Audit Function And The Role Of Regulation Accounting Essay


One of the issues which affect the running of any organization or company either public or non public is that the owners and managers have two different sets of information, with managers generally having more information than the owners or investors. Agency theory is concerned with resolving problems that can exist in agency relationships; that is, between principals (such as shareholders) and agents of the principals (for example, company executives) provides one way to deal with this. Regulation and audit also help.

The role of audit

The general meaning of an audit is evaluation but it is normally taken to mean an evaluation of the financial and other records of business and is undertaken on behalf of the owners of the business by some independent expert. The purpose is to ensure that the information presented in the public accounts provides a (true and fair) view of the activities of the business and that the balance sheet provides a realistic assessment of the assets and liabilities of the business. It is undertaken on behalf of the owners and investors who tend to need to rely on this information for their assessment.

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In most countries audit is just a statuary function which must be undertaken by someone appropriately qualified. This someone is either a qualified auditor or a qualified accountant with some appropriate experience. Increasingly other information such as environmental impact assessment is subject to audit by appropriately qualified people. This kind of audit is growing in importance but is not yet subject to control such as for the financial statement auditing.

Although auditors are supposedly impartial they are appointed by the Board of Directors of the company and receive fee from the company. This had raised questions regarding their actual independence from the company and this is one important issue as far as governance is concerned. It should be noted that an impartial assessment is not always arrived at. For example the accounts of Enron were always audited and confirmed, although the auditors- Arthur Andersen- went out of the business at the same time as Enron did. Thus the role and impartiality of auditors remains a problematic subject.

The Audit Committee

Every company must have an audit committee. This is an operating committee from the Board of Directors charged with oversight the financial reporting and disclosure. Committee members are drawn from members of the company’s board of directors. It should contain independent directors and at least one member must be qualified as a financial expert. The role of the audit committee continues to evolve as a result of the passing of the Sarbanes-Oxley Act 2002.

Responsibilities of the audit committee typically include:

Overseeing the financial reporting and the disclosure process. In order to monitor the integrity of the financial statements and the disclosures.

Monitoring choice of accounting policies and principles. In order to consider if the accounting policies have been changed or different from the previous accounting period.

Overseeing hiring, performance and independence of the external auditors.

Overseeing regulatory compliance, ethics, and whistleblowers hotlines. In order to make sure that any organization has the ability to detect, prevent and respond to any illegal activities such as Fraud.

Monitoring the internal control process. This is done by requiring directors to write reports regarding their internal control system for example.

Overseeing the performance of the internal control function.

Discussing risk management policies and practices with management.

As a result to the preceding typical responsibilities, the role of the audit committee may therefore incorporate some of the following components:

The external audit process: the activities of the audit committee regarding the external audit typically includes:

Selecting the external auditor and paying him/her the agreed fees.

Establishing the engagement letter and specifying the terms of the engagement.

Making sure that the external auditor completes the entire parts of the audit plan that was agreed on.

Making sure that the external auditor is independent and any concern raised by him/her is dealt with by company management.

Making sure that the external auditor has a good and healthy relationship with company officials.

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Reviewing non-audit fees in order to ensure that they do not affect the independence of the external audit process.

The final accounts: as an audit committee considering the annual accounts and the report of the external auditor is really necessary for numerous reasons.

Discussing these accounts with the management and making sure that any concern or matter or even the existence of any scope in the financial statements regarding the accounts is properly handled and addressed.

Approving the final accounts by the board and the accounting polices used are some good methods for recommendation.

Systems of internal control: in order to maintain an adequate internal control system, the directors are required to report on the effectiveness of their system. In addition to that, they can do several means to keep the system effective such as

Seeking advice from the internal and external auditor about the best way to secure the internal controls. Besides that, they must review the material recommendations done by the auditors in order to improve the internal control.

Making sure that any breach of internal control is investigated and a special report about it is conducted.

Reviewing some major topics. For example, any significant related party transaction, management letter regarding the internal control and the overall control environment within the organization. Furthermore, they should assess the agreed control framework that is in use.

Internal audit: in any organization the appointment of qualified internal auditors is an important step that should be carefully planned in order to ensure that these individuals are performing the required functions. As an audit committee there are numerous key functions to think about relative to internal control, for example:

Supervise the internal audit activities and its objective. Moreover, the committee should agree on the strategy developed by the internal auditors. In addition to that, there should be always discussion with the internal auditors and managements about internal controls and any legal matters that may affect the organization.

Evaluate the performance of the internal auditors and make sure that their work is linked to an accepted professional standard. Any reports discuss internal audit must be considered also. Furthermore, think about the annual internal audit report that should be received.

Keep a good communication line between external auditors, internal auditors, board of directors and management.

Risk management: this is considered with the development of strategies for dealing with risk. The development of these strategies is dependent upon the assessment of the types of risk to which the situation is susceptible and the quantification of possible effects through analysis. The committee will guarantee that reporting risk is coordinated through several activities. First, to identify the existence of risk there must be a formal process and there must be a risk policy and strategy for dealing with it. Second, as a committee you should promote awareness and training workshops for all the staff in the organization in order to help them understand the problem and what they are expected to do. Third, there should be periodic monitoring by writing reports about the effectiveness of risk management procedures and implementation. By doing so, the audit committee is heading toward having an effective system.

Compliance and propriety: the internal control implemented is intended to provide reasonable assurance about the compliance with laws, rules, and regulation which is actually a control objective. The audit committee should be able to promote compliance including staff awareness and review the code of conduct and receive reports on any violations. As a result of these actions, the organization is able to detect, respond and even prevent any illegal act. Moreover, the consequences of such an action should be discussed and penalties must be taken.

Financial management: the audit committee takes the responsibility to consider the capital and expenditure of the organization by ensuring that a good financial reporting system and a suitable budgeting system are in place. Moreover, any concern regarding the financial statements must be properly addressed and resolved. That way the probability of financial misreporting is minimized as a result of tight control.

Special investigations: the audit committee may request special investigation from the internal auditor, external auditor or external specialist and even compliance officer where there is a need to investigate sensitive problems that fall within its remit. Special investigation will tend to happen in unusual areas where there are sensitive issues relating to audit, accountability and conduct.

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The audit committee’s constitution

Since the audit committee plays an important role in any organization, it should have a formal constitution to enable it to fulfill its role in an effective way. The Treadway Committee in the US said that (the mere existence of an audit committee is not enough. The audit committee must be vigilant, informed, diligent and probing). The constitution will depend on the organization in question, but may incorporate some of the following matters:

Principle role: since the audit committee is a subset from the board of directors a report regarding several issues such as the performance of the internal control, internal audit, external audit and self assessment exercises is presented to the board. In addition to that, the audit committee supervises the integrity of the accounting, auditing, risk management control and compliance with rules and regulations. It also can request investigation in suspicious activities in order to detect and prevent any illegal act or fraud.

Membership: since the audit committee is a subset from the board of directors, members of this committee is selected by them. The audit committee should consist of at least 3 independent members who follow a formal code of conduct. These members should be independent in order to carry their duties and responsibilities without having any conflict of interest that might affect their objectivity and independence. If this happens, independence issue must be disclosed. Not only should these members continue until their terms expire but also not more than two terms.

Competence: members of any audit committee must have sufficient competence to help them in performing and conducting their work and obligations. As an organization an important matter is to define the competencies applicable to the audit committee members. For example, at least one member of the audit committee should have an experience in financial accounting and reporting. Also, at least one other member of the audit committee should have an experience in corporate affairs and compliance with rules, regulations and other requirements. The other members should have an experience of serving on an audit committee. A major point to keep in mind is that these members must always demonstrate a degree of professional skepticism and good understanding of the business.

Meetings: all members should attend the meetings unless there are some exceptional circumstances. At least 4 times a year meetings should be held. It is preferable that no committee member must have so many seats on company boards or committees because it will prevent him to attend audit committee meetings. Any high levels of absences by members may lead to their disqualification and quorum shall be either 3 members or 50% of the membership.

Reporting Lines: since the audit committee is a subset from the board of directors, any recommendation and report is presented to the board. In addition to that, the audit committee has access to several people working inside the organization such as employees, CEO and CFO or any other individual working outside the organization such as the external auditor and specialists.

Authorities: the audit committee has access where it is important to fulfill its duties and obligations such as the records, information and personnel.

Agency theory and asymmetric power

Agency theory argues that managers merely act as custodians of the organization and its operational activities and places upon them the burden of managing in the best interest of owners of that business. Accordingly to the agency theory all other stakeholders of the business are largely irrelevant and if they benefit from the business then this is coincidental to the activities of management in running the business to serve the shareholders. This focus as the shareholders alone as the intended beneficiaries of a business has been questioned considerably from many perspectives, which argue that it is either not the way in which the business is actually run or that it is a view which does not meet the needs of the society in general.

Conversely stakeholders’ theory argues that there are a whole variety of stakeholders involved in the organization and each deserves some return for their involvement. Accordingly to stakeholder theory therefore benefit is maximized if the business is operated by its management on behalf of all stakeholders and returns are divided appropriately amongst those stakeholders, in some way which is acceptable to all. Unfortunately, a mechanism for dividing returns amongst all stakeholders which as universal acceptance does not exist, and stakeholder theory is significantly lacking in suggestions in this respect. Nevertheless this theory has some acceptance and is based upon the premise that operating a business in this manner achieves as one of its outcomes the maximization of returns to shareholders as part of the process of maximizing returns to all other stakeholders.

These two theories can be regarded as competing explanations of the operations of a firm, which lead to different operational foci and to different implications for the measurement, and reporting of the performance. It is significant however that both theories have one feature in common. This is that the management of the firm is believed to be acting on behalf of others, either shareholders or stakeholders more generally. They do so, not because they are the kind of people who behave unselfishly but because they are rewarded appropriately and much effort is therefore devoted to the creation of reward schemes which motivate these managers to achieve the desired ends. This is the subject of Agency Theory.


The role of regulation is essentially to compensate for the inefficiencies and inequities of the market place. In other words, it is to ensure that everyone gets a more fair chance in transacting with each other while seeking to minimize the costs of doing so. Unfortunately, the transaction cost minimization imperative has assumed superordinacy at the expense of fairness. This is a part of the problem. The main part of the problem however is one which no one seems to be addressing or even recognizing. This is that the market based model of economic activity is an aggressive one- one in which the winner takes all is the basis for behavior. This has led to the kind recklessness which we have witnessed and which has led directly to the financial crisis.

Economic theory has suggested that free market forces and competition is the preferable environment within which economic entities and industries should operate. The reason for this is that competitive forces provide incentives for economic efficiencies equitable distribution. If market forces are expected not to be capable of providing the correct incentives to the companies there is a need for government intervention. This is known as regulation which is used as a substitute for the missing market forces. The purpose of such regulation is to ensure that no party is able to exploit their unequal position for gain and ensure that efficiency incentives and equitable distributions are achieved.

Often the method of regulation which has been accepted is that of self regulation- with an industry effectively policing its members. Sometimes, as with the auditing industry, this has proved to be ineffective and external regulators have been appointed. Each regulator has the role of addressing and balancing up the needs of the various stakeholders of their respective industry. The stakeholders of regulated industries or markets include the press, customers and their pressure group, shareholders, city analysts and the government. Each of the stakeholders is interested in a different aspect of performance and so views the performance of the industry from a different perspective in order to reach different conclusions. From the list of stakeholders the prime concern has been with addressing the needs of the two dominant stakeholders: shareholders and customers.

Within western capitalist societies the emphasis is very much on companies providing the return to the shareholders and therefore they are a dominant stakeholder. In the case of the regulated industries the regulators have also been given the task of protecting the customers who would otherwise be gouged by monopoly abuses. In terms of customers the prime focus is upon domestic customers, possibly because they are the most numerous and in the weakest bargaining position, or possibly because these are the people who will vote for a government in the next election. Sliding scale regulation is more specifically oriented to the idea of ensuring consumers are not abused at the expense of shareholders. It allows greater returns to shareholders only if consumer prices are reduced.