Codewords
Don Bawtree and Fiona Condron review financial reporting guidance and its particular relevance to the non-profit sector
With two new corporate governance codes in the sector, revisions to Charity Commission guidance and more recent additional guidance from the Financial Reporting Council for audit committees, trustees may be wondering exactly what they should be doing in terms of governance and compliance in 2011.
It is worth therefore understanding where good practice can be drawn from both codes. It is also important to pick up other requirements which sit within the codes themselves.
The UK Corporate Governance Code
The UK Corporate Governance Code was issued on 28 May 2010.1 This code sets out standards of good practice for listed companies in relation to issues such as board composition and development, remuneration, accountability and audit and relations with shareholders. The 2010 code replaced the Combined Code 2008, the last significant revisions to which were made in 2003 to incorporate recommendations from the Higgs and Smith reports.2
The FRC’s review of the 2008 Combined Code took place against the background of a significant decline in economic conditions in the UK and was conducted in parallel to a separate review of the governance of banks carried out by Sir David Walker.
The intent of the changes is to improve the governance of listed companies in the UK. Nevertheless there are many areas of best practice which can be translated and applied in the voluntary sector.
Four new main principles have been introduced in the 2010 Corporate Governance Code addressing the:
- chairman’s responsibility for leading the board;
- need for directors to devote sufficient time;
- requirement for non executive directors to constructively challenge and develop strategy and;
- need for the board to have balance of skills and experience.
In addition to new main principles, some existing principles have been extended or amended. The main changes from are summarised as follows:
- In order to encourage boards to be well balanced and avoid ‘group think’, there are new principles on the composition and selection of the board, including the need to appoint members on merit, against objective criteria, and with due regard for the benefits of diversity, including gender diversity.
- To promote proper debate in the boardroom, there are new principles on the leadership of the chairman, the responsibility of the non-executive directors to provide constructive challenge, and the time commitment expected of all directors.
- To help the board’s performance and awareness of its strengths and weaknesses, the chairman should hold regular development reviews with each director and board evaluation should be externally facilitated, for larger organisations, at least every three years.
- To increase accountability to shareholders, all directors of larger companies should be re-elected annually and chairmen are encouraged to report personally on how the principles relating to the leadership and effectiveness of the board have been applied.
- To improve risk management, the company’s business model should be explained and the board should be responsible for determining the nature and extent of the significant risks it is willing to take.
- Performance-related pay should be aligned to the long-term interests of the organisation and its risk policies and systems.
Application to the charity sector
These general principles have direct application across to the charity sector, for instance:
- How often is the chairman actually seen, or is actually, acting as some sort of super CEO, rather than concentrating on managing the board? ‘The chair, as well as helping to plan and chair trustee meetings, may also be the link between the trustees and the employees and representing the charity at appropriate events. However, when it comes to making decisions about the charity, the trustees must take them together.’
- Do trustees have enough time to operate effectively? This applies not only to the overall time commitment but appropriate amounts of time in meetings to discuss relevant issues. The Charity Commission also consider the need for appropriate energy levels in ‘The Essential Trustee’:3 ‘Giving adequate time and energy: Being a trustee will involve preparation for and attendance at trustee meetings, and often also at other meetings and functions. It is essential that trustees are able to devote enough time to these essential duties of being a trustee. This means they should be aware of their responsibilities and duties and how much time they will need to give.’
- Non-executive challenge is a helpful reminder that the occasional argument is a good thing, and trustees should not be steamrollered by the executive, or a dominant trustee. This provision also focuses on ‘strategy’ – another important reminder for trustees to focus on the big issues – not to spend hours discussing the colour of the new paintwork. The Good Governance Code refers more delicately to ‘avoiding inappropriate involvement in operational matters.’
- Balancing the board relates to skills, experience and diversity. This is certainly an increased focus for commercial organisations but one which charities are generally more aware of. The subsequent reference to “group think” certainly applies in charities, and is a useful prod to consider how – and how often – the board is refreshed, a topic which the Good Governance Code also addresses. The charity code and the corporate code both refer to board and trustee appraisal – but note the corporate code’s quite explicit requirement for some sort of externally facilitated review every three years. This is likely to become a routine process in most of the larger charities as they seek to match high standards of governance. The Good Governance Code suggests that boards reflect on performance and functioning of the board and its committees as teams, and identify and deal with any areas for improvement.
- Accountability is engrained into the sector: but there is not much guidance out there in terms of what chairs should be saying in annual reports about govern-ance and accountability. Statements of internal control and audit committee reports are standard in public sector and government funded organisations, and one can foresee these sorts of statements becoming more common in charities.
Charity Commission guidance
The Charity Commission issued some guidance which impinges on governance during 2010. In its revised risk management guidance (Charities and Risk Management, June 20104) the Commission encourage boards to say more about risk:
‘Many charities, particularly larger charities or those with more complex activities, will, as a matter of best practice, expand on this basic approach in their reporting. Where this more detailed approach to reporting is adopted the following broad principles can be useful:
- a description of the major risks faced;
- the links between the identification of major risk and the operational and strategic objectives of the charity;
- procedures that extend beyond financial risk to encompass operational, compliance and other categories of identifiable risk;
- the link between risk assessment and evaluation to the likelihood of its occurrence and impact should the event occur;
- a description of the risk assessment processes and monitoring that are embedded in management and operational processes;
- trustees' review of the principal.’
Apart from their guidance on risk, the Commission also reissued CC8 ‘Internal financial controls for charities’ in the summer of 2010. This too includes some requirements for trustees which support both the charity and the corporate code. Two specific excerpts are helpful.
The first (‘The tone at the top’) is a reminder that the trustees are responsible for the overall attitude to control and management. The second (‘Review of controls’) is a new specific requirement which the trustees may wish to incorporate into any corporate governance statement.
1) ‘The tone at the top’
‘Executive management and the charity's staff and volunteers are responsible for ensuring that the controls put in place by the trustees are implemented. There should be a culture of control embedded in the operations of the organisation; this culture is created by the trustees and senior management, who should lead by example in adhering to the charity's internal financial controls and good practice.’
This wording is also reflected in the Good Governance Code,5 within principle 1: ‘The board should consider how it will set the culture of the organisation. They should lead by example, ensuring that individuals representing the organisation in any capacity do so in a way that positively reflects its values. The ethos and culture of the organisation should underpin the delivery of its activities or services and the achievement of its objects.’
2) Review of controls
‘The trustees should, at least annually, ensure a review is conducted of the effectiveness of the charity's internal financial controls. This should include an assessment of whether the controls are relevant to, and appropriate for, the charity and not too onerous or disproportionate.’
Trustee and audit committees
FRC update’s relevance to charities
The FRC’s guidance: ‘Financial Reporting Council Update for Audit Committees on issues arising from current economic conditions’ (November 2010)6 focuses upon risk identification and reporting. The update document also seeks to stimulate an appropriate environment for key estimates, assumptions and models produced by management to be challenged in a constructive way and for providing support for auditors carrying out their work with an appropriate degree of professional scepticism.
Whilst the work of the FRC is focused on matters most likely to affect the private sector, the key messages are once again likely to resonate with trustees and audit committee members of voluntary organisations. In the words of the FRC: ‘in the past 12 months the financial crises has taken a further step, with the focus of concern shifting from the banking sector to government deficits and companies that are dependent upon government spending.’
As most of us involved in the non-profit sector know, it is not only companies who are dependent upon government spending.The November update provides additional guidance around three key areas of consideration. These are:
- Assessing and communicating risk and uncertainties. The key question here is whether the annual report clearly sets out the organisation’s activities, principal risks and uncertainties and whether the financial statements describe, with sufficient clarity, all the key judgements? In the current economic climate, has the organisation given full consideration to how the business may have changed to address the effects of the recession and the additional challenges, if any, posed by the forecast significant reduction in government expenditure?
- Reliance on estimates, assumptions and forecasts. It is generally accepted that many areas of the financial statements are based on estimates, assumptions and forecasts. However has the audit committee considered in sufficient detail, how those forecasts have been prepared as well as how sensitive they are to changes in estimates and assumptions? Do models and key assumptions adequately address low probability but high impact events? Has management considered which combination of scenarios could conspire to be the most challenging for the organisation? Again, trustees should refer to CC26, where different methods of assessing risk are discussed.
- Assessing audit quality and creating the right environment for constructive challenge. Questions in this area should focus on the external and internal audits and should consider whether all business and financial risks have been adequately discussed with the auditors such that their work can be appropriately directed.
1. www.frc.org.uk/corporate/ukcgcode.cfm
2. For more background on accounting standards, see ‘Shape of the SORP to come’ by Clarissa Dann in Caritas, Guide to Finance, December 2010, page 26. www.charitiesdirect.com/caritas-magazine/shape-of-the-sorp-to-come-867.html
3. www.charity-commission.gov.uk/ Publications/cc3.aspx
4. www.charitycommission.gov.uk/ Publications/cc26.aspx
5. See also Rodney Buse’s article: ‘Of the sector, by the sector’ in Caritas, issue 36, November 2010, page 7. www.charitiesdirect.com/ caritas-magazine/of-the-sector-by-the-sector-828.html
6. www.frc.org.uk/press/pub2442.html
Author: Don Bawtree
Don Bawtree is lead partner in charities at BDO Stoy Hayward.
He is chair of the Auditing Practices Board committee responsible for publishing APN 11 governing the audit of charities and lectures and writes extensively on charity sector developments.
Author: Fiona Condron
Fiona Condron is a senior manager in the BDO charity team and joined the firm having spent the first ten years of her career with a Big Four firm.
She now focuses exclusively on not for profit clients.
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