During the year the Audit Committee continued to focus on monitoring the integrity of the Group's financial reporting and also advised the Board on the application of recently introduced reporting and governance requirements, including whether the Annual Report is fair, balanced and understandable
Jeff Hewitt (Committee Chairman)
The Audit Committee
The Audit Committee comprises all of the independent Non-executive Directors of the Company. The Members bring a wide range of financial and commercial expertise to the Committee's deliberations. I continued to be the Committee Chairman. I am a qualified accountant and have the required recent and relevant financial experience. Jane Hinkley joined at the time of the demerger of Cookson Group and Nelda Connors joined the Committee in March 2013; both Nelda and Jane have brought a fresh perspective to the Committee's activities. Member's biographies are in the Board of Directors. The Company Secretary is Secretary to the Committee.
The Committee met four times during the year. We continue to operate in an inclusive manner. Hence, the Board Chairman, non-independent Non-executive Director, Chief Executive, Chief Financial Officer, Group Financial Controller, Head of Internal Audit and KPMG were invited to each meeting. Other management executives were invited to attend as appropriate. This openness supported the quality and transparency of the Committee's work and the communication of its deliberations with the Board, executives and auditors. The Committee also met privately with the external auditor KPMG and the Head of Internal Audit without any executives being present, and I met informally with KPMG and with the Head of Internal Audit between the scheduled meetings to discuss any emerging issues. This "avoidance of surprises" approach was reinforced by regular meetings with relevant executives. I reported on the outcome of our meetings to the Board and all members of the Board received the agenda, papers and minutes of the meetings.
Roles and Responsibilities
The primary roles and responsibilities of the Committee remained the same as in 2012, with the addition that in 2013 the Committee advised the Board on whether it believed the Annual Report and Accounts taken as a whole to be fair, balanced and understandable.
The Committee operates under formal terms of reference which were reviewed and updated during the year and approved by the Board. The terms of reference are available on the Group's website (www.vesuvius.com). Within these terms the Committee and its individual members are empowered to obtain outside legal or other independent professional advice (at the cost of the Company). Such powers were not required during the year. The Committee may also secure the attendance at its meetings of any employee or other parties with relevant experience and expertise should it be considered necessary.
Activities in 2013
In 2013 we particularly focused on the requirements arising from guidance and regulation relating to financial reporting, and in particular on changes to narrative reporting. I and the other members of the Committee believe that we received sufficient, relevant and reliable information from management and the external auditor, to enable us to discharge our responsibilities. Rather than reporting our meetings chronologically I will highlight the areas of our focus.
In relation to the year under review, we discharged our primary responsibility to review the integrity of the half year and annual financial statements with management and the external auditor. This included assessing:
- The quality, acceptability and consistency of the accounting policies and practices
- The clarity and consistency of the disclosures, including compliance with relevant financial reporting standards and other reporting requirements
- Significant issues where judgements have been made that are material to the reporting or where discussions have taken place with the external auditor in arriving at the judgement or estimate
- At the request of the Board, whether the Annual Report and Accounts taken as a whole is fair, balanced and understandable taking into consideration all the information available to the Committee.
The Committee deliberated reports from the Chief Financial Officer and Group Financial Controller that were well prepared and analysed various alternatives as appropriate. KPMG also delivered memoranda for the half-year and year-end reporting their views on significant issues. KPMG provided a summary for each issue, including their assessment of the prudence of management's judgements. The Committee considered the overall degree of prudence applied this year and also in comparison with the prior year. Importantly, the Committee agreed with KPMG that the judgements made were cautious, but not overly prudent, and consistent over time. Consistency remained a critical consideration, so that the trend in reported performance is not distorted by differing judgements on issues that span more than one reporting period. KPMG proposed no material audit adjustments arising from their audit work, which provided additional comfort to the Committee.
Significant Issues and Material Judgements
In discussing the significant issues and areas of material judgement, I have distinguished between issues that were specific to the year and ongoing topics that persist from year to year. Both were and are important areas for the Committee to consider, but the ongoing topics have been and are covered regularly in the accounts with disclosures and are generally common topics across many companies.
Significant topics specific to the year:
- Recognition of US deferred tax asset. The recognition of £29.2m of deferred tax assets as explained in Note 12 was a major judgement taken during the second half of the year and was arrived at after extensive modelling, specifically of future profits in the United States. The Group has additional tax losses and other timing differences in the United States and elsewhere which have not been recognised, but recognition will be kept under review in future years as expectations of future profits, and hence the prospects for utilising these losses, evolve. This is a highly technical area where the Committee drew on the views of internal and external experts to agree the treatment.
- Disposal of Precious Metals. The disposal of the Precious Metals Processing division in the year was completed and a number of warranties were given, for which reasonable and prudent reserves have been established. The Committee agreed the accounting treatment and the outstanding matters on the disposal were completed within expectations.
- VAT Claim. As noted in the Contingent Liability Note 37, the Precious Metals Processing business in the UK was subject to a Missing Trader VAT fraud claim by HMRC. During the second half of the year this claim failed and the prior year provision that had been made was substantially reversed within Discontinued Operations. The Committee was regularly updated on progress and agreed the accounting treatment.
Significant ongoing topics considered were:
- Income Tax provisions. Provisioning for income tax is an ongoing complex area where major judgements are made, for example, on provisions relating to taxes that might arise from transfer pricing policies. The Committee agreed the overall tax provision of £45.0m, as reflected in the Group balance sheet, after consideration with internal and external experts.
- Other provisions. The Committee considered the level of provisions established in the context of all available internal and external advice, together with any existing insurance cover. The level of provisions held in respect of open litigation matters is an area of significant ongoing management judgement. Provisioning for future potential costs associated with businesses disposed of or closed or restructured is a further area where ongoing long-term judgements are required. Expert advice is taken on the relevant areas, including litigation claims, environmental liabilities and warranty claims, together with provisions in respect of indirect taxation matters and the level of
- provisions held was adjusted appropriately as reflected in Note 35 to the accounts. Given that the trading of the Group's steel industry customers was difficult during the year, particular attention was paid again to the working capital reserves held against receivables and inventories to ensure that appropriate levels have been established.
- Impairment of intangible assets. The carrying value of goodwill and other intangible assets, being some £555m and £162m at year-end, respectively, was tested against the current economic backdrop and the Committee agreed that no impairment charge was required (see Note 19).
- Pensions. Given the complexities of the pension accounting treatment and assumptions described in Note 31 to the accounts, these were challenged as to their appropriateness for the Group's major schemes.
The judgements made on each of the significant issues were considered and found to be appropriate and acceptable by the Committee.
The Committee assessed all information available to it in considering the overall drafting of the Annual Report and the process by which the report was compiled and reviewed so as to be able to provide its advice to the Board that the Annual Report is fair, balanced and understandable. The Committee noted that the "understandable" test is challenging given the complexity of the accounting standards that have to be applied.
The Committee considered the process by which management evaluated internal controls across the Group. The Head of Internal Audit provided the Committee with a review and analysis of the assurance provided by the controls and the testing of these controls. The Committee agreed that the review indicated a satisfactory control environment.
The Group is made up of mainly small operating units in geographically diverse locations and so segregation of duties and remote management oversight can give rise to fraud opportunities. Over the years there have been limited instances of fraud, which had been detected and preventative actions taken. The amounts involved were small. The internal audit scope and coverage was reviewed again in light of such risks, and line management was further strengthened. This year the external auditor performed enhanced procedures around the Code of Conduct, the Code itself and the process for embedding it across the Group. The Committee found this further process useful. Each year the General Managers and Finance Managers of the businesses self-certify compliance with Group policies and regulations, which provides another safeguard.
After considering these various processes, the Committee was able to provide its assurance to the Board on the effectiveness of internal control within the Group.
The Committee also continued its monitoring and oversight of the procedures for the receipt, retention and treatment of complaints by employees. This is an independent and confidential service worldwide where employees may register any concerns about any incorrect or irregular practices they perceive in their workplace. The very limited number of complaints were followed up appropriately and related to organisational grievances. The effectiveness of these procedures will be reviewed further during 2014.
The Group's internal audit function operates on a global basis. The Head of Internal Audit is responsible for the team of five professionally qualified individuals located in the major regional areas of the Group's activities. As in previous years, the team carried out assignments in accordance with an annual internal audit plan approved by the Committee. The plan is based on assessed risks and aims to cover all locations on a three-year cycle as the minimum.
In 2013, 48 audit assignments were undertaken covering 30% of the business. The Head of Internal Audit reports directly to me and the Committee reviewed progress against the plan and discussed recent reports from the Head of Internal Audit at each of its meetings. Where control issues or other problems were flagged by the fieldwork the Committee ensured appropriate and timely action by the responsible management, involving senior management as necessary, with a follow-up review. An internal survey of the quality and effectiveness of internal audit was undertaken and again the team scored highly on their professional approach. The long-standing Head of Internal Audit retired at the end of the year and a successor has been recruited. She will review and, as necessary, further develop the effectiveness of the internal audit function.
Risk management is inherent in the business planning processes of the Group and risk registers were constructed and reviewed in each major business. The Head of Internal Audit coordinated the accumulation of these operational risks for consideration by the Group Executive Committee and then by the Board, who also input top-down strategic risks into the process. The Committee oversaw this process and its members fully participated in the Board examination of risks and mitigating actions. In particular, the Committee determined that the principal risks and uncertainties as set out on in the Principal Risks and Uncertainties of the Strategic Report properly reflect the outcome of this process.
The Committee and the Board is committed to the continued excellence of the external audit process and this expectation is well understood by management. The effectiveness of the external audit in the past year was tested by reviewing the quality of issues and challenges raised by KPMG to the Committee and to management across the Group, supported by a quality review carried out by the Group Financial Controller. The effectiveness of the external audit was deemed high by the Committee and management.
The audit report provided by KPMG set out within the Independent Auditor's Report to the Members of Vesuvius plc provides a summary of the scope, coverage and materiality levels applied by KPMG in the audit. The Committee agreed as part of the audit planning based on the forecast results of the year and a detailed risk assessment, a materiality figure of £7.0m for Group financial reporting purposes. Importantly much lower levels of materiality are used in the audit fieldwork on the individual businesses in the Group and these lower figures drive the scope and depth of audit work. Small operations were subject to statutory audit but were also subject to internal audit reviews based on risk assessments. Any misstatements at or above £0.4m are reported to the Committee. There were no significant changes to the audit scope during the course of the audit.
The KPMG audit fee was reviewed in light of the audit work required and thence agreed by the Committee for recommendation to the Board. The Board approved the fee estimate, which is flat with 2012 for the Group's continuing operations.
KPMG provided updates at the half year and running up to the year-end, including commentaries on significant issues and their assessment of prudence in the judgements made. Private sessions were held with KPMG without management being present covering reporting and control issues in the context of the demerged Group and the resourcing of the finance team. More specific matters discussed included the auditor's assessment of management's identification of business risks and of the action taken by management in relation to them. In these sessions KPMG confirmed that their work had not been constrained in any way and that they were able to exercise their appropriate professional scepticism and challenge through the audit process.
External Auditor Independence
The Committee continued to operate safeguards to ensure that the independence and objectivity of the external audit was and is not compromised, including:
- Regular confirmation that the external auditor is independent of the Company in its own professional judgement
- Evaluating all the relationships between the external auditor and the Group, including those relating to the provision of non-audit services to determine whether these impair, or appear to impair, the auditor's independence.
In accordance with established Group policy, the external auditor was, and is, prohibited from performing services where it:
- May be required to audit its own work
- Would participate in activities that would normally be undertaken by management
- Is remunerated through a "success fee" structure
- Acts in an advocacy role for the Group.
Other than these, the policy does not impose an automatic prohibition on the external auditor undertaking non-audit work that is not, or is not perceived to be, in conflict with auditor independence, provided it has the skill, competence and integrity to carry out the work in the best interests of the Group. In the coming year, the Committee will consider the implications of the draft EU legislation on further limiting non-audit work by the external auditor. The Group's existing policies will probably have to become more restrictive as a result of the changes, but the Committee's overriding principle will continue to be that the quality of the external audit should not be compromised in any way by any other activity.
An annual budget for non-audit related fees which management is proposing to pay to the external auditor, is presented for pre-approval to the Committee. Where the non-audit fee is likely to be in excess of £50,000, it must be pre-approved by the Committee and where appropriate, services are tendered prior to the awarding of work.
During 2013, the non-audit fees amounted to £0.2m, or 12% of the audit fee, primarily relating to assurance services related to the review of the Company's interim financial statements and taxation advice (see Note 6). This showed a large reduction from 2012 where KPMG undertook significant work relating to the demerger. The Committee also monitored fees paid to other accounting firms as part of the review so as to determine where there might be any current or future conflicts of interest.
External Auditor Reappointment
The Committee is responsible for making recommendations to the Board in relation to the appointment, reappointment and removal of the external auditor. In relation to the reappointment of the external auditor for 2014, the Committee considered various factors, but most importantly the demonstrated quality of the teams delivering the audit, both locally and centrally, and in particular the presence and capabilities of the lead partner. We also consider the overall quality of the firm's work as reflected in the reports of the Audit Quality Review Team of the Financial Reporting Council.
The Committee is well aware that KPMG or its predecessor firms have had a long-standing tenure as the auditor of Vesuvius and its predecessors. The services of KPMG were retained during the demerger in 2012 as it represented the most efficient and cost-effective accounting firm to undertake the work and at that time the lead audit partner was changed in accordance with lead partner rotation regulatory requirements.
Given the tenure, the Committee goes to considerable lengths to determine that the audit by KPMG is of maintained high quality, with excellent staffing, tested by internal reviews by management. The Committee is conscious of the proposals for audit firm rotation from the FRC, the Competition Commission and the EU Commission. Our advice is that the proposed EU legislation (though not yet finally formulated) will prevail, be mandatory and will come into force in the coming year. This will require audit firm rotation after a maximum of ten years with
a possibility of an extension of a further ten years if a competitive tender has taken place at the ten year point, though these periods could be shorter if determined by enabling national legislation. Importantly there are proposed transitional arrangements which, as currently formulated, would require the Group to undertake a competitive tender within six years of the proposed EU legislation coming into force.
The Committee and the Board believe the Group is receiving a very good quality of audit service from KPMG. Consequently, the Board intends that the Group will have a competitive tender process at the time of the next partner rotation in 2016. Meanwhile, demanding audit performance requirements will continue to be applied to KPMG. By 2016 the requirements arising out of what is currently still proposed legislation will be much clearer. As such, the Committee has recommended, and the Board has agreed, that, subject to shareholder approval, KPMG will be reappointed at the 2014 AGM. Should any shareholder wish to discuss this approach and timing with me then I should be happy to do so.
The Committee's activities formed part of the evaluation of Board effectiveness performed in the year. Details of this approach are given in the Performance Evaluation.
On behalf of the Audit Committee
Chairman, Audit Committee
4 March 2014