Audit Committee - Explained
What is an Audit Committee?
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Table of ContentsAudit Committee DefinitionA Little More on What is an Audit CommitteeHow the Audit Committee Works with ExampleExampleDuties and Responsibilities of the Audit CommitteeQualifications for the Audit Committee MembersKey Factors to Enhance Audit Committee EffectivenessAcademic Research
What is an Audit Committee?
An audit committee is a section of a company's board of directors in charge of ensuring that there are transparency and accuracy in financial reporting and disclosure. It is regarded as one of the company's major operating committees on the board of directors. It is a requirement in the United States, for all publicly traded companies to maintain a competent and qualified audit committee to be able to qualify for listing on the stock exchange. The audit committee members should comprise of independent outside directors, and at least one person should be a financial expert with proven qualifications.
What Does an Audit Committee Do?
In the corporate world, the audit committee plays a major role in any given organization as far as controlling, directing, and accountability are concerned. It represents the board of directors and the major part of the corporate governance mechanism. Its involvement in the organization also touches on:
- Both external and internal audits
- Internal control
- Financial reporting
- Regulatory compliance
- Risk management
Audit committees are generally known for their effectiveness in corporate governance when it comes to reducing deceitful financial reports. They have the obligation of protecting and preserving the equity and interest of the shareholders. To achieve this, they have to oversee the activities of the management of the organization as well as external and internal auditors. To ensure transparency in the financial reports and statements, the audit committee report has to be part of the firms proxy statement. The reports should say if the audit committee conducted a discussion and review of the financial statements with the internal auditors and management. Note that the audit committee has the authority to acquire any expertise and consulting resources they may need to execute their duties and responsibility. Generally, it is the responsibility of the audit committee to monitor and share financial information that is correct, complete, accurate, and reliable with the public. There should be no gaps in the report that may lead to uninformed expectations or predictions.
How the Audit Committee Works with Example
To verify if their financial analysts and managers are using the right procedure in financial reports and statements, organizations usually engage the audit committee. Some of the financial procedure it observes includes business regulations, risk management, and accounting policies. The committee also assists organizations in creating financial reporting procedures.
Lets assume the company ABC is nearing the fourth quarter of the fiscal year. So, it decides to engage an audit committee, to review its financial reporting and figures if they are accurate. The company then approaches a panel of 5-7 people from outside to form the official committee. The committee is brought before the board of directors for approval, and they then proceed to start the auditing process. The committee uses federal regulatory policies and guidelines to analyze the adherence and efficacy of the said standards by different company departments. The committee confirms that the financial regulations were followed and that the company's financial reports and statements are correct. While wrapping up the audit process, the committee will give the company recommendations to help it improve on the financial reporting and operation.
Duties and Responsibilities of the Audit Committee
The audit committees typical duties and responsibilities include the following:
- Maintaining communication with the company's controller and chief financial officer
- Oversight of financial reporting to ensure that it is accurate
- Monitoring of accounting policies to ensure that they comply with the set regulations
- Discussing risk management policies with the company's management
- Whistleblowing in case of any irregularities in the financial reports and statements
- Communication with the company's shareholders on their activities
- Initiating investigation in case there is a problem with the accounts
Qualifications for the Audit Committee Members
Knowledge and Skills - The members that form the audit committee should possess the necessary experience as well as skills. Any member of the audit committee should be knowledgeable in the following:
- The external and internal audit process
- The internal financial control
- Corporate law and regulations
- Risk management policies
- The integrated reporting especially financial reporting
- The general process of governance within an organization
- Information and technology governance
- Education qualifications
Education Qualifications - According to the companies act, it is a requirement for one third of the audit committee members to have any of the following academic qualifications or work experience:
- Corporate governance
- Commerce public affairs
- Human resource management
Key Factors to Enhance Audit Committee Effectiveness
To enhance the effectiveness of an audit committee, the following factors should be put into consideration:
Audit Committee transparency Transparency is key for enhancing the effectiveness of an audit committee. The committees disclosure is one of the important aspects when it comes to transparency, as it makes reporting more meaningful. The disclosure should revolve around the work and other key areas of the audit committees operations. The disclosure should give insights issues that the committee can put into consideration as far as the financial statements and reports are concerned. It should also show how the committee was able to address the issues. Generally, determining how the committee discharges the audit process is essential. It enables the organizations board of directors to assess its performance and effectiveness for transparency purposes.
Effective Communication Effective communication is also another factor that enhances the effectiveness of an audit committee. When there is a good flow of information to and from the audit committee, it shows how effective it is. Effective communication should apply to the following:
- Written and oral
- Formal and informal
- Internal and external audit
- Communication with the company's management, CFO, and board
Generally, the audit committee needs to communicate with the management and board of directors and explain to them how it has been able to discharge the audit process. It needs to have a broad discussion to deliberate on key aspects of the entire audit process, highlighting issues that may require the boards input.
Committee Composition Another factor that can enhance the effectiveness of the audit committee is the composition. The composition of the audit committee must be made up of individuals who are skilled and competent. It is a requirement that one-third of the members should have perfect knowledge in finance as well as a diversity of experience in financial reporting oversight. Members of the audit committee should also have the urge to continue learning and developing themselves. By doing this, they will keep-up-to-date on the current and emerging issues in the world of finance and accounting.
Efficient and Effective Working Methods The audit committee should find efficient methods of executing their work, especially with the increase in risks and complexity in their workload. Clear terms and references with well spelled out duties and responsibilities is a good example of best work practices.
Academic Research on Audit Committee
Audit committee, board of director characteristics, and earnings management, Klein, A. (2002). Audit committee, board of director characteristics, and earnings management.Journal of accounting and economics,33(3), 375-400. This study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process. Audit committeecharacteristics and restatements, Abbott, L. J., Parker, S., & Peters, G. F. (2004). Audit committee characteristics and restatements.Auditing: A Journal of Practice & Theory,23(1), 69-87.Earnings management and corporate governance: the role of the board and theaudit committee, Xie, B., Davidson III, W. N., & DaDalt, P. J. (2003). Earnings management and corporate governance: the role of the board and the audit committee.Journal of corporate finance,9(3), 295-316. We examine the role of the board of directors, the audit committee, and the executive committee in preventing earnings management. Supporting an SEC Panel Report's conclusion that audit committee members need financial sophistication, we show that the composition of a board in general and of an audit committee more specifically, is related to the likelihood that a firm will engage in earnings management. Board and audit committee members with corporate or financial backgrounds are associated with firms that have smaller discretionary current accruals. Board and audit committee meeting frequency is also associated with reduced levels of discretionary current accruals. We conclude that board and audit committee activity and their members' financial sophistication may be important factors in constraining the propensity of managers to engage in earnings management. Audit committeecomposition and auditor reporting, Carcello, J. V., & Neal, T. L. (2000). Audit committee composition and auditor reporting.The Accounting Review,75(4), 453-467.Economic determinants ofaudit committeeindependence, Klein, A. (2002). Economic determinants of audit committee independence.The Accounting Review,77(2), 435-452. This paper provides empirical evidence that audit committee independence is associated with economic factors. I find that audit committee independence increases with board size and board independence and decreases with the firm's growth opportunities and for firms that report consecutive losses. In contrast, no relation is found between audit committee independence and creditors' demand for accounting information. Although the analyses are based on data from 1991 to 1993, these results have implications for NYSE and NASDAQ listing requirements for audit committees adopted in December 1999. Specifically, the new requirements give firms the option of including nonoutside directors on their audit committees if it is in the best interests of the firm to do so.