DAO Letter

HM Treasury | Parliament Street London SW1P 3AG
Frank Martin |
| DAO (GEN) 13/97 28 November 1997

Dear Accounting Officer

### CORPORATE GOVERNANCE: STATEMENT ON THE SYSTEM OF INTERNAL FINANCIAL CONTROL

I attach guidance on the requirement that the accounts of departments executive agencies trading funds and executive Non-Departmental Public Bodies (NDPBs) should in future include a statement by the Accounting Officer concerning the system of internal financial control. The requirement for such a statement and its wording have been the subject of discussion with departments. The model wording provided in the annexes to the guidance incorporates suggestions made by departments on a draft statement circulated to Principal Finance Officers following a meeting on 23 April 1997. The wording has also been agreed with the National Audit Office. The requirement applies to accounts relating to financial periods beginning on or after 1 January 1998.

Purpose of the statement

2. The statement on the system of internal financial control confirms that the Accounting Officer has satisfied the responsibility set out in the Accounting Officer Memorandum to ensure that effective management systems including financial monitoring and control systems have been put into place. The inclusion of such a statement in annual accounts stems from the initiative to improve the management and governance of companies begun by the Code of Practice introduced by the Cadbury Committee. Where appropriate and advantageous some aspects of this initiative are being applied in the public sector.

Relationship with letters of representation

3. Accounting Officers have also been required to sign letters of representation to their auditors (see DAO(GEN) 4/96 dated 14 February 1996). A letter of representation serves a different purpose from the new statement on the system of internal financial control: it simply provides auditors with assurances on a number of issues connected with the audit and is a working document for the auditors which does not form part of the published accounts. The statement on the system of internal financial control has a different purpose and does not therefore overlap with or replace the letter of representation.

Scope

4. The requirement for a statement on the system of internal financial control applies to appropriation accounts and to accounts prepared by executive agencies trading funds and Non-Departmental Public Bodies. The attached annexes provide model wording for use with the various types of accounts. Paragraph 10.4.1 of the Resource Accounting Manual refers to the need for departmental resource accounts to include such a statement; further guidance on this will follow.

Auditors’ opinion on the statement

5. In line with the recommendations of the Cadbury Code and guidance issued by the Auditing Practices Board ("Disclosures relating to Corporate Governance" - Bulletins 1995/1 and 1996/3) external auditors are required to express an opinion on the statement on the system of internal financial control. Where appropriate bodies to which this DAO letter applies should ensure that the letter of engagement to their external auditors includes a requirement to report on the statement of the system of internal financial control. It is not expected that the requirement to provide this opinion will add significantly to the audit burden.

Date from which effective

6. A statement on the system of internal financial control should be included in accounts relating to financial periods beginning on or after 1 January 1998.

Enquiries

7. Enquiries on the accounting and disclosure aspects of the guidance should initially be addressed to your accountancy advisers who are familiar with the background. Questions to the Treasury should be addressed to Nick Bailey in the Central Accountancy Team (0171 270 4535; fax 0171 270 4545). Questions relating to the role of internal audit should initially be addressed to your internal audit division with enquires to the Treasury addressed to Gordon Adam in the Audit Policy Advice Team (0171 270 1759; fax 0171 270 1757).

Further action

8. Departments should ensure that their executive agencies trading funds and Non-Departmental Public Bodies are aware of the requirements of this letter.

FRANK MARTIN

###

Attachment to DAO (GEN) 13/97

### CORPORATE GOVERNANCE: STATEMENT ON THE SYSTEM OF INTERNAL FINANCIAL CONTROL

1. In December 1992 a committee chaired by Sir Adrian Cadbury produced a Code of Practice relating to the management and control of companies (the "Cadbury Code"). Although the proposals were aimed at listed companies the committee encouraged its adoption by other enterprises. To the extent that the proposals could be applied to central government bodies in 1994 the Treasury issued a "Code of Best Practice for Board Members of Public Bodies"(since revised by the Cabinet Office and reissued in January 1997 as "Guidance on Codes of Practice for Board Members of Public Bodies"). The Cadbury Code was not implemented in full as the Cadbury Committee acknowledged that further study was required into the implications of the proposal that accounts should include a statement by the directors concerning the effectiveness of the system of "internal control" .

2. The subsequent study was conducted by a working group chaired by Mr Paul Rutteman which recommended that directors should provide information about the system of "internal financial control" but need not report on its effectiveness. In August 1997 a committee chaired by Sir Ronald Hampel (Chairman of ICI plc) to review the implementation of the Cadbury Code issued its preliminary report which supports the approach taken in the Rutteman report.

3. The Hampel Committee has also raised a number of other issues and the Treasury will be considering the implications of its recommendations for this guidance once the Committee’s report has been finalised.

Application of the Rutteman recommendations to central government

4. As effective systems of internal financial control are essential to the management of public bodies the Rutteman group’s recommendation has a clear relevance to central government. In that the proposed statement is an outline description of the system which has been put into place and the steps taken to review its effectiveness it will provide a confirmation that Accounting Officers have carried out their responsibility for ensuring that effective management systems including financial monitoring and control systems have been put into place (paragraph 8 of the Accounting Officer Memorandum and paragraph 10 of the NDPB Accounting Officer Memorandum).

5. The requirement set out in this guidance has been the subject of consultation with departments and the model wording for the statement incorporates comments made on earlier drafts. The requirement applies both to the appropriation accounts prepared by departments and to the commercial-style accounts prepared by executive agencies trading funds and Non-Departmental Public Bodies.

6. Adapting the Rutteman recommendations to departments and other central government bodies will require Accounting Officers to prepare and sign a statement on the system of internal financial control which includes the following:

- acknowledgement by the Accounting Officer that he or she is responsible for the department’s or body’s system of internal financial control. Where this responsibility is shared the relationship between a principal Accounting Office and an additional Accounting Officer or between an agency Accounting Officer and a departmental Accounting Officer should be reflected in the wording;

- explanation that such a system can provide only reasonable and not absolute assurance against material misstatement or loss;

- description of the key procedures designed to provide effective internal financial control (see paragraph 7 below);

- confirmation that there has been a review of the effectiveness of the system of internal financial control. The results of this review do not have to be disclosed; and

- (if appropriate) information about those weaknesses in internal financial control that have resulted in material losses contingencies or uncertainties which require disclosure in the financial statements or the auditors’ report on the financial statements (see paragraphs 8 and 9 below).

7. The key procedures include:

- the steps taken to ensure an appropriate control environment (such as clearly defined management responsibilities and evidence of reaction to control failures);

- processes used to identify business risks and to evaluate their financial implications;

- details of the major information systems in place (such as budgets and means of comparing actual results with budgets during the year);

- the procedures for addressing the financial implications of major business risks (such as financial instructions and notes of procedures delegation practices such as authorisation limits segregation of duties and methods of preventing and detecting fraud);

- the procedures for monitoring the effectiveness of the internal financial control system which may include: Audit Committees; management reviews; Consultancy Inspection and Review (CIR) studies; the work of Internal Audit; Quality Audit reviews and statements from the Heads of Internal Audit;

8. The information relating to weaknesses in internal financial control should be a description of the action taken or intended to be taken to correct the weaknesses or an explanation of why no action is considered necessary. Again this wording may need to record that the action is shared with another Accounting Officer. Unlike the accounts of departments and some NDPBs the accounts of private sector organisations do not as a matter of routine include information relating to losses (ie a losses statement) and the Rutteman requirements may appear to impose additional burdens on public sector bodies. However the occurrence of losses does not necessarily mean that there will be a need to provide the additional information required by Rutteman as the losses have to be both material and to have been the result of weaknesses in the system of internal financial control. The Rutteman requirements do not apply to losses which are not related to weaknesses in the system.

9. If additional information is required it should be given as part of the statement on the system of internal financial control. It is not possible to provide definitive guidance on this wording since this will need to reflect the particular circumstances.

Model wording

10. The attached annexes provide model wording for statements on the system of internal financial control which addresses the points noted above. Annex 1 shows the version for use with appropriation accounts and Annex 2 the version to be used by executive agencies trading funds and executive non-departmental public bodies. Those agencies which are departments in their own right will produce both appropriation accounts and accruals-based accounts and hence will need to use both statements.

Other points

11. Accounting Officers are now asked to sign letters of representation by the external auditors in line with the recommendations of Statement of Auditing Standard (SAS) 440 "Management Representations". Guidance on the application of SAS 440 to the public sector was given in the Auditing Practice Board’s Practice Note 10 "Audit of Central Government Financial Statements in the United Kingdom" (see DAO(GEN) 4/96 dated 14 February 1996). Letters of representation are intended to provide auditors with assurances on a number of areas connected with the audit and form part of the auditor’s working papers. They are not published in the annual accounts. The statement on the system of internal financial control serves a different purpose being part of the published information about the financial governance of the body. The practice of Accounting Officers signing letters of representation is not affected by the requirements of this guidance note.

12. There is no requirement for a statement on the system of internal financial control to be included in summarised accounts where the Accounting Officer has no direct responsibility for the individual accounts included in the summary.

13. The model wording for the statement to be used by agencies trading funds and NDPBs refers to actions being undertaken by the Board. However it is appreciated that some activities may be undertaken by committees of the Board or that some issues are decided by correspondence rather than at formal meetings. These approaches meet the intention of the statements.

14. External auditors are required to provide a separate audit opinion on the statement on the system of internal financial control (this requirement also extends to resource accounts - see paragraph 14.2.1 of the Resource Accounting Manual). Guidance issued by the Auditing Practices Board provides background on the responsibilities of the external auditor and model wording for the audit opinion. Where appropriate bodies should ensure that the requirement to provide this opinion is included in the terms of engagement for the external auditor. It is not expected that any additional work required to provide the audit opinion will add significantly to the audit burden on departments executive agencies or NDPBs.

Review

15. This guidance will be reviewed in due course to consider its application in the light of experience and of developments in the private sector such as the reaction to the recommendations of the Hampel Committee. It will also be reviewed to take account of the introduction of resource accounting.

TREASURY OFFICER OF ACCOUNTS TEAM
NOVEMBER 1997

Attachment to DAO(GEN)13/97: ANNEX 1

MODEL WORDING FOR THE STATEMENT ON THE SYSTEM OF INTERNAL FINANCIAL CONTROL: VERSION 1 - FOR USE BY DEPARTMENTS IN APPROPRIATION ACCOUNTS

This statement is given in respect of the appropriation account for Class 00 Vote 00. As Accounting Officer for this Vote I acknowledge my responsibility for ensuring that an effective system of internal financial control is maintained and operated in connection with the resources concerned. [I carry out this responsibility in conjunction with the department’s principal Accounting Officer the relationship between us being set out in a written statement.]

The system of internal financial control can provide only reasonable and not absolute assurance that assets are safeguarded transactions authorised and properly recorded and that material errors or irregularities are either prevented or would be detected within a timely period.

The system of internal financial control is based on a framework of regular management information financial regulations administrative procedures including segregation of duties and a system of delegation and accountability. In particular it includes [see note 3]:

- comprehensive budgeting systems with an annual budget;

- procedures to review and agree the budgets;

- the preparation of regular financial reports which indicate actual expenditure against the forecasts;

- clearly defined capital investment control guidelines;

- as appropriate formal project management disciplines.

The department has an internal audit unit which operates to standards defined in the Government Internal Audit Manual. The work of the internal audit unit is informed by an analysis of the risk to which the department is exposed and annual internal audit plans are based on this analysis. The analysis of risk and the internal audit plans are endorsed by the department’s Audit Committee and approved by me [and the department’s principal Accounting Officer]. At least annually the Head of Internal Audit (HIA) provides me with a report on internal audit activity in the department. The report includes the HIA’s independent opinion on the adequacy and effectiveness of the department’s system of internal financial control.

My review of the effectiveness of the system of internal financial control is informed by the work of the internal auditors and the executive managers within the department who have responsibility for the development and maintenance of the financial control framework and comments made by the external auditors in their management letter and other reports.

[Details of the action taken or proposed to correct weaknesses in the system of internal financial control or an explanation of why corrective action is not considered necessary should be given here. The wording should be tailored to reflect the circumstances of the case including where the action taken or proposed is the responsibility of the principal Accounting Officer rather than the Accounting Officer for the Vote.]

Notes

1. Each Accounting Officer must prepare a statement for each Vote for which he or she is responsible.

2. The statement should be included as a separate document normally coming between the "Statement of Accounting Officers’ responsibilities" and the Summary of Outturn.

3. Changes to the wording should be kept to a minimum. However the key areas described in the third paragraph are the minimum features to be expected in the system and Accounting Officers are encouraged to describe any additional features of the system of internal financial control which are relevant to the effectiveness of the system such as improvements in control procedures or new accounting systems with additional control facilities. Accounting Officers may also wish to mention any special reviews or similar work undertaken within the department to verify or improve the system of internal financial control. Any such information should be given as an additional paragraph. It may also be appropriate to refer to such reviews in the fifth paragraph which comments on the means by which the Accounting Officer satisfies him or herself on the effectiveness of the system.

TREASURY OFFICER OF ACCOUNTS TEAM
NOVEMBER 1997

Attachment to DAO(GEN)13/97: ANNEX 2

SUGGESTED WORDING FOR THE STATEMENT ON THE SYSTEM OF INTERNAL FINANCIAL CONTROL: VERSION 2 - FOR USE BY EXECUTIVE AGENCIES TRADING FUNDS AND EXECUTIVE NDPBs

As Accounting Officer I acknowledge my responsibility for ensuring that an effective system of internal financial control is maintained and operated by (name of body).

The system can provide only reasonable and not absolute assurance that assets are safeguarded transactions authorised and properly recorded and that material errors or irregularities are either prevented or would be detected within a timely period.

The system of internal financial control is based on a framework of regular management information administrative procedures including the segregation of duties and a system of delegation and accountability. In particular it includes [see note 3]:

- comprehensive budgeting systems with an annual budget which is reviewed and agreed by [a committee of] the Management Board [or other appropriate description];

- regular reviews by the Management Board of periodic and annual financial reports which indicate financial performance against the forecasts;

- setting targets to measure financial and other performance;

- clearly defined capital investment control guidelines.

- as appropriate formal project management disciplines;

(Name of body) has an internal audit unit which operates to standards defined in the Government Internal Audit Manual. The work of the internal audit unit is informed by an analysis of the risk to which the body is exposed and annual internal audit plans are based on this analysis. The analysis of risk and the internal audit plans are endorsed by the body’s Audit Committee and approved by me. At least annually the Head of Internal Audit (HIA) provides me with a report on internal audit activity in the body. The report includes the HIA’s independent opinion on the adequacy and effectiveness of the body’s system of internal financial control.

My review of the effectiveness of the system of internal financial control is informed by the work of the internal auditors the Audit Committee which oversees the work of the internal auditor the executive managers within the body who have responsibility for the development and maintenance of the financial control framework and comments made by the external auditors in their management letter and other reports.

[Details of the action taken or proposed to correct weaknesses in the system of internal financial control or an explanation of why corrective action is not considered necessary should be given here. The wording should be tailored to reflect the circumstances of the case. If in the case of an executive agency the action taken or proposed involves an Accounting Officer in the parent department that should be explained.]

Notes:

1. The statement should be signed by the appointed or designated Accounting Officer.

2. The statement should follow the statement of the Accounting Officer’s responsibilities. If the latter is included as part of the Foreword so may the new statement.

3. Changes to the wording should be kept to the minimum. However the key areas described in the third paragraph are the minimum features to be expected in the system and Accounting Officers are encouraged to describe any additional features of the system of internal financial control which are relevant to the effectiveness of the system such as improvements in control procedures or new accounting systems with additional control facilities. Accounting Officers may also wish to mention any special reviews or similar work undertaken within the department to verify or improve the system of internal financial control. Any such information should be given as an additional paragraph. It may also be appropriate to refer to such reviews in the fifth paragraph which comments on the means by which the Accounting Officer satisfies him or herself on the effectiveness of the system.

TREASURY OFFICER OF ACCOUNTS TEAM
NOVEMBER 1997

Return to:

- DAO Letters home page