Brian May

Chair of the audit committee

These are changing times for audit committees.

Audit committee members

  • Brian May (chair)
  • Mark Clare
  • Nick Salmon
  • Catherine Bell

Biographies of the directors are in the Board of Directors

Dear Shareholder

This is my first report as chair of the audit committee ('the committee'), having taken over the role from Paul Heiden in July last year. On Paul's retirement, Nick Salmon was reappointed as a member of the committee (thereby ensuring at all times there were at least three independent non-executives directors on the committee). I am also pleased to welcome Mark Clare, who joined the board as an independent non-executive director on 1 November 2013, as a member of the committee.

Much of the committee's work, in addition to its role in reviewing the group's financial statements, is necessarily targeted at the regulated activities of UUW, which represents over 98 per cent of group revenues. This reflects our commitment to safeguarding the interests of our stakeholders and all the members of the committee are also independent non-executive directors of UUW, which reinforces this. Details of our activities over the past year are set out below.

During the year, the committee was renamed as the 'audit committee' to help clarify the committee's role in relation to risk, which is to review internal control and risk management processes and systems, but it does not advise the board on current risk exposures and the strategies to manage these risks, which is a matter for the board itself.

These are changing times for audit committees and this report reflects the new requirements placed on audit committees by recent changes to the Code. We are committed in this report to providing a meaningful insight into our activities and this report contains sections on: the committee's main duties; the activities on its agenda during the year; the new Code requirements placed on audit committees; and the group's risk management systems, internal audit function and internal controls.

I trust you will find this useful and informative.

Brian May
Chair of the audit committee

Quick facts

  • Brian May was appointed as chair of the committee following the retirement of Paul Heiden, in July 2013
  • The chair of the committee is a serving finance director of a FTSE100 company and chartered accountant and is considered by the board to have recent and relevant financial experience
  • The Code requires that the audit committee should consist of three independent non-executive directors
  • Other regular attendees at meetings include the Chairman of the board, the chief executive officer, the chief financial officer, 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 the presence of management
  • Terms of reference – corporate.unitedutilities.com/corporate-governance.aspx

Main duties of the committee

The main duties of the committee are:

  • to make a recommendation to the board for the appointment or reappointment of the auditor and 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.

Activities undertaken during 2013/14 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 are in the process of resolving any outstanding issues or concerns;
  • reviewing the reports from the financial reporting team on the financial statements and considering matters such as the accounting judgements and policies being applied by management;
  • reviewing the going concern assumption prior to making a recommendation to the board;
  • 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;
  • overseeing the introduction of updated processes for whistleblowing and reporting fraud;
  • bi-annual oversight and monitoring of the group's compliance with the Bribery Act which the board reviews annually; and
  • reviewing the committee's terms of reference and the conclusions of the committee's annual evaluation.

How we assessed whether the annual report and accounts, taken as a whole, is 'fair, balanced and understandable'

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 performance, business model and strategy'.

To make this assessment, the committee reviewed the KPIs included in the Strategic Report (see Key Performance Indicators) and concluded that, in light of the five-year regulatory cycles that our business operates within, they continued to be appropriate for our shareholders' understanding of the development, performance, position or future prospects of the business. For consistency and comparative purposes, the committee judged that KPIs should be retained unamended (other than to reflect regulatory reporting changes) up until and including the 2015 financial year end. In addition, the committee is satisfied that all the key events and issues which have been reported to the board in the CEO's monthly report during the year, both good and bad, have been adequately referenced or reflected within the annual report.

How we assessed the effectiveness of the external audit process

All members of the committee, as well as key members of the senior management team, received a questionnaire seeking their views on how well KPMG had performed the audit in 2012/13. The feedback was collated and discussed at the committee's meetings in May and November 2013 and at the meeting in May 2014, when the conclusions were discussed and approved. As a result, 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 which include that none of their 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 their independence or on the objectivity of the lead partner and the audit team. The lead partner in the audit team must change every five years, 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.

The policy in relation to non-audit fees is that non-audit fees paid to the statutory auditor shall not, ordinarily exceed 100 per cent of the audit fee. The committee has discretion in exceptional circumstances for this cap on fees to be exceeded. The CFO has pre-approval to authorise certain non-audit services, such as tax compliance work up to £100,000. Thereafter, any non-audit fees up to the 100 per cent cap can be approved by the committee chair. These are then 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. In June 2013, Makinson Cowell was acquired by KPMG, thereby increasing the level of non-audit fees paid to KPMG. Given the board's satisfaction with Makinson Cowell's services and a desire to retain them going forward, the committee decided that it was in the best interests of the group to retain Makinson Cowell's services for the year ended 31 March 2014. These services will be reviewed annually.

As part of UUW's licence conditions it is required to prepare audited regulatory accounts. Given the audit of the statutory accounts is already undertaken by KPMG, there are efficiencies and cost savings if KPMG also audits the regulatory accounts.

Table of fees paid to KPMG

2014
£'000s
2013
£'000s
Statutory audit – group and company3938
Statutory audit – subsidiaries216207
Regulatory Reporting3030
285275
Audit related services4545
Other non-audit services20384
533404

Note:
Included in the above statutory audit fee for the year ended 31 March 2014 is £26,000, in relation to the company (year ended 31 March 2013: £25,000).

Taking into account our findings in relation to the effectiveness of the audit process and in relation to the independence of KPMG, the committee is satisfied that KPMG continues to be independent, and free from any conflicting interest with the group. As a result, the committee has recommended to the board that KPMG be proposed for reappointment at the forthcoming AGM in July 2014.

Audit tender

In 2010 the group completed the disposal of its non-regulated businesses to concentrate on its core regulated water and wastewater business and, as a consequence, it was felt that this was an appropriate time to tender the audit. This took place in March 2011 at the end of which process KPMG was appointed in place of Deloitte. In accordance with the Code, the committee will tender the audit at least every ten years and more frequently if thought beneficial to the needs of the business or in accordance with any new audit tender requirements.

Significant issues considered by the committee in relation to the financial statements and how these issues 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 assessed the appropriateness of the group's approach to capitalising costs. Management demonstrated how expenditure was only capitalised where it was directly attributable to the eventual construction of assets under the group's capital programme. Following challenge of management's rationale and considering KPMG's technical advice, the committee concluded that the approach was appropriate.
  • The committee also considered expenditure on infrastructure assets and the split between what is charged to the income statement as 'maintenance' (see Consolidated Income Statement for infrastructure renewal expenditure) and capitalised as an 'enhancement'. Management confirmed that capital projects are subject to regular stage gate approvals and monthly project control reviews, which includes project by project assessment of expenditure split between infrastructure renewals expenditure (IRE) and enhancements. After further questioning of management and KPMG, the committee was satisfied that processes were in place to ensure that IRE was appropriately charged to the income statement.

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 household 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 16 for more detail). Management explained that the increase in the provision for doubtful debt was largely due to the allowed annual increase in customer bills and that the bad debt charge as a percentage of turnover was in line with the prior year. The committee determined that the levels of provisioning made were reasonable.

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 21 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 upon 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 is 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 deterioration 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 (see note A2) 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 A2 for more details). The committee employs the services of an external actuary to perform these calculations and determine the appropriate assumptions to make. In addition, KPMG audit these assumptions and report 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 obligation.

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.

Taxation

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.

The committee was informed of the settlement reached with HMRC, primarily in relation to industrial business allowances, and the significant impact this would have on the group results (see Financial performance for more details).

Photograph: Liz McAndrew, who heads a team of scientists at our laboratories in Warrington.

Internal audit function

The internal audit function, led by the head of audit and risk, is a key element of the group's corporate governance framework, supporting the organisation's vision and objectives by evaluating and recommending improvements to risk management systems, business processes and internal controls. Internal audit covers the whole of the group's activities and reports to the committee and functionally to the CFO.

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 at every meeting.

It produces an annual audit plan, endorsed by management, which the committee approves formally. The plan is risk-based and includes risk assessments, issues raised by management, prior audit findings and a cyclical review programme to provide assurance coverage over time across the whole business.

The annual business unit risk assessment process (BURA) seeks to identify how well risk management is embedded across the different teams in the business.

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.

The CFO has executive responsibility for risk management processes and systems 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 board and the executive team. This then forms the basis of the determination of the most significant risks that the company faces which are then reviewed by the board.

The internal audit function, led by the head of audit and risk, is a key element of the group's corporate governance framework.

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. Implementation of internal control systems are the responsibility of the executive team, 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 tested 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.