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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.
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 companyâ€™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.
The audit committeeâ€™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.