The audit function is crucial for ensuring the integrity of a company’s financial systems, which includes not only its financial results but also the control systems and code of ethics that are the cornerstones of an accurate financial reporting system. The key player in this area is the audit committee, which is comprised of independent directors who report directly to the Board of Directors. This committee is briefly overviewed in this post.
Composition Of The Audit Committee
The audit committee should be a standing committee of the Board of Directors, and should be comprised primarily of non-officer directors. These directors should not be involved in the management of the company, nor have previously been its officers. These restrictions are intended to create the most independent overview environment possible for the committee.
The committee is generally comprised of between three and five members, not all of whom must have an accounting, auditing, or finance background. It can be more useful to have some directors with a solid operational knowledge of the industry in which the company operates; these people can spot potential control weaknesses, based on their knowledge of how transactions flow in an industry-specific environment.
Nonetheless, at least one committee member should have considerable training or experience in the accounting and finance arena. The committee should be expected to meet on at least a quarterly basis.
Financial executives [Controller and CFO] are rarely a member of this committee. Instead, they will sometimes be asked to attend its meetings in order to advise committee members on specific issues, or to answer questions about problems that the committee has uncovered through its review activities. Controller and CFO should certainly maintain a strong line of communication with committee members, in order to inform them of possible accounting rule changes or prospective policy changes that may impact the reporting of financial information.
The Controller and CFO should also educate committee members about key financial topics, such as corporate lines of business, accounting policies, legal obligations, regulatory filings, and industry accounting practices.
The director of the internal audit function usually reports to the CFO, but can report instead to the audit committee. The most common reporting relationship is for the internal audit director to be supervised by the CFO, but to have unimpeded access to the audit committee at any time; this reporting system is designed to give committee members direct access to the results of internal audits, while at the same time giving the internal audit director the ability to go around the CFO if that person appears to be obstructing the dissemination of internal audit results.
In short, the audit committee’s structure is intended to be as independent of the management team as possible, while still giving it direct access to key accounting and audit personnel within the management team.
Role Of The Audit Committee
The goal of the audit committee is to assist the Board of Directors by providing oversight of the financial reporting process and related controls. The committee is not empowered to make any decisions—rather, it recommends actions to the full Board, which may then vote on its recommendations. The exact range of tasks granted to the audit committee will vary, but are generally confined to the following issues:
Tasks Related to Company Management:
- Review expenses incurred by the management team – It’s used to spot any excessive use of corporate funds by managers.
- Review business transactions between the company and the management team – It’s used to ensure that managers are neither enriching themselves at the expense of the company nor holding their personal interests above those of the company.
Tasks Related to External Auditors:
- Recommend the hiring of external auditors – It’s used to ensure that a truly independent auditor is used, rather than one having connections with the company in some way that may influence its review of the company’s financial statements. The audit committee should also base this recommendation on the auditor’s expertise in the industry, the quality of its services, the extent to which it performs other services for the company, and the amount of its quoted fees for the audit.
- Review auditor recommendations – It’s used to ensure that control issues spotted by the auditors are properly dealt with by the management team, resulting in a stronger control environment.
- Review disputes between the external auditors and management – It’s used to determine if the management team is attempting to force the auditors to agree with an alternative accounting treatment for transactions.
- Review the use of external auditors for other services – It’s used to determine if the external auditor has obtained such a significant amount of extra business with the company that it may be less inclined to issue an unfavorable audit opinion, due to the risk of losing the additional business.
Tasks Related to Internal Audits:
- Review the replacement of the internal audit director – It’s used to verify that the internal audit director is being replaced for reasonable cause, rather than because the CFO wants to install a more malleable director.
- Review the internal audit staff’s objectives, work plans, training, and reports – It’s used to verify that the internal audit staff is appropriately targeted at those areas of the company that are at greatest risk of control problems, and that the audit staff is appropriately trained to handle the audits. A detailed review of the annual work plan will reveal if the internal audit director has allocated a sufficient amount of time to each audit, or has sufficient staff available to complete all goals.
- Review the cooperation received by the internal auditors – It’s used to spot possible areas of fraudulent activities, since minimal cooperation is a signal that an auditee may be hiding information from audit teams.
- Review disaster recovery plans – It’s used to ensure that adequate recovery plans have been created and tested for the most likely disaster scenarios.
Tasks Related to Financial Systems:
- Investigate fraud and other forms of financial misconduct – It’s used as the grounds for a direct investigation of any situation possibly involving deliberately inaccurate financial reporting or the misuse of company assets.
- Review corporate policies for compliance with laws and ethics – It’s used to ensure that all corporate policies, irrespective of their relationship to financial systems, are constructed in accordance with local regulations and meet the restrictions of the corporate statement of ethical activities.
- Verify that financial reports address all information requirements of lenders – It’s used to ensure that lender-required financial information is reported to them at the appropriate times and in the correct formats, so there is minimal risk of losing vital credit lines as a result of missing information.
- Review all reports to shareholders, including special reports, for consistency of information – It’s used to verify that all reports present a consistent picture of corporate financial health to investors. This is of particular concern for special reports, which tend to include different types of measures (such as Earnings Before Interest, Taxes, Depreciation, and Amortization [EBITDA] instead of the net income figure found on financial statements) and bullish statements by management that do not always match the tenor of information presented in the standard set of financial reports.
Of special interest is the audit committee’s emphasis on the review of a wide range of financial activities—with the exception of one item. The audit committee is empowered to investigate fraud and other forms of financial misconduct, rather than review the results of such an investigation by someone else. The reason for this direct action is that employees are probably involved in the fraudulent activities, which may possibly involve members of management, so the audit committee can only obtain an unbiased review of the situation by investigating it itself.
Thus, in all cases besides the investigation of financial misconduct, the audit committee’s role is to examine the results of a variety of audits and other investigations to ensure that the company’s system of financial reporting fairly represents actual operating results.