For accounting folks who works for a listed entity (company that sells its share to public), audit committee is probably their friends (or enemy?)—at least they know what audit committee really is. But for those who don’t, it is most likely a stranger.
In broader scope, international investors are concerned about the quality of corporate governance because of the impact of financial collapses and alleged frauds on securities markets. In response, to more effectively attract foreign equity investment, a number of stock exchanges around the world have adopted audit committees to increase transparency and competence in the management of their listed member companies.
So what is audit committee, why it matters, how it works? This post describes it shortly, in hope that you (and readers in general) get basic knowledge about it. It does not affect you life for not knowing it, surely, but accumulating more knowledge is always good, though. So read on…
Again, audit committee is a key institution in the context of corporate governance. The committee ensures that boards of directors fulfill their financial and fiduciary responsibilities to shareholders. Through their audit committees, boards of directors establish a direct line of communication with internal and external auditors as well as with the chief financial officer of the entity.
Such an organizational structure combined with reporting responsibility in an environment of free and unrestricted access enables full boards of directors not only to gain assurance about the quality of financial reporting and audit processes, but also to approve significant accounting policy decisions.
Moreover, strong and effective audit committees, through their planning, reviewing, and monitoring activities, can recognize potential problem areas and take corrective action before problems that affect companies’ financial statements and other financial disclosures arise. Thus, audit committees have an important role in helping boards of directors avoid litigation risk because such committees provide due diligence related to financial reporting.
Who Requires The Existence of Audit Committee?
Audit committees have long been seen as an important group in ensuring greater corporate accountability in the United States, initially. The value of such committees has been noted by the U.S. Congress, the U.S. Securities and Exchange Commission (SEC), the New York Stock Exchange (NYSE), and the American Institute of Certified Public Accountants.
Audit committees are required by the NYSE, American Stock Exchange (AMEX), and National Association of Securities Dealers (NASDAQ/National Market System issuers).
Prior to changes imposed by the passage of the Sarbanes-Oxley Act of 2002, other major efforts were directed at the betterment of audit committees. One such effort was the publication of the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees in 1999. There followed, in the same year, new rules and disclosures related to audit committees by the NYSE, NASDAQ, and AMEX.
Notwithstanding earlier events, in 2001 with the disclosure of a number of major accounting scandals (e.g., Enron and WorldCom), questions were raised about the effectiveness of audit committees. As a result, the U.S. Congress passed the Sarbanes-Oxley Act and the SEC adopted final rules amending the securities laws. Such actions have had an impact on audit committees.
In response, the self-regulatory organizations (such as NYSE, AMEX, and NASDAQ) enacted amendments to their listing standards with respect to the role and responsibilities of audit committees within the corporate governance framework. Hence, the major thrust of these reforms is to create a new legal and regulatory environment and corporate governance framework. The goal is to restore investor confidence through an efficient securities market system.
The events noted have led to a number of audit committee best practices becoming federal statutes. Audit committees, as a result of the changes, must adhere to higher standards in corporate accountability to ensure the quality of financial information and investor protection against accounting scandals. The Sarbanes-Oxley Act has mandated significant changes in how boards and their audit committees can meet their oversight responsibilities in both the auditing and financial reporting areas.
In addition to the presence of audit committees in companies listed on U.S. stock exchanges, a number of stock exchanges in Canada, Europe, Africa, the Middle East, and the Asia/Pacific region have adopted requirements for audit committees for their listed companies.
As worldwide financial markets expand and more companies are listed on major stock exchanges in different countries, the international investing public’s demand for consistent and equal oversight protection through the use of audit committees will continue.
How Audit Committee Is Organized and Structured
The Sarbanes-Oxley Act of 2002 explained that the term ‘audit committee’ means:
(a) a committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer;
(b) if no such committee exists with respect to an issuer, the entire board of directors of the issuer. Section 301 of the act contains an amendment to Section 10A of the Securities Exchange Act of 1934, which relates to independence of audit committee members. The requirement is stated in these words:
(a) In General – It means: each member of the audit committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent.
(b) Criteria—In order to be considered to be independent for purposes of this paragraph, a member of an audit committee of an issuer may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee—(i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof.
Boards of directors form their audit committees by passing a board resolution or by amending corporate bylaws. Audit committees’ responsibilities should be clearly defined and documented in their charter. Although the scope of the audit committees’ responsibilities is predetermined by boards, the committees should be allowed to expand their charge with board approval and investigate significant matters that affect financial reporting disclosures.
Boards of directors should carefully give consideration to the following points with respect to their appointments of directors to audit committees:
1. Number of directors – The number of independent directors appointed to audit committees depends on the nature of the business and industry dynamics, the size of the company, and the size of the board of directors. The general consensus seems to be that three to five members are adequate.
2. Composition – Because members of audit committees have varied backgrounds and occupations, they provide a mix of skills and experience. Although the members have different levels of expertise, it is strongly advisable to have at least one individual who has a financial accounting background.
3. Meetings – Audit committees meet one to four times each year, with three or four meetings being the most common.
Nature Of Audit Committee Responsibilities
Boards of directors define the role and responsibilities of their audit committees. This jurisdictional charge is usually disclosed in the audit committees’ written charter, which includes the terms of reference, such as mission statement, membership (size and composition), term of service, frequency of meetings, scope of responsibilities, and reporting responsibilities. Audit committees are primarily responsible for the quality related to such matters as:
- External auditing process
- Internal auditing process
- Internal controls
- Conflicts of interest (code of corporate conduct, fraud presentation)
- Financial reporting process
- Regulatory and legal matters
- Other matters (interim reporting, information technology, officers’ expense accounts)
Although boards of directors have defined the responsibilities of audit committees, boards may expand the scope of the audit committees’ charter; boards should, however, avoid diluting the committees’ charge with information overload.
Recognizing that audit committees operate on a part-time basis and serve in an advisory capacity to boards, it is essential that boards place limitations on the scope of the committees’ charge. Such a scope limitation enables boards to evaluate the committees’ performance as well as protect the committees against legal claims for their inactions that are outside their charge.
Roles and responsibilities of audit committees are disclosed in the annual proxy statements of publicly owned companies.
Since the Enron and WorldCom fallout, a number of public and private sector institutions have issued reforms with respect to audit committees in the corporate governance context. Presumably these reforms and the new legal and regulatory framework will provide guidance and assistance to boards of directors and their audit committees in effectively discharging their fiduciary responsibilities to shareholders.
Likewise, these reforms will enable audit committees to maintain quality in their oversight of both the internal and external audit processes as well as the financial reporting process to restore investor confidence in the financial reporting system.
Finally, it is evident that the scope for the responsibilities of audit committees will significantly increase. Therefore, it is essential that audit committees engage in an active, continuous educational improvement program to help their boards discharge their fiduciary responsibilities to shareholders. Contemporary corporate governance imposes serious responsibility on audit committees. Failure to assume such responsibility may require different organizational structures for corporate governance.