Chair of the audit committee
- Brian May has chaired the committee since July 2013. He is a serving finance director of a FTSE 100 company and chartered accountant and is considered by the board to have recent and relevant financial experience
- Other regular attendees at meetings include the Chairman, the CEO, the CFO, the company secretary, the head of audit and risk, the group controller, and representatives from the external auditor KPMG LLP (KPMG)
- KPMG and the head of audit and risk both have time with the committee to freely raise any concerns they may have without management being present
- The committee is authorised to seek independent advice as it sees fit, but has not done so during the year
Terms of reference – corporate.unitedutilities.com/corporate-governance
*The Statutory Audit Services for Large Companies Market Investigation (Mandatory Use of Competitive Tender Processes and Audit Committee Responsibilities) Order 2014.
It has been another year of evolution for the work of audit committees, with the publication by the FRC of the 2014 version of the Code and the publication by the Competition and Markets Authority of the Statutory Audit Services Order 2014*. At the request of the board, the audit committee ('the committee') has considered the new requirements.
We are not required to report against the 2014 Code until our next financial year. However, we decided that it was appropriate for the board to provide the long-term viability statement (see here) applying the principles of the 2014 Code, given the long-term nature of our business. For the 2015/16 financial year the committee's terms of reference have been amended to reflect the 2014 Code requirements, and we are committed to ensuring that the committee's agenda is kept under review and keeps abreast of relevant developments.
There have been a number of changes during the year to the membership of the committee. As planned, Nick Salmon stood down at the AGM in July 2014 and Stephen Carter joined the board and the committee on 1 September 2014. I am pleased to welcome Stephen as a member of the committee, his views and previous experience will add considerable breadth of knowledge to the committee. On Nick leaving, Mark Clare replaced him on the remuneration committee, stepping down from the audit committee on 1 September 2014. Although Mark's time on the committee was relatively short, I would like to thank him for his valuable contribution.
Although audit committees have specific responsibilities rooted in reviewing the group's financial statements and reviewing the internal assurance work and external audit of those financial statements, the committee also reviews the internal control and risk management processes, leaving the review of the significant risks to be undertaken by the board. A lot of the work of the committee is necessarily targeted at the regulated activities of UUW, which represents over 98 per cent of group revenues. This is a reflection of our commitment to safeguarding the interests of our customers; all the members of the committee are also independent non-executive directors of UUW. Details of the committee's activities over the past year are set out below.
We have again worked to enhance this report and make it more informative for the reader and we continue to be committed to providing meaningful disclosure of the committee's activities.
The following report was approved by the committee at its meeting held on 14 May 2015.
Chair of the audit committee
The committee's agenda is kept under review and keeps abreast with relevant developments
Main responsibilities of the committee
The main responsibilities of the committee are:
- to make a recommendation to the board for the appointment or reappointment of the auditor, and to be responsible for the tender of the audit from time to time and to agree the fees paid to the auditor;
- to establish policies for the provision of any non-audit services by the auditor;
- to review the scope and the results of the annual audit and report to the board on the effectiveness of the audit process and how the independence and objectivity of the auditor has been safeguarded;
- to review the half-year and annual financial statements and any announcements relating to financial performance, including reporting to the board on the significant issues considered by the committee in relation to the financial statements and how these were addressed;
- to review the scope, remit and effectiveness of the internal audit function and the group's internal control and risk management systems;
- to review the group's procedures for whistleblowing, reporting fraud and other inappropriate behaviour and to receive reports relating thereto; and
- to report to the board on how it has discharged its responsibilities.
What has been on the committee's agenda during the year
In addition to fulfilling its ongoing duties, the committee has an extensive agenda of items addressing issues relating to the day-to-day activities of the business which it deals with in conjunction with senior management, the auditor, the internal audit function and the financial reporting team. There were four scheduled meetings of the committee during the year. Items on the agenda included:
- considering the issues and findings brought to the committee's attention by the internal audit team and satisfying itself that management has resolved or is in the process of resolving any outstanding issues or concerns;
- reviewing the assurance work undertaken by internal audit relating to: the content of the regulatory business plan and the processes supporting the preparation of the plan; and the annual regulatory reports;
- reviewing the reports from the financial reporting team on the financial statements, including the UUW financial statements and other regulatory reports, and considering matters such as the accounting judgements and policies being applied;
- reviewing the audit reports from KPMG on the financial statements and tasking management to resolve any issues relating to internal controls and risk management systems;
- reviewing the going concern and longer term viability assessments prior to making its recommendations to the board;
- annual review and approval of the policy on non-audit services provided by the auditor including the continued use during 2014/15 of Makinson Cowell (now owned by KPMG);
- monitoring incidents of whistleblowing and fraud reporting;
- biannual oversight and monitoring of the group's compliance with the Bribery Act which the board reviews annually;
- overseeing and approving the strategic internal audit planning approach;
- an externally facilitated review of the quality and effectiveness of internal audit; and
- reviewing the committee's terms of reference and the conclusions of the committee's annual evaluation. The externally facilitated evaluation was undertaken as part of the overall board evaluation (see Corporate governance report). The review explored: time management and the composition of the committee; the committee's processes and support; and the agenda and work of the committee. It was concluded that the committee was effective.
How we assessed whether 'the annual report and accounts, taken as a whole, is fair, balanced and understandable and provides the information necessary for shareholders to assess the company's position and performance, business model and strategy'
The committee, further to the board's request, has reviewed the annual report and financial statements with the intention of providing advice to the board on whether, as required by the Code, 'the annual report and accounts, taken as a whole, is fair, balanced and understandable and provides the information necessary for shareholders to assess the company's position and performance, business model and strategy'.
To make this assessment, all members of the committee received copies of the annual report and financial statements to review early in the drafting process to ensure that the key messages being followed in the annual report were aligned with the company's position, performance and strategy being pursued; and that the narrative sections of the annual report were consistent with the financial statements. The significant issues considered by the committee in relation to the financial statements were consistent with those identified by the external auditor in the Independent auditor's report.
The presentation of the company's business model has been reformatted to make it more understandable for the reader and there are clear linkages to the company's strategic objectives throughout the document.
The committee concluded that the key performance indicators (KPIs) included in the strategic report were, amongst others, those used by management and, for consistency and comparative purposes, should be retained unamended (other than to reflect regulatory reporting changes) up until the 31 March 2015 financial year-end. As is described in the strategic report, management have refined the KPIs used for 2015–20 reflecting the new measures to be monitored by Ofwat during that period.
In addition, the committee was satisfied that all the key events and issues which had been reported to the board in the CEO's monthly report during the year, both good and bad, had been adequately referenced or reflected within the annual report.
How we assessed the effectiveness of the external audit process
The committee, on behalf of the board, is responsible for the relationship with the external auditor, and part of that role is to examine the effectiveness of the audit process.
Audit quality is a key requirement. Prior to the statutory audit at the half-year, KPMG presented the strategy and scope of the audit for the financial year, highlighting any areas requiring special consideration. KPMG then reported against this audit scope at subsequent committee meetings.
On completion of the audit at the full-year, all members of the committee, as well as key members of the senior management team, were required to complete a questionnaire seeking their views on how well KPMG performed the year-end audit. The views of the respondents was sought in respect of: the robustness of the audit process; the quality of the delivery of the audit; the expertise of the audit team conducting the audit and that the degree of professional scepticism applied by the auditor was appropriate; the quality of the service they gave; and their views on the quality of the interaction between the audit partner and audit manager and the company. The feedback was collated and presented to the committee's meeting in November 2014, at which the conclusions were discussed and any opportunities for improvement brought to the attention of the external auditor.
Private meetings are held at each committee meeting between the audit committee and the representatives of the external auditor without management being present in order to encourage open and transparent feedback by both parties. The committee was satisfied that the overall external audit process and services provided by KPMG were effective.
How we assessed the independence of our external auditor
There are two aspects to the auditor independence test that the committee monitors.
First, in accordance with the Auditing Practices Board Ethical Standards, KPMG has to implement rules and requirements such that none of its employees working on our audit can hold any shares in United Utilities Group PLC. KPMG is also required to tell us about any significant facts and matters that may reasonably be thought to bear on its independence or on the objectivity of the lead partner and the audit team. The lead partner must change every five years and the quality review partner, who reviews the judgements of the audit team actually doing the audit, rotates every seven years along with the key audit partner.
Secondly, the committee considers and approves all the fees that it pays for audit, audit-related and non-audit services from KPMG. KPMG is prohibited from providing certain services to the group, such as operational consulting, internal audit services and strategic planning support, as it is felt that these types of services could impede their independence. Furthermore, auditor independence is also safeguarded by limiting the value of non-audit services performed by the external auditor which should not ordinarily exceed 100 per cent of the audit fee. The committee has discretion in exceptional circumstances or where a compelling commercial justification can be provided for this cap on non-audit fees to be exceeded. The CFO can pre-approve expenditure in respect of non-audit services, such as tax compliance work of up to £100,000 (as was the figure for the year ended 31 March 2015) thereafter, any fees for non-audit services up to 100 per cent of the audit fee cap can be approved by the committee chair. Any such fees are reviewed and, if appropriate, ratified by the committee.
For a number of years, the group has engaged the consultancy firm Makinson Cowell to provide it with investment research and advice. As reported in the 31 March 2014 annual report, Makinson Cowell was acquired by KPMG in June 2013, therefore the fees paid to Makinson Cowell are included in the total of 'other non-audit services' paid to KPMG (see the bar chart below). As part of the annual review by the committee of the non-audit services policy the engagement of Makinson Cowell was considered. The committee took into account the board's satisfaction with the services provided by Makinson Cowell and concluded that it was appropriate for their services to be retained for the year ended 31 March 2015.
As part of UUW's licence conditions it is required to prepare audited regulatory accounts, which are derived from the statutory financial statements. Given the audit of the statutory financial statements is already undertaken by KPMG, there are efficiencies and cost savings if KPMG also audits the regulatory accounts. Fees paid to KPMG also include audit related services in relation to UUW regulatory assurance work as shown in the bar chart below.
Taking into account our findings in relation to the effectiveness of the audit process and in relation to the independence of KPMG, the committee was satisfied that KPMG continues to be independent, and free from any conflicting interest with the group. As a result, the committee recommended to the board that KPMG be proposed for reappointment at the forthcoming AGM in July 2015. There are no contractual obligations that restrict the committee's choice of external auditor and no auditor liability agreement has been entered into.
The external audit was last competitively tendered in March 2011 when KPMG was appointed and completed the audit for the year ended 31 March 2012. The committee has considered the final Statutory Audit Services Order 2014 published by the Competition and Markets Authority which came into effect on 1 January 2015. The committee's terms of reference already provided for the competitive tender of the external audit contract every 10 years, and for the committee to be responsible for overseeing the tender process and agreeing the scope of the audit, but they have been amended to reflect that the committee shall be responsible for agreeing the audit fee and the appointment of the audit engagement partner. Terms of reference can be found at corporate.unitedutilities.com/corporate-governance.
The committee is also mindful of the EU Audit Directive and Regulation of the Audit of Public Interest Entities on which the FRC has issued a consultation, the outcome of which was awaited at the time of writing this report.
Fees paid to KPMG
Significant issues considered by the committee in relation to the financial statements and how these were addressed
In relation to the group's financial statements, the committee reviewed the following principal areas of judgement (as noted in the accounting policies):
Capitalisation of fixed assets
Fixed assets represent a subjective area, particularly in relation to costs permitted for capitalisation and depreciation policy.
- The committee considered the capital overhead rate which management proposed to apply for the next five-year regulatory period. The capital overhead rate historically has been established at the commencement of each five-year regulatory period and is applied as a percentage of capital expenditure to charge certain capital overhead costs to capital projects. Management explained the basis upon which the proposed capital overhead rate for the next five-year regulatory period had been determined and why it was considered an appropriate rate to adopt.
The committee challenged management over the factors which had been considered in determining the rate and its consistency against rates applied previously. In addition, the committee considered the views of KPMG, particularly that the proposed capital overhead rate was within the range used by other utility companies of which they were aware. The committee concluded that management had taken appropriate steps in determining the future rate to be applied.
- The committee requested that management provide it with an update on the implementation of a new reactive work order scheduling and settlement system and specifically the realisation of the financial reporting benefits the system would bring in automating the process and enhancing cost allocation accuracy. Management reported to the committee that in May 2014 functional changes had been successfully implemented. The committee noted the improvements resulting from the new system.
Revenue recognition and allowance for doubtful receivables
Due to the nature of the group's business, the extent to which revenue is recognised and doubtful customer debts are provided against is an area of considerable judgement and estimation.
- The committee considered the appropriateness of the existing revenue recognition policy which derecognises revenue for certain customers who have not paid their bills within a particular period of time. After reviewing cash collection history and practice, the committee concluded the revenue recognition policy was appropriate.
- The committee also questioned the current levels of doubtful debt and credit note provisioning (see note 15 for more detail). The committee challenged management over the adequacy of the overall levels of provisioning following these reviews and were satisfied that the resulting net debtor balance was appropriate.
Provisions and contingencies
The group makes provisions for contractual and legal claims which by their nature are subjective and require management to arrive at a best estimate as to the probable outcomes and costs associated with each individual case.
- The committee received regular updates on new and existing claims being made against the group and the extent to which these have been provided for (see note 20 for details). The committee focused their attention on the more significant items and discussed the judgements made by management in arriving at appropriate provisions in relation to these matters.
- Based on the facts behind each provision and taking account of any relevant legal advice that may have been received as well as the past experience of management in making such provisions and challenging where necessary the views taken by management and through the assurance provided by KPMG who cover these as part of their audit, the committee concluded that the provisions management had made were appropriate.
Retirement benefit obligations
The group's defined benefit retirement schemes are an area of considerable judgement and the performance and position of which is sensitive to the assumptions made.
- The committee sought from management an understanding as to the factors which led to the significant improvement in the IAS19 net retirement benefit position during the period and noted that the scheme-specific funding basis had not been impacted by this volatility. Management presented an explanatory note in order to communicate most effectively what is a complex area for the benefit of the group's stakeholders. The committee was satisfied with the explanations provided by management and following a review of the explanatory note approved its inclusion in the financial statements.
- The committee reviewed the methodology and assumptions used in calculating the defined benefit scheme positions (see note A4 for more details). The committee employs the services of an external actuary to perform these calculations and determine the appropriate assumptions to make. The external actuary prepared a report showing how the assumptions applied compared to their client base and this was summarised for the committee's information. In addition, KPMG audit these assumptions and provide their own report showing how the assumptions applied compare against other companies. After considering the above, the committee concluded that the approach taken and assumptions made were appropriate and fairly balanced in determining the net retirement benefit surplus.
Derivative financial instruments
The group has a significant value of swap instruments, the valuation of which is based upon models which require certain judgements and assumptions to be made. The committee requires management to perform periodic checks to ensure that the model derived valuations agree back to third party valuations and that KPMG check a sample against their own valuation models. It was confirmed to the committee that such testing had been undertaken during the year and there were no significant issues identified.
The committee considered the tax risks that the group faces and the key judgements made by management underpinning the provisions for potential tax liabilities and deferred tax assets. In addition, the committee took account of KPMG's assessment of these provisions. Based on the above, the committee was satisfied with the judgements made by management.
The main features of the group's internal controls and risk management systems are summarised below:
a. Internal audit function
The internal audit function is a key element of the group's corporate governance framework. Its role is to provide independent and objective assurance advice and insight on governance, risk management and internal control to the audit committee, the board and to senior management. It supports the organisation's vision and objectives by evaluating and assessing the effectiveness of risk management systems, business processes and internal controls.
In addition to reviewing the effectiveness of these areas and reporting on aspects of the group's compliance with them, internal audit makes recommendations to address any key issues and improve processes. Once any recommendations are agreed with management, it monitors their implementation and reports to the committee on progress made at every meeting.
A five-year strategic audit planning approach has been developed and adopted during the year. This facilitates a more efficient deployment of internal audit resource in providing assurance coverage over time across the whole business. Following approval by the audit committee, this strategic approach supports the annual audit plan, which is then endorsed by management, and which the committee also approves. The plan focuses the team's work on those areas of greatest risk to the business. Building on the strategic planning approach, the development of the plan considers risk assessments, issues raised by management, prior audit findings and a cyclical review programme. The in-house team is expanded as and when required with additional resource sourced from external providers – primarily PwC at present. The committee keeps the relationship with PwC under review to ensure the independence of the internal audit function is maintained. In the course of its work, the internal audit function also liaises with the statutory auditor, discussing relevant aspects of their respective activities which ultimately supports the assurance provided to the audit committee and board.
The effectiveness of the internal audit function's work is continually monitored using a variety of inputs including the ongoing audit reports received, the audit committee's interaction with the head of audit and risk, an annual review of the department's internal quality assurance report, annual stakeholder surveys in which committee members also participate as well as any other periodic quality reporting requested. In addition, during 2015, the quality and effectiveness of the internal audit function was externally assessed. Following this assessment, the committee concluded that the internal audit function was effective and appropriate resources available as required.
Internal audit, led by the head of audit and risk, covers the whole of the group's activities and reports to the committee and functionally to the CFO. The head of audit and risk attends all scheduled meetings of the audit committee, and has the opportunity to raise any matters with the members of the committee at these meetings without the presence of management. He is also in regular contact with the chair of the committee outside of the committee meetings.
b. Risk management systems
The committee receives updates and reports from the head of audit and risk on activities relating to the company's risk management systems and processes at every meeting. These are then reported to the board, as appropriate. The group designs its risk management activities in order to manage rather than eliminate the risk of failure to achieve its strategic objectives.
A five-year strategic audit planning approach has been developed and adopted to facilitate a more efficient deployment of internal audit resource in providing assurance.
The CFO has executive responsibility for risk management and is supported in this role by the head of audit and risk and the corporate risk manager and his team. The group audit and risk board (GARB) is a sub-committee of the executive team. The GARB meets quarterly and reviews the governance processes and the effectiveness and performance of these processes along with the identification of emerging trends and themes within and across the business. The work of the GARB then feeds into the information and assurance processes of the audit committee and into the board's assessment of risk exposures and the strategies to manage these risks.
The annual business unit risk assessment process (BURA) seeks to identify how well risk management is embedded across the different teams in the business. The BURA involves a review of the effectiveness of the controls that each business unit has in place to mitigate risks relating to activities in their area of the business, to encourage the identification of new and emerging risks and generally to facilitate improvements in the way risks are managed. The outcome of the BURA process is communicated to the executive team and the board. This then forms the basis of the determination of the most significant risks that the company faces which are then reviewed by the board. During the year, new risk management software was developed and is in the process of implementation across the business with a view to enhancing the company's risk management process.
c. Internal controls
The committee reviews the group's internal control systems and receives updates on the findings of internal audit's investigations at every meeting, prior to reporting any significant matters to the board. Internal control systems are part of our 'business as usual' activities and are documented in the company's internal control manual which covers financial, operational and compliance controls and processes. Internal control systems are the responsibility of the CFO, with the support of the GARB, the internal audit team and the financial control team, although the head of audit and risk and his team are directly accountable to the audit committee.
Confirmation that the controls and processes are being adhered to throughout the business is the responsibility of managers, but is continually tested by the work of the internal audit team as part of its annual plan of work which the committee approves each year. Compliance with the internal control system is confirmed annually by the completion of a self-assessment checklist by senior managers in consultation with their teams. The results are then reviewed and audited by the internal audit team and reported to the committee.