Dear Shareholders, I am pleased to present the Audit Committee Report for the financial year ended 31st December 2016. I am delighted to welcome Karl Gruber as a member of the Audit Committee allowing us to benefit from his extensive experience in the steel industry. Over the course of the last year, I have visited our operations at NTMK, ZMSK and the Uskovskaya mine at Raspadskaya and will continue a rolling programme to visit all the key assets over the coming year.
Once again, I would like to extend the thanks of the Committee to the executive and financial management of the Company, the internal audit department and EY, our external auditor, for their continuing diligence and valued contributions to the work of the Committee.
Deborah Gudgeon Independent Non-Executive Director, Chairman of Audit Committee
During 2016, the Audit Committee reviewed and amended its terms of reference to reflect latest regulatory developments and the transformation of the Risk Committee into the Risk Management Group as detailed on page (see Risk migration in 2016 and robust assessment) . The revised terms of reference for both the Audit Committee and the Risk Management Group were approved by the Board.
The Audit Committee minutes are tabled at the Board meeting for consideration, and the Chairman updates the Board orally on the Committee proceedings, making recommendations on areas covered by its terms of reference if appropriate.
During the year, the Committee members undertook a self-assessment process to consider the performance and composition of the Committee, its duties and responsibilities, and access to management. The results of this assessment were judged satisfactory. An external assessment will be undertaken during 2017.
EVRAZ also confirms its compliance, during the financial year commencing 1 January 2016, with the provisions of the Competition and Markets Authority Order 2014 on mandatory tendering and audit committee responsibilities.
Committee Members and Attendance
On 14 March 2016, Olga Pokrovskaya stood down from the Board and was replaced on the Audit Committee from that date by Karl Gruber. As a result, all of the Audit Committee members are Independent Non-Executive Directors. Karl Gruber has extensive experience in the steel industry and enhances the sectoral expertise of the Audit Committee. As disclosed in the Corporate Governance Report, Olga Pokrovskaya continues to attend Audit Committee meetings as an observer, providing additional technical expertise and valuable regional expertise.
Senior members of the Group’s finance function, the head of Group Internal Audit (who acts as secretary to the Audit Committee and the Risk Management Group), and the external auditors also attend Committee meetings. Key members of the management team and Risk Management Group are also invited to attend Committee meetings when appropriate; in 2016, these included the CEO and VP’s of Strategy, Steel, IT, Security, Legal, Compliance and Personnel, the CFO of Evraz North America plc (hereinafter ENA) and the Director of Investor Relations. Other members of the EVRAZ management team and the Internal Audit Function were also invited to attend Committee meetings as appropriate.
The Audit Committee met 9 times during 2016 and 4 times in early 2017 before the publication of this Annual Report.
During 2016, the Audit Committee has continued to focus on the integrity of the Group’s financial reporting, the related internal control framework and risk management, including finance, operations, regulatory compliance and fraud. These areas were comprehensively reviewed on an ongoing basis and the Committee received regular updates from the Company’s financial and operational management, Internal Audit, the Compliance Officer and legal team, as well as the external auditors.
In line with regulatory guidance, the Audit Committee undertook a tender process to appoint an external auditor for the years ending 31 December 2017 and 2018, and recommended the reappointment of EY to the Board. Further details of the tender process are included later in this report.
The Committee monitored the progress of the 2016/17 financial transformation project which includes migration of the operations of three Russian accounting centres to one shared service centre in Novokutznetzk and changes to the operational model of the accounting function, and considered the implications for the quality, timeliness and continuity of financial reporting through the transition process and in the future. The financial statements for 2016 were prepared under the existing reporting structure and the Committee will continue to monitor the migration process during 2017.
The Committee monitored the process for collating information and reviewed the disclosure required in support of the Payment to Government filing on the website at 30 June 2016 and to Companies House by 30 November 2016. This review identified an error in the original filing on the website in which an amount was erroneously classified as a payment to government.
A verification process was undertaken by management, and reviewed by EY, to review the completeness and accuracy of the disclosure and an updated report was uploaded to the website and filed with the FCA.
In preparing the 2015 financial results, management identified an undisclosed related party transaction in respect of the prior year. Although the transaction itself was not material, management reviewed and updated the process for capturing, monitoring and approving related party transactions. This review, and the accuracy and completeness of the disclosures in the 2016 financial statements, were considered by the Committee and will be reviewed again during 2017.
The Committee reviewed and updated its own terms of reference, the internal audit charter and the Group Financial Reporting Procedures Manual (“FRP”). The effectiveness and status of the anti-corruption policy and sanctions risk compliance controls were reviewed throughout the course of the year, together with progress to meet the governance requirements of the FRC’s Guidance on Risk Management, Internal Control and Related Financial and Business Reporting.
At the request of the Board, the Audit Committee also considered the proforma Viability Statement and supporting analysis produced by management and reviewed by the Risk Management Group.
In December 2016, EVRAZ received advance notice from the Financial Reporting Council of its intention to review the judgements and estimates disclosures in the 2016 financial statements as part of its thematic review.
Significant Financial Reporting Issues considered by the Audit Committee in 2016
The primary objective of the Audit Committee is to support the Board in ensuring the integrity of the Company’s financial statements and Annual Report including review of:
compliance with financial reporting standards and governance requirements;
the material financial areas in which significant accounting judgements have been made;
the critical accounting policies and substance, consistency and fairness of management estimates;
the clarity of disclosures; and
whether the annual report, taken as a whole, is fair, balanced and understandable, and provides the information necessary for shareholders to assess the Company’s performance, business model, strategy, principal risks and uncertainties.
Financial reporting standards and governance requirements
The Audit Committee considered a number of financial reporting issues in relation to the Interim Results for H1 2016 and the financial statements for 2016. These included the appropriateness of accounting policies adopted, disclosures and of management’s estimates and judgements. The Committee considered papers produced by management on the key financial reporting judgements and reviewed reports by the external auditor on the full year and half year results which highlight any issues with respect to the audit work.
The financial statements continue to be impacted by fluctuations in the key functional currencies of the business (primarily the Russian rouble and, to a lesser extent, the Ukrainian hryvnia) against the US dollar, the presentation currency of the financial statements, as set out in Note 2 . As a result, challenging the consistency and comparability of balances in the financial statements remains difficult but management separate out where appropriate the forex impact on areas of significant judgements and estimates.
The following financial reporting issues are considered significant.
Going concern (Note 2) and the viability statement
EVRAZ is exposed to a range of risks and inherent uncertainties as set out on Principal risks page, many of which are outside the control of the Company. 2016 saw significant volatility in raw material prices with a four-fold increase in coking coal prices and steel prices rising 80% over the year. The Audit Committee reviewed management’s going concern analysis which included both a base case and a flexed downside scenario which is based upon forward pricing close to the bottom of the range of current investment analyst forecasts, and a reduced level of budgeted capital expenditure. The Committee carefully considered the projected Use and Sources of Funds for the period to June 2018 which includes scheduled loan repayments, new committed funding and free cash flow after capital expenditure. Given the volatility of the current global supply/demand environment, the Committee again focused on the pessimistic downside case and the implications on free cash flow and compliance with financial covenants.
Following these detailed considerations, the Audit Committee resolved to recommend the going concern basis of preparation for the Financial Statements as at 31 December 2016 to the Board.
The Committee reviewed the analysis supporting the viability statement before it was considered by the Board. The Committee reviewed the scenarios that might challenge viability, the key assumptions in each scenario and the proposed disclosures in the viability statement.
Areas of significant accounting judgement and management estimates
Impairment of goodwill and assets (Notes 5 and 6). The Committee considered management’s impairment recommendations in the context of the current and future trading environment. Testing was undertaken as at 30 September 2016 and reassessed at 31 December 2016 when no further impairment triggers were identified. The continued weakness of the rouble means that the carrying values of Russian cash generating units remain low in US dollar terms and are largely not challenged by the value in use comparisons used to determine impairment, even in a negative pricing environment During H1 2016, the organisational, cash flow and asset interdependence of the ENA business was reassessed for the purpose of impairment testing and the constituent plants allocated to 5 new cash generating units based upon the end markets they serve.
As a result of deteriorating market conditions in North America during H2 2016, management undertook a detailed review which resulted in the reduction of both volume and price forecasts used in the impairment testing of these assets. Of the $465 million impairment charge in 2016, $446 million relates to the goodwill and PPE impairment of operations in North America. The balance of $19 million relates to the specific impairment of PPE at other cash generating units including unutilised assets at Raspadskaya and Yuzhny Stan, and increased site restoration provisions at Evrazruda and Yuzhkuzbassugol. As the operation of Palini e Bertoli has been restarted, the VIU was reassessed resulting in a partial reversal of the impairment already recognised on the idling of this asset. The Audit Committee considered this reversal and concluded that it was appropriate.
In October 2016, EVRAZ entered into a contract to sell Evraz Yuzhkoks with consideration payable in a number of instalments to August 2017. Completion of the transaction requires fulfilment of several conditions not fully within the control of the parties to the transaction. Management consider that the agreement has not yet become unconditional and continue to treat Evraz Yuzhkoks as an asset held for sale in the financial statements, with consideration instalments already received classified as “advances from customers” in the statement of financial position. Given the uncertainty on completion, the Audit Committee accepted management’s proposed treatment.
Property tax accrued and paid by production subsidiaries has been reclassified from general and administrative expenses to cost of revenue, and the costs and related expenses of certain personnel have been reclassified to better reflect the current operational structure and make the financial statements more comparable with industry peers. The Committee reviewed the implications of the change and the adequacy of the disclosure and were satisfied. The implications of the change are set out in Note 2.
EVRAZ internal policy is to undertake a valuation of mineral reserves on a regular basis, at least every three years, but the valuation due in 2016 was postponed due to cost reduction initiatives. A valuation will be undertaken during 2017 which will reflect the changes in mining plans and expected long term prices.
Fair, balanced and understandable
In considering whether the Annual Report is fair, balanced and understandable, the Committee reviewed the information it had received, discussions held with management throughout the year and the preparation process adopted. Management agreed the key overall messages of the Annual Report at an early stage to ensure a consistent message in both the narrative and financial reporting. Regular meetings were held to review the draft Annual Report and for management and Committee members to provide comments, and detailed review of the appropriate draft sections were undertaken by the relevant Directors and external advisers. The Committee particularly considered whether the description of the business, principal risks and uncertainties, strategy and objectives were consistent with the understanding of the Board, and whether the controls over the consistency and accuracy of the information presented in the Annual Report are robust.
Taking into account the disclosure implications of the issues discussed in this report, the Committee recommended to the Board that, taken as a whole, it considers the Annual Report to be fair, balanced and understandable. The Audit Committee recommended approval of the Group’s 2016 Consolidated Financial Statements by the Board. Both recommendations were accepted by the Board.
UK Bribery Act (“UKBA”)
The Committee continued to monitor the status of the procedures, controls and data collection of the Group’s anti-corruption policy and Code of Conduct, including the regulation of interaction with state authorities introduced by the Company in November 2014, and progress in respect of the areas for improvement and implementation identified by the external audit in 2014. A comprehensive framework for annually monitoring compliance with EVRAZ’ anti-corruption policies and identifying risk was developed during 2016 by the compliance, legal and internal audit teams. Using this framework, compliance was tested in November and December 2016 indicating further progress in reducing risk. Internal audit also tested the procedure and completeness for maintaining registers of entertainment costs, business gifts, charitable and sponsorship expenditure at a number of key entities during the year. Based upon the output, the mitigation plan and training programmes will be updated to reflect the increasing maturity of these processes.
In March 2016, Transparency International produced a report on “Transparency in Corporate Reporting: Assessing Emerging Market Multinationals”. EVRAZ achieved a score of 85% for its anti-corruption programme compared to an average score of 48% for all the firms surveyed.
Sanctions Compliance Controls
Compliance with the control processes, procedures and reporting framework established to minimise the risk of breaching sanctions was tested by Internal Audit during the year, along with progress against the recommendations of the Group’s external legal advisers, and found to be satisfactory. The controls and processes for monitoring compliance are regularly updated to incorporate the latest guidance from the Group’s external legal advisers and there is a process of continuing education of compliance personnel and executive management.
EVRAZ has an integrated approach to risk management to ensure that the review and consideration of risks inform the management of the business at all levels, the design of internal controls and internal audit process. During 2016, the Risk Committee was replaced by the Risk Management Group with membership comprising the Group’s vice-presidents and chaired by the CEO.
The Group’s financial reporting procedures, internal controls, risk management systems and activities are documented in a comprehensive Financial Reporting Procedures Manual (FRP). The manual was updated in December 2016 and reviewed by the Audit Committee in December 2016.
The Risk Management Group attended the Audit Committee in October 2016 and presented the updated Risk Register and their recommendation on the level of Risk Appetite. These were reviewed by the Audit Committee, along with the draft Statement of Principal Risks and Uncertainties to be included in the Annual Report, prior to the Board’s consideration.
Internal Audit findings on control issues that exceed the Group’s risk appetite are reported to the Board by the Audit Committee and followed up by the Group’s Management Committee and the progress on resolving issues is monitored regularly.
The Audit Committee continues to receive bi-annual updates on whistleblowing reports together with a security report on the progress of follow-up investigations and resulting actions in relation to fraud and theft. Any significant whistleblowing report is reported to the Committee on an ad hoc basis when it arises.
Assessment of the Group’s risk profile and control environment
Internal Audit reviews the Group’s risk and control environment bi-annually and this is considered by the Risk Management Group and the Audit Committee. In particular, the Audit Committee considered whether the accelerated reporting timetable and financial transformation project had implications for the risk and control environment.
The Chairman of the Audit Committee tables the Internal Audit report judgement on the risk and control environment to the Board.
The Group continued the implementation of the IT security risk mitigation plan during 2016 and an external risk reassessment was undertaken in early 2017, revealing significant progress. The mitigation plan will be updated by March 2017 to recalibrate the mitigation plan to reflect the progress already made.
The EVRAZ policy on the level and economic terms of external insurance cover was reviewed by the Audit Committee in January 2017 and approved by the CEO. The Risk Register was amended in 2016 to acknowledge the level of self-insurance by the Group.
The Audit Committee reviewed the internal audit plans for 2017 and recommended certain revisions in view of the macroeconomic environment, risk profile of the business and resources available. The plan was revised to reflect the updated risk analysis and to prioritise key business cycles and controls from a risk perspective. Overall, the Committee considers the current Internal Audit resource to be adequate for the internal control and risk management assurance requirements.
The Audit Committee reviewed and updated the Internal Audit Charter and Key Performance Indicators of the Internal Audit function in early 2017. An annual assessment of the effectiveness, independence and quality of the Internal Audit function was undertaken by way of a questionnaire to Committee members, management and the external auditors and was again found to be very satisfactory. An external assessment of the Internal Audit function in the Russian Federation, CIS and Europe was undertaken during 2015 and confirmed that it conformed to the International Standards for the Professional Practice of Internal Auditing, Code of Ethics and Definition of Internal Audit of the Institute of Internal Auditors.
The Head of Internal Audit is secretary to both the Audit Committee and Risk Management Group and prepares the minutes.
The Audit Committee is responsible for monitoring the ongoing effectiveness and independence of the external auditor, and making recommendations to the Board as to the re-appointment of the auditor.
Effectiveness and Independence
The Audit Committee has an established framework through which it monitors the effectiveness, independence, objectivity and compliance of the external auditor with ethical, professional and regulatory requirements. These include:
review and approval of the external audit plan for the interim review and year-end audit, including consideration of the audit scope, key audit risks and audit materiality measures, and compliance with best practice;
review and approval of the external auditor’s engagement letter;
consideration of the external auditors report on the Interim Review and Annual Report and Representation Letters; and
reviewing the external auditors management letter on the 2015 audit with management, considering management’s response and proposed actions, and requesting that Internal Audit undertake a follow-up audit of key areas.
The 2016 financial reporting timetable was accelerated compared to 2015, and the Audit Committee gave particular consideration to the implications for the external audit process and the resulting early hard close, acceleration of substantive procedures and year-end roll forward procedures.
Following completion of the 2015 audit, Mr Ken Williamson was replaced as Senior Statutory Auditor by Mr Steven Dobson. Management and members of the Audit Committee also completed a questionnaire to assess the effectiveness and independence of the external audit process in 2015, which was found to be satisfactory.
The Audit Committee holds regular meetings with the external auditor at which management are not present to consider the appropriateness of the Company’s accounting policies and audit process. During 2016, the external auditor confirmed that these policies and processes were appropriate. The Committee Chairman also meets the Senior Statutory Auditor regularly outside of Audit Committee meetings.
Engagement of the external auditor for non-audit services is managed in accordance with the Group’s policy which can be found on the Company’s website: www.evraz.com. This policy identifies a range of non-audit services which are prohibited on the basis that they might compromise the independence of the external auditor, establishes threshold limits for the level of non-audit fees relative to audit fees and authorisation processes for the approval of all audit and non-audit fees. During 2016, non-audit fees totalled $612,000 and were primarily in relation to capital market transactions and cyber security risk assessment. Non- audit fees were 14.7% of the 2016 audit fee of $4.1 million. Irrespective of prior approval of the CFO and Audit Committee Chairman, all fees are reported to the Audit Committee for noting and comment.
The Audit Committee continues to consider EY to be effective and independent in their role as auditor.
Re-appointment of the external auditor
In view of the UK Governance Code guidance on re-appointment of the external auditor and the EU legislation on audit regulation, the Audit Committee resolved in 2015 to undertake a tender process during 2016 to allow for the appointment of an external auditor for the year ended 31 December 2017.
A Request for Proposal was sent to six firms who were judged to have suitable, relevant experience. Interested candidates who could confirm their independence attended a series of meetings with key management and with the Chairman of the Audit Committee before the deadline for submission of their proposals in the middle of July 2016. Based upon these submissions, management selected two candidates to make a presentation to a special meeting of the Audit Committee. The Audit Committee considered both proposals and presentations in accordance with a number of pre-agreed specific criteria including steel and mining experience in Russia and worldwide, experience of comparable complex organisations, quality control and local team experience, audit co-ordination and service delivery. Based upon this review, the Audit Committee concluded that Ernst & Young LLP (“EY”) was the preferred candidate and recommended their reappointment as external auditor to the Board for the years ending 31 December 2017 and 2018.