Audit Committee: Background, Evaluation, Recommendation

Table of Contents

Introduction

Corporate governance plays an important role in disciplining the management of the company like transparency in financial reporting and having robust internal controls. Enormous responsibilities like audit committee, a duty of the auditors and induction of non-executive directors to act independently have been inflicted on the management of the company and any deviations will be viewed seriously and action against directors can be initiated by the compliance authorities. In this essay, I will be analyzing the role and functions of an audit committee which are the essential elements of corporate governance for the proper financial reporting of a company’s annual performance.

Spira (2002) in his book cites Arthur Anderson description of the audit committee, which is a group of directors who are not concerned with day-today management of the company but supervising how business is administered, conducted and reported. A committee of directors which is entrusted with the precise duty to evaluate the yearly financial reports of the business is known as the audit committee. An audit committee acts as a link between the board of directors and the auditor which includes the evaluation of the statutory audit report, the suggestion of the auditors, the general extent of the audit, internal financial controls, the financial information for publication, and outcomes of the audit. According to the Cadbury committee, an audit committee refers to the properly constituted audit committee which is an essential step in increasing the standards of corporate governance (p.5).

Theory

Spira (2002) explains agency theory of corporate governance as the separation of ownership and control of a business. Spira cites Keasey et al (1997) views of agency theory as the principal –agent or agency or finance model as it offers effective restraints on managerial powers and shareholders thus can exercise their voting rights to allocate corporate resources to value-maximizing ends (p.10).

Spira (2002) cites Tricker (1996) who lamented that three theoretical model namely agency theory, stewardship theory and stakeholders theory, which were really underpinning the corporate governance research as these theories offered very restricted brainstorms into the realistic functioning of corporate governance systems. Stewardship theory rests on the myth that directors can be relied and offers the structure for the present legislative and regulatory structure. However, stewardship theory ignores the energetic functions of boards, social insights of effects and roles of board leadership.

According to Tricker, stakeholder theory was emanated from a panic at social level especially transnational companies which had turned too big and mighty to be held responsible through the traditional stewardship form (p.14).

Miettinen (2008) in his book cites the framework advocated by DeZoort et al (2002) which focuses on effectiveness of the audit committee. This framework recommends that effectiveness of the audit committee depends upon different aspects associated to composition of the audit committee as well as diligence of audit committees. Thus, I recommend that operational measures for an effective audit committee should be based on the theoretical framework of DeZoort et al. (2002). Miettinen also recommends the framework of Watkins et al (2004) that effectiveness of the audit committee as a significant driver for audit quality (p.25).

In his book, Dallas (2004) describes about the U.K‘s new Combined Code which came into force from November 2003. This combined code demands a company to have an effective board of directors who is jointly liable for success of the company. Sir Robert Smith commission report published in 2003 recommended about the need for the audit committee to have a bigger role to make sure good financial reporting (p.335).

Background

Generally accepted good business practice demands that Board should make sure that effective arrangements are in place to offer assurance on risk management, internal control and governance. In this aspect, the Board should be guided by an audit committee independently. The various legislations like Cadbury code, combined code, in UK and Sarbanes Act , USA prescribes rules and regulations for setting , establishing and overseeing by the audit committee. After series of corporate failures in 1980’s, at the efforts of London Stock Exchange , a committee was established under the chairmanship of Sir Adrian Cadbury mainly to look into all financial aspects of corporate governance as the failed companies financial accounts and reports were either misleading or there was “window dressing ‘ to report profits. Thus, the main aim of the Cadbury committee was to analyse the effectiveness and functions of the Board of directors, to elevate the standards of the corporate governance and to fix the responsibility for financial reporting. The committee later submitted its report, which included a bunch of recommendations on best practice in corporate governance that was known as the Cadbury Code which was made applicable to UK public companies. In 1995, Greenbury Code was published, which aimed to streamline the director’s remuneration in UK. In 1996, The Hampel Committee was established to review the Cadbury code and the Greenbury Report and to recommend amendments wherever proper, and it submitted its report in 1998. Hampel report, in its introduction, stated that while Cadbury and Greenbury reports had been dealt mainly with prevention of abuses, whereas the Hampel committee was equally concerned with positive advantages that could be derived from best practice in corporate governance.

On the recommendations of the Hampel Committee, both Cadbury and Greenbury recommendations were combined with the Hampel Committee to make a single code of corporate governance for UK listed companies and known as the Combined Code 1998. In 1999, the Turnbull Report which dealt with Internal Control: Guidance for Directors on the Combine Code was published with the support of London Stock Exchange. It suggested a risk-oriented approach to operation, design and asserting of a sound scheme of internal control. In 2003, the Higgs Report which dealt with the non-executive director’s role and the Smith Report which dealt with the role and duties of the audit committee was published and its majority of recommendations were adopted in 2003. Thus, in 2003, a revised version of the Combined Code was published on the basis of Turnbull, Higgs and Smiths Reports. The above Code still remains as voluntary and the ‘explain or comply ‘need is still implemented by the UK Listing Rules. In 2003, GKN was the first listed UK Company where its shareholders rejected the director’s remuneration report as they felt its chief executive was overpaid (Coyle 2006:p.217-226).

According to Combined Code, the audit committee standards require a certain minimum standard like a minimum number of committee members, they should be the non-executive, external and independent directors. At least, one of the directors should have financial experience.

Evaluation

The Combined Code requires that the board of directors should constitute an audit committee consisting at least three directors or two directors in case of small companies who should be the non-executive, independent directors. Audit committee should not have the chairperson of the board of directors of the company as its member. Further, Combined code expects that the audit committee should be liable for some aspects of control and audit. It is significant that the committee should be able to do its assignment adeptly and with impartiality. Thus, the Combined Code stress that at any rate one of the audit committee member should have recent and relevant financial experience. Further, the Smith Guidance stresses that one member should have adequate accounting background or qualification (Coyle 2006: p.250).

Responsibilities and Roles of Audit Committee

According to the Combined Code, the main responsibilities and roles of an audit committee include the following:

  • The committee should monitor the integrity of the financial statements of the business.
  • The committee should probe into the accounting policies adopted and the opinions of the auditor about the judgments made by the top management.
  • The committee should periodically review the internal control and risk management system in the company periodically.
  • The effectiveness of the internal audit should be frequently monitored and reviewed by the audit committee.
  • Relationship with the outside auditors of the company should be reviewed by the audit committee. Audit committee has to fix the terms of external auditors and to approve their remuneration.
  • The audit committee should watch the autonomy of external auditors and should review the efficacy of the external audit process. The committee should review the work and the audit findings.
  • Audit committee should structure a company policy for awarding non-audit assignment to the external auditors and make suitable suggestions to the board in this regard (Coyle 2006: p.250).

These responsibilities and roles make the audit committee a significant body for the purpose of the corporate governance. Though, the audit committee is assigned with the role of supervising financial reporting, all the directors of the board of a company are equally responsible in law. The rest of the directors should be aware what audit committee is doing and any disagreement between them should be thrashed out at the board level.

Combined Code requires that the report of the audit committee should be included in the annual accounts and annual reports of the company. Further, it requires that the chairman of the audit committee should attend the annual general meeting to answer the queries if any raised from shareholders of the company (Coyle 2006: p.251).

Role of Audit Committees of the Board in fraud detection

Audit committee will deal with complaints regarding any objectionable auditing or accounting matters including:

deliberate error or fraud in the preparation, assessment, appraisal or audit of any fiscal statement of the company:

  1. fraud or intentional error in the maintaining and recording of financial records of the company;
  2. shortages in or nonconformity with the company’s internal accounting controls;
  3. falsification or false statement to or by a senior executive or accountant regarding a subject contained in the financial records, audit reports or financial reports of the Company;
  4. departure from full and fair reporting of the Company’s monetary condition.

About 72 % of the survey’s out of a sample of 330 respondents have responded that internal controls are of their paramount attention and focus of the member of the audit committee as disclosed by the survey conducted by Ernst & Young during first half of 2006. Compliance with regulations and laws and business risk management were their next aim and it constituted about 60% of the respondents. About 35% respondents responded that anti-fraud was the main focus of the audit committee. Further, Ernst & Young survey indicated that audit committee members have undergone a demanding workload with internal control issue [Directors& Trustee Digest, August 2006].

A study conducted in the banking industry in USA by Fiesher, Dale L reveals that about 30% of the survey’s of the audit committee had reported violations. Audit committee with the all outside directors reported about 29% violations. As a rectification measure for violations, measures such as civil money penalties, a cease and desist order and termination of an executive. About 9% of banks with an audit committee have dismissed an executive for theft, fraud, misfeasance and misuse of funds.

For instance, the audit committee of Sapient Corporation, U.S.A had disclosed it had reached the conclusion to investigate into the Sapient’s chronological stock-oriented reward practices.

The report of the sapient audit committee’s consisted the under mentioned major revelations:

  • The inquiry witnessed no misbehavior by any constituent of its present management band.
  • The investigation found short of of checks and controls and credentials with Sapient’s stock-oriented reparation allotting method, and misdeeds associating to the valuation of some stock option allotments granted mainly during the phase from 1996 through 2001.
  • The investigation revealed that the Sapient’s previous CFO, previous CEO and previous General Counsel involved, to varying extents, in issuing these allotments.
  • Whether the management has found out, and the audit committee concurs, that the corporation will require restating some of its past financial statements to account for charges of non-cash for reparation expenses pertaining to earlier period stock option allotment [Business Wire, 2006].

Thus, Audit Committee plays a pivotal role in detecting and preventing frauds as evidenced by survey made by Ernst & Young and by Fiesher, Dale L. Hence IRS should closely scrutinize the audit committee’s report to assess whether the company is engaged in fraudulent activities or not.

Table 1 : Audit committee Findings effectiveness in Banking sector in USA

Audit committee Findings effectiveness in Banking sector in USA. Banks with Audit Committee Banks without Audit Committee
Violations and Frauds 30% 36%
Order for amended call report 41% 32%
Enforcement Action Initiated 3% 3%
Employee’s dismissal 12% 9%

After Enron issue, matters concerning the external auditor have also raised in the failure of Superior Bank in Chicago and First National Bank of Keystone [Freibert, George, 2003].

Internal auditing criterion framed by “The Institute of Internal Auditors “supports reporting through stipulated conduits, especially to the audit committee on some transactions like serious frauds or misappropriations.

A scenario may arise where an internal auditor may witness where reported wrongdoing has been neglected by the audit process. In such a scenario, an internal auditor has the first and foremost duty to get resolution on the issue through the internal audit department right up to top audit executive of the company or the audit committee itself. If the audit management decides to ignore or neglect the issue, then the internal auditor has the moral responsibility and duty to report the issue through company’s hotline function or even through the Stock Exchange Commission (Moeller 2004:210).

Recommendation

One another special feature of SOX (Sarbanes Act of USA) is that it safeguards the interest of whistleblowers especially employees. Section three hundred one of SOX now demands publicly traded companies’ audit committee to frame structures for “secret unknown revelation by employees as regards to suspicious accounting practices or questionable audit matters.” Whistle blowing employees now being offered protection under SOX from being fired from the company.

Hence, I strongly recommend that same protection to whistle blowers should be extended in UK also so that many corporate frauds and accounting frauds can be brought to the notice of the audit committee.

Conclusion

Thus, Audit Committee plays a pivotal role in detecting and preventing frauds as evidenced by survey made by Ernst & Young and by Fiesher, Dale L. Sapient Corporation, U.S.A had disclosed that the audit committee had released the conclusion of its examination into the Sapient’s chronological stock-oriented reward practices. An effective audit committee will deter corporate frauds. Further, an efficient audit committee helps the external auditor to function independently. An audit committee will help to safeguard the interests of the various stakeholders of a corporation. Thus, audit committee, can be explained as pivotal element of the corporate governance mechanism.

List of References

Business Wire. (2006). Sapient Audit Committee Reports findings of Stock-based Compensation Investigation, Business Wire, 06(11).

Coyle, B. (2006). Risk Awareness & Corporate Governance. London: Lessons Professional Publishing.

Dallas, G. S. (2004). Governance and Risks. New York: McGraw: Hill Professional.

Flesher, D, L. (2004).Audit Committee Effectiveness in the Banking Industry. Management Accounting Quarterly, (4).

Freibert, G. (2003). Audit Committee after Enron. Hoosier Banker, (2).

Miettinen J. (2008). The Effect of Audit Quality on the Relationship between Audit Committee. Vaasa: University of Vaasa.

Moeller R.R. (2004) Brink’s Modern Internal Auditing. New York: Wiley Publishing.

Spira, L. F. (2002). The Audit Committee: Performing Corporate Governance. New York: Springer.

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