Who owns the auditor

Why committees

A board of seven cannot examine an audit plan, design a bonus scheme and recruit its own replacements in a two-hour meeting. So boards delegate the detailed work to standing committees, each with a written charter, which report back to the full board. Three are standard for a TSX-listed company:

• The audit committee — the financial-reporting process, internal control, and the relationship with the external auditor.
• The compensation committee — the CEO’s pay, the design of incentive plans, and executive succession. NP 58-201 s. 3.15 says it should be composed entirely of independent directors.
• The nominating / governance committee — identifying and recruiting new directors, board evaluation, and governance policy. NP 58-201 s. 3.10: entirely independent.

The pattern is deliberate: the committees that decide who sits on the board and what management is paid are exactly the ones management must not sit on.

The audit committee: two rules, two sources

The midterm wants the two layers attributed correctly.

The CBCA floor (s. 171). A distributing corporation must have an audit committee of at least three directors, a majority of whom are not officers or employees of the corporation or its affiliates. The committee reviews the financial statements before the board approves them, and the auditor is entitled to attend its meetings.

The securities-law rule (NI 52-110 s. 3.1). For a non-venture reporting issuer, the committee must have at least three members, every one of whom is a director, independent (lesson 5.3’s test), and financially literate — able to read and understand financial statements of a breadth and complexity comparable to the issuer’s own (s. 1.6). A member may be appointed and become literate within a reasonable time. Venture issuers are exempt from Part 3 and instead need a majority who are not executive officers, employees or control persons (Part 6).

So “majority not officers” is the CBCA; “all independent and financially literate” is NI 52-110. Financial literacy is required of audit committee members, not of every director.

Who owns the auditor

The external auditor examines management’s statements. If management hired, paid and could fire the auditor, the auditor’s independence would exist on paper only. NI 52-110 therefore moves the relationship out of management’s hands:

• The auditor reports directly to the audit committee (s. 2.2).
• The committee recommends to the board the auditor to be nominated and the auditor’s compensation (s. 2.3(2)) and is directly responsible for overseeing the auditor’s work, including resolving disagreements between management and the auditor (s. 2.3(3)).
• It pre-approves all non-audit services the auditor provides (s. 2.3(4)) — so the auditor cannot build a consulting relationship that makes it reluctant to disagree.
• It reviews the financial statements, the MD&A and the earnings press releases before they are released (s. 2.3(5)), and establishes whistle-blower procedures (s. 2.3(7)).

The shareholders formally appoint the auditor at the annual meeting (CBCA s. 162), on the committee’s recommendation. At Lakehead Marine the auditor’s engagement partner meets the audit committee without the CFO in the room at least once a year — the mechanism that makes independence real.

What the auditor’s report says

The product of the relationship is the auditor’s report, printed in front of the statements. It gives an opinion on whether the statements present fairly, in all material respects, the company’s position and performance in accordance with the framework — IFRS for a public company. That is reasonable assurance, not a guarantee: the auditor tests samples and applies a materiality threshold; it does not certify every number. Canadian Auditing Standards allow four opinions:

• Unmodified (clean) — the statements are fairly presented. The report every public company wants.
• Qualified — fairly presented except for a named matter: one material misstatement, or one area where evidence could not be obtained, whose effect is not pervasive.
• Adverse — the statements are materially misstated and the misstatement is pervasive; the auditor says they do not present fairly.
• Disclaimer of opinion — the auditor could not obtain enough evidence and the possible effects are pervasive, so it expresses no opinion at all.

A qualified opinion fences off one matter; an adverse opinion and a disclaimer condemn the statements as a whole — one because of what the auditor found, the other because of what the auditor could not find. The audit committee reads the draft report before it is issued and is where any modification is argued out with management.

Lakehead’s committee, and what is wrong with it

Lakehead’s audit committee is the CFO, the CEO’s sister, and the chartered accountant. Two violations at once: the CFO is management — the very person whose statements the committee reviews and whose disagreements with the auditor it must resolve — and the sister is not independent. Only one of three members qualifies. The fix is a committee of the three independent directors, with the accountant chairing; the CFO attends by invitation and leaves when asked.

Related parties

A transaction between the company and a director, officer or their family — Lakehead buying legal services from its director’s firm — is a related-party transaction. It is not forbidden, but it must be disclosed in the notes so that readers can judge whether it was at arm’s length. The audit committee, and under the CBCA the board, are where such transactions are reviewed. An undisclosed related-party transaction is both a governance failure and a reporting failure.