget and resources and the nature and extent of any outsourcing to specialist co-source providers. It also approved the FY2021 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, an anonymous survey completed by the Board, management and the external auditor was conducted into the function’s effectiveness. Overall, Internal Audit is deemed to be effective and is seen as a valued assurance function throughout the Group. It is appropriately resourced and conforms with industry standards in its approach.

Ethics and compliance

During the year, the Committee reviewed the Ethics and Compliance annual work programme, and provided oversight of performance in line with, and investigations into, allegations of non-compliance with the Code of Business Ethics. This included matters raised through the Group’s ethics reporting procedures including the Group’s ‘Speak-Out’ line which allows for anonymous reporting. Smiths ‘Speak Out’ system comprises a number of different channels (including call centres operated by an independent third party across the Group’s global operations) for employees and other stakeholders to report concerns. The Committee also provides oversight for any significant investigations. During the year there were no matters raised that required the Committee’s direct intervention or investigations which resulted in a material loss to the Group or a detrimental impact on our customers or suppliers. The Committee receives regular reports on the total number and nature of cases by region, the ratio of anonymous vs attributed ethics reports, and the ratio of substantiated to unsubstantiated cases. The anonymous vs attributed metric is used to monitor trust in the Group’s nonretaliation policy.

Accordingly, the Committee considered that the Group’s processes and arrangements for employees to report concerns, including anonymously and without retaliation, about any improprieties and the arrangements for any subsequent investigation as necessary, were both appropriate and effective.

During the year, the Committee provided oversight of a number of areas targeted by the Ethics and Compliance work programme. More information on the Group’s approach to Ethics & Compliance can be found on page 26.

Assessment of internal control and risk management arrangements

The Committee was satisfied that the Group’s processes governing financial reporting and controls, its culture, ethical standards and its relationships with stakeholders continued to be effective. The Committee was also satisfied with the appropriateness and adequacy of the Group’s risk management arrangements, internal control framework and four lines of defence model.

AUDIT & RISK COMMITTEE REPORT (extract 2)

Significant accounting estimates and judgements

An important responsibility of the Committee is to review and agree the most significant management accounting estimates and judgements which impact the financial statements. The key areas of judgement in the year are set out below. After receiving reports on the significant estimates and areas of judgement and after discussion with KPMG, the Committee agreed that the judgements made were appropriate and correctly reflected and presented in the Annual Report. More detailed information on the Group’s Accounting Policies and significant judgements can be found on pages 149-157.

Presentation of headline profits and underlying growth

The Committee considered the policy, presentation and judgements in relation to the Group’s performance, in particular the separation of headline and non-headline items including the treatment of the strategic restructuring programme costs and consideration of which items related to the Group’s ongoing trading activity or those which should be recorded as non-headline.

In terms of the strategic restructuring programme, the Committee concurred with management’s conclusion that costs did not meet the criteria under the Group’s non-headline items policy which requires that non-headline items should only relate to either M&A activity or provisions for legacy issues. Restructuring costs are therefore reported in the headline performance. The Committee also agreed that it was appropriate to disclose an additional alternative performance measure to show operating profit excluding restructuring costs and asset write downs. See note 30 of the financial statements.

Other items included the amortisation of intangible assets and the impact of integration activity on acquired entities and material one-off items relating to pensions and other legacy provisions. In addition, the Committee also considered those judgements in connection with items to be reflected or adjusted in underlying performance. See note 3 of the financial statements.

Acquisitions and divestments

The Committee reviewed the treatment and presentation of the acquisition of Reflex Photonics. The Committee also considered the appropriateness of the recognition of business acquisition and disposal costs and post-acquisition integration programme costs between headline and non-headline profits.

Discontinued operation held for distribution

The continued treatment of Smiths Medical as a discontinued operation and a business held for distribution to owners was also considered and agreed.

The Committee recognised that a key IFRS 5 requirement for classifying a business as held for distribution to owners is that the distribution must be highly probable, with the expectation that it will be completed within one year from the date of classification.

It is recognised that unforeseen circumstances during FY2020 did not allow the distribution to occur; therefore further judgement was required to determine whether the Smiths Medical business continues to meet the criteria for classification as a discontinued operation given the delay in the demerger.

The Committee agreed that the separation was not completed in FY2020 due to exceptional external circumstances as stated in our trading update on 31 March 2020, that the Group remains committed to completing the separation within FY2021 and the recognition criteria of IFRS 5 continue to be fully met.

However, the Committee and the Board will give consideration to any exceptional external circumstances arising, including significant adverse consequences arising from the evolving pandemic and associated economic dislocation which may impact the separation of Smiths Medical.

Revenue recognition

The Committee reviewed management’s revenue recognition judgements. The Committee noted that the timing of revenue recognition involves judgements as to when control of an asset passes to the customer or, particularly in Smiths Detection and Smiths Interconnect, as to the stage of completion of contract activity and whether the separate performance obligations have been fulfilled.

The Committee reviewed and concurred with management’s conclusions on the significant judgements for complex programmes and contract accounting. See note 1 of the financial statements.

Taxation

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; deferred tax assets relating to the John Crane, Inc. asbestos provision; and the Titeflex Corporation CSST provision. The Committee noted the ongoing tax audits that are likely to conclude in the next 12 to 24 months, and the uncertainty associated with their outcome. The Committee noted that the final outcome may vary significantly from the amounts currently provided for tax risks. See note 6 of the financial statements.

Impairment

The intangible assets and the assumptions used to justify their carrying values, including ‘value in use’ and ‘fair value less costs to sell’ were reviewed. The applicable discount rate used for impairment testing purposes was also considered particularly where headroom had reduced in the year.

Smiths Detection and Smiths Interconnect were the only CGUs where the impairment headroom was limited for FY2020 and where a plausible downside scenario or a reasonable change in the key assumptions could have caused the carrying value to exceed its recoverable value. The limited impairment headroom for Smiths Detection was driven by lower forecast cash-flows due to the expected COVID-19 downturn in the aviation sector. The net impact is that long-term earnings growth projections have reduced from the FY2019 model but that the CGU recoverable amount exceeded its carrying value and therefore no impairment was necessary. The limited impairment headroom for Smiths Interconnect was driven by FY2020 performance and inherently uncertain future performance.

The Committee concurred with management’s conclusion that additional sensitivity disclosures on the impairment risk of the Smiths Detection CGU and the Smiths Interconnect CGU were required and reviewed the appropriateness of the disclosures proposed.

The carrying value of capitalised development expenditure, notably in respect of Smiths Detection and Smiths Medical, was reviewed and the treatment was considered reasonable.

The Committee provided significant focus and challenge to management on the progress achieved on Smiths Medical’s IntellifuseTM infusion pump(s) (Intellifuse) programme, which has been in development for a number of years. The Committee recognised that during FY2020 Smiths Medical experienced delays in achieving regulatory clearance for Intellifuse from the US Food and Drug Administration (FDA). The Committee agreed with management’s view that the delay in FDA approval, together with impact of expected competitor product launches, were indicators of potential impairment.

The Committee challenged management’s impairment review of Intellifuse before agreeing that the fair value less costs to sell of Intellifuse is in excess of the carrying value so no impairment remains appropriate.

The Committee reviewed and agreed the additional disclosures on Intellifuse within ‘Discontinued operations and businesses held for distribution to owners’. See note 11 of the financial statements.

New accounting standards – IFRS 16

The Committee received updates on the adoption of IFRS 16 ‘Leases’ in the current year and in particular considered the impact of IFRS 16 on the Group’s cash conversion Alternative Performance Metric. The Committee approved the Group’s accounting policy and the proposed disclosures under the new standard.

Provisions for liabilities and charges

The Committee considered the appropriateness of the level of the provisions held against John Crane, Inc. asbestos litigation and the Titeflex Corporation CSST claims. In particular, the Committee considered the treatment of potential liabilities, the changes to the assumptions made in calculating the provisions, sensitivities to changes in assumptions and met with the Group’s specialist external advisers and agreed 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, due to both known and as yet unknown developments in the US legal system and other events that will impact the asbestos legal environment, 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.

Post-retirement benefits

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 2020, 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.

Notes to the accounts (extract)

2 Operating profit is stated after charging

Research and development (R&D) cash costs were £119m (FY2019: £111m) comprising £83m (FY2019: £84m) of R&D expensed to the income statement, £16m (FY2019: £9m) of capitalised costs and £20m (FY2019: £18m) of customer funded R&D.

Administrative expenses include £1m in respect of lease payments for short term and low value leases which are not included within right of use assets and lease liabilities.

Strategic restructuring programme and write-downs

In June 2020 the Group announced a strategic restructuring programme that will ensure it emerges stronger from the COVID-19 crisis and better able to deliver consistent outperformance. The programme is Group-wide and has an operating cash cost of c.£65m which will be spread across FY2020 and FY2021. Programme costs of £31m were recognised in continuing operations and £4m in discontinued operations during FY2020.

The table below shows the analysis of the costs recognised for the restructuring programme and asset write-downs and the calculation basis for headline operating profit excluding restructuring and write-downs:

Auditors’ remuneration

The following fees were paid or are payable to the company’s auditors, KPMG LLP and other firms in the KPMG network, for the year ended 31 July 2020. Figures in the table and notes below for the year ended 31 July 2019 are in respect of fees paid to the company’s previous auditor, PricewaterhouseCoopers LLP (‘PwC’).

Other services comprise audit-related assurance services £0.3m (FY2019: £0.2m) and fees for reporting accountant services in connection with a class 1 disposal £0.2m (FY2019: £nil). Total fees for non audit services comprise 9% (FY2019: 4%) of audit fees. Audit-related assurance services include the review of the Interim Report.