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The support for audit committees has gained impetus in the last two decades primarily as a result of corporation failures due to poor corporate controls and low confidence in the credibility of financial statements, independence and effectiveness of the external audit function. In the light of these problems, more attention was given to the establishment of audit committees and their role to enhance the reliability and quality of financial statements.

Despite the fact that there is still no statutory requirement to have an audit committee in the UK, public sector initiatives are in evidence from as early as 1973. The internal

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audit in the Civil Service noted the advantage of having an audit committee that included the discussion of audit plans and results as one of its roles. Private sector initiatives have been most active in the last two decades. In 1977, the Companies Bill tried to advocate for legislation on the establishment of audit committees. However, its efforts were unsuccessful (Dafinone 2001).

In 1982, Pro-Ned, an organization for the promotion of non-executive directors, was set up by the Bank of England, CBI, and other financial institutions (Goobey, 2001). In 1987, Pro-Ned published the Code of Recommended Best Practice (Pro-Ned, 1987) which included the recommendation that

“…the appointment of non-executive directors… to facilitate the establishment of audit committees in large quoted companies”

In 1986, an Institute of Chartered Accountants of England and Wales working party recommended that audit committees be responsible for both the appointment and remuneration of auditors, the approval of audit plans and the review of management reports issued by auditors. In 1987, the Bank of England issued a paper entitled “the Role of Audit Committees in Banks” that recommended that all banks have to establish an audit committee (Vanasco, 1994b). In the same year, the London Stock Exchange also recommended that all listed companies should establish audit committees composed of non-executive directors.

On May 1991, the Financial Reporting Council, the London Stock Exchange and the Accountancy Profession established the Committee on the Financial Aspects of Corporate Governance to address the financial aspects of corporate governance. In 1992, this committee published its recommendations in a Code of Best Practice- The Cadbury Report (Cadbury Committee 1992).

This report required that all companies listed on the Stock Exchange should disclose, as a continuing listing obligation, a statement of compliance with the Code of Best Practice. It further recommended that the external auditors should review the statement of compliance and they were also required to state if the company had complied with the Code of Best Practice. Paragraph 4.3 of the Code of Best Practice recommended that the Board should establish an audit committee of at least 3 non-

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executive directors with written terms of reference, which deal clearly with its authority and duties (Cadbury Committee 1992).

The Hampel Report (1998) restated the recommendations with respect to the establishment, structure, role and duties of audit committees in the UK. The recommendations of both reports (Cadbury Committee and Hampel Report) were included in the Combined Code on Corporate Governance.

The Turnbull Report (1999) considered the role of audit committees and highlighted that the annual review of the effectiveness of internal control could be delegated to the audit committee. However, the definition of internal control in this report was widened to include all controls rather than just financial controls. The delegation of this review to the audit committee therefore inferred that audit committee roles could be extended to include an assessment of the overall risk to the organization.

In late July 2002, the Government asked the Financial Reporting Council (FRC) to put in hand the development of the existing Combined Code guidance on audit committees. On 12 September the FRC issued a Press Notice announcing the establishment of the FRC-Appointed Group. A report by this group was submitted to the FRC in December 2002 and published in January 2003. This report is well known as the Smith Guidance on Audit Committees. This guidance is designed to assist companies in making suitable arrangements for their audit committees and to assist directors serving on the board of audit committees in carrying out their role.

This guidance includes certain essential requirements that every audit committee should meet. Compliance with these is necessary for compliance with the Code. Listed companies that do not comply with these requirements should include an explanation as to why they have not complied with these requirements in the statement required by the Listing Rules. It is recognized that some of the requirements may be inappropriate for some listed companies. In particular, many smaller companies may have fewer than three non-executive and independent directors. All listed companies are encouraged to meet the requirements but if they cannot, or if they believe that a requirement is inappropriate in the circumstances of the company, the right course is to explain the position. Finally, this guidance applies to all the UK-

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listed companies and shall apply in respect of accounting periods starting on or after 1 January 2003.

In April 2002, the Secretary of State, Patricia Hewitt, and the Chancellor, Gordon Brown, appointed Derek Higgs to lead a short independent review of the role and effectiveness of non-executive directors. Higgs published his report in January 2003 (Higgs 2003).

Whereas in the US most governance discussion has focused on corporate malpractice, in the UK sharp loss of shareholder value is more common than fraud or corporate collapse. The fall in stock markets in the period 2000-2002 has thrown up some harsh examples. In recent cases of corporate under performance in the UK, the role of the board and its committees has been called into question. Thus, Higgs Report focuses on enhancing the competence and effectiveness of boards and on issues of accountability.

In July 2003, the FRC issued its latest report regarding Corporate Governance entitled the Combined Code on Corporate Governance. This Code supersedes and replaces the Combined Code issued by the Hampel Committee (1998) on Corporate Governance. It derives from a review of the role and effectiveness of non-executive directors (Higgs 2003) and a review of audit committees. It is intended that the new Code will apply for reporting years beginning on or after 1 November 2003.

The Code contains main and supporting principles and provisions. The existing Listing Rules require listed companies to make a disclosure statement in two parts in relation to the Code. In the first part of the statement, the company has to report on how it applies the principles in the Code. In future this will need to cover both main and supporting principles.

The form and content of this part of the statement are not prescribed, the intention being that companies should have a free hand to explain their governance policies in the light of the principles, including any special circumstances, applying to them which have lead to a particular approach.

In the second part of the statement the company has either to confirm that it complies with the Code’s provisions or – where it does not – to provide an explanation. This

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‘Comply or Explain’ approach has been in operation for over ten years and the flexibility it offers has been widely welcomed both by company boards and by investors. It is for shareholders and others to evaluate the company’s statement.

While it is expected that listed companies will comply with the Code’s provisions most of the time, it is recognized that departure from the provisions of the Code may be justified in particular circumstances. Every company must review each provision carefully and give a considered explanation if it departs from the Code provisions. In summary, despite the fact that the establishment of audit committees is not mandated by statute in the UK, the self-regulation approach, which has been taken by government through the FRC, requires all listed companies to disclose in their annual reports the degree of compliance with the Combined Code on Corporate Governance. It is felt that a statutory regime would not be as flexible and adaptable as a self- regulatory system (Financial Reporting Council, 2003).