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

Smiths Group plc – Annual report – 31 July 2019

Industry: manufacturing

GOVERNANCE (extract)
AUDIT & RISK COMMITTEE (extract 1)
EXTERNAL AUDIT
The Committee places great importance on the quality, effectiveness and independence of the external audit process. PwC or a predecessor firm have been the Company’s external auditor since 1997. Andrew Kemp, the current audit partner, has led the engagement for five years. In respect of the period, the Committee approved and monitored PwC’s execution of the audit plan. The Committee also considered PwC’s report on its review of the FY2019 interim results announcement and its ‘early warnings’ report on the FY2019 audit. It also discussed any significant issues identified, PwC’s final report on the FY2019 audit including the key accounting and audit judgements taken by management and management’s responses to any audit findings.

The Committee confirms that the Company has complied with the provisions of the 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 Financial Reporting Council 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 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 PwC for the year ended 31 July 2019 can be found in note 2 to the financial statements on page 151. Non-audit fees as a percentage of audit fees totalled 4% (FY2018: 5%). 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 PwC during the year was properly assessed and authorised in accordance with the Group Policy.

In addition to monitoring compliance with Group policies, 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, and considering the performance and tenure of the audit engagement partner, who is required to rotate every five years in line with ethical standards.

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; and monitoring the independence and transparency of the audit. The Committee also reviewed the performance of PwC and the effectiveness of the audit process by conducting a survey of the Board, senior management and divisional finance teams. The survey included questions on independence and objectivity, audit strategy and planning, conduct and communication, audit findings and feedback, and expertise and resourcing. The results were positive and the Committee concluded that PwC and its audit process were effective, and that audit teams continued to provide effective and objective challenge.

AUDIT TENDER
As set out in the Annual Report FY2018 the Committee concluded a tender for the external audit in November 2018. Following evaluation of each firm participating in the tender against agreed evaluation criteria, the Committee recommended its first and second choice firms to the Board for appointment. In making its recommendation the Committee agreed that KPMG was likely to deliver a high-quality audit aligned to the Smiths business model and specific risks, facilitated by the greater use of technology. The Committee further noted KPMG’s significant commitment to improve audit effectiveness following regulatory criticism, and was assured that the audit would therefore be carried out to the highest possible standard with appropriate levels of challenge and scepticism. The recommendation was free from third party influence and no restrictive clauses were imposed on the Committee or the Board. The Board endorsed the Committee’s recommendation and a resolution recommending KPMG’s appointment will be proposed at the 2019 AGM. During the year the Committee has overseen the activity necessary to transition the audit to KPMG, including establishing independence by exiting pre- existing non-audit services engagements. This allowed KPMG to shadow PwC’s audit of the FY2019 results to support an orderly handover. The Committee also discussed the findings of the FRC’s 2019 Audit Quality Inspection Report in respect of KPMG with the proposed audit partner, Mike Maloney, and agreed that there was no reason why KPMG’s appointment should not be recommended to shareholders.

The Committee also noted the findings in the FRC’s 2019 Audit Quality Inspection Report. PwC was provided with an opportunity to describe the activities being undertaken to address the findings.

RISK MANAGEMENT AND INTERNAL CONTROL
The Board is responsible for ensuring that there are sound risk management and internal control systems 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 62 and 63.

In FY2019, 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. 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 62 to 70 and 71 and 72.

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. It also received reports from each of the divisions on the risk management 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 undertakes deep-dive reviews on a rolling basis of the Group’s principal risks. During FY2019, deep-dives were carried out on: not operating in the right markets (with a focus on Asia); supply chain – manufacturing concentration; and supply chain – sole source. The two supply chain risks were subsequently merged to form the new principal risk of ‘integrated supply chain’. Separately the full Board considered the people, technology and cyber security principal risks.

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 Chairman of the Committee, 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 Chairman 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 FY2019 Internal Audit Plan and discussed recommendations made by the Internal Auditor. 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 FY2020 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. As described in the Annual Report FY2018, the Committee also oversaw the implementation of enhancements identified by an independent third party engaged to conduct an effectiveness review of the Internal Audit function. 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 work programme, and provided oversight of performance in line with, and investigations into, allegations of noncompliance with the Code of Business Ethics. This included any matters raised through the Group’s ethics reporting procedures. During the period, the Committee provided oversight for investigations in respect of three unrelated matters, none of which resulted in material loss to the Group or a detrimental impact on our customers or suppliers. No matters were raised that required the Committee’s direct intervention. Accordingly, the Committee considered that the Group’s processes and arrangements for employees to report concerns, including anonymously, about any improprieties and any subsequent investigation as necessary, were both appropriate and effective. The Committee receives regular reports on the ratio of anonymous v.s attributed ethics reports. This metric is used to monitor trust in the Group’s non-retaliation policy.

Recognising that culture plays a significant role in determining the strength of ethics and compliance performance, the Committee received a report on the Group’s framework designed to help monitor culture down to a site level. In particular the framework focuses on monitoring the value of respect. The approach seeks to evaluate the results of various data sets which, when aggregated, may demonstrate low levels of respect. This may then indicate those sites which are at a higher risk of experiencing a serious ethical failure. The Group is then able to target its ethics audits at those sites which are potentially higher risk.

The Committee was also appraised of the results of a third-party audit over the effectiveness of certain Group policies and processes supporting ethics and compliance. The review covered the Group’s approach to antitrust compliance and to labour standards. The report concluded that there has been significant progress in strengthening the overall compliance framework and processes around these policy areas from its previous audit conducted in 2016.

ASSESSMENT OF INTERNAL CONTROL AND RISK MANAGEMENT ARRANGEMENTS
In light of its work, 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 three lines of defence model.

AUDIT & RISK 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 are set out below. After receiving reports on the significant issues and areas of judgement and after discussion with PwC, the Committee agreed that the judgements made were appropriate and are correctly reflected in the Annual Report. More detailed information on the Group’s Accounting Policies can be found on pages 139 to 146.

Revenue recognition
The Committee reviewed the impact of the adoption of IFRS 15 ‘Revenue from Contracts with Customers’ including the interpretation judgements made in drafting the Group’s revenue recognition policies. The Committee also supported simplified presentation of divisional revenue segmentation. See note 1 of the financial statements.

Acquisitions and divestments
The Committee reviewed the treatment and presentation of a number of transactions including the United Flexible acquisition, an adjustment following completion of the post-acquisition review of Seebach GmbH and the disposal of Smiths Medical’s sterile water bottling business. The treatment of Smiths Medical as a discontinued operation held for distribution was also discussed and agreed. The Committee also considered the treatment of acquisition integration costs for Morpho Detection and United Flexible, and disposal and separation costs between headline and non-headline.

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. Following the separation of Smiths Medical the future Smiths UK Group is anticipated to be in a structural loss-making position from a tax perspective. Therefore UK deferred tax assets will be
derecognised at the end of F20Y19 save to the extent that accounting rules require them to be recognised. See note 6 of the financial statements.

Impairment
The intangible assets and the assumptions used to justify their carrying values, including ‘value in use’ were reviewed. As specifically noted in the Annual Report FY2018, the Smiths Interconnect and Flex-Tek divisions are now considered single cash generating units (CGUs) for impairment testing purposes. The applicable discount rate used for impairment testing purposes was considered particularly where headroom had reduced in the year. This headroom decline was driven by a more conservative impairment model whereby certain forecast cash-flows were removed from future years. 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.

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 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.

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 2019, 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.

Working capital
Judgements within working capital, including the level of inventory and provisions and overdue receivables were reviewed. Following adoption of IFRS 9: Financial Instruments and the associated necessary accounting policy the Committee also reviewed the impact of introducing an expected credit loss model on the Group’s receivables provisioning. See the Accounting Policies section of the financial statements.

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 and consideration of which items related to the Group’s ongoing trading activity or those which should be recorded as non-headline. Due to its scale and the extent of the disclosures required, the presentation of Smiths Medical as a discontinued operation held for distribution was a particular focus. 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 to the financial statements.

NOTES TO THE ACCOUNTS (extract)
2 OPERATING PROFIT IS STATED AFTER CHARGING

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  • The comparatives for the year to 31 July 2018 have been restated to reflect the reclassification of the Smiths Medical business as a discontinued operation.

Research and development (R&D) cash costs were £111m (FY2018: £96m) comprising £84m (FY2018: £75) of R&D expensed to the income statement, £9m (FY2018: £10m) of capitalised costs and £18m (FY2018: £11m) of customer funded R&D.

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Other services comprise audit-related assurance services £0.2m (FY2018: £0.2m) and other services £nil (FY2018: £0.1m). Total fees for non-audit services comprise 4% (FY2018: 5%) of audit fees. Audit-related assurance services include the review of the Interim Report.