The Role Of The Audit Committee

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This report will focus on the role of the audit committee. Recent high profile failures such as Enron, Worldcom certainly brought the spotlight onto the role of the audit committee. This report will examine the role of the Audit Committee over the years and who exactly they are and what they do. Recent current issues that have highlighted areas of weakness with the audit committee shall be assessed and it will also look into finding out what remedies if any there have been to correct them.

Methodology

This report will mainly use reports, such as the HM Treasury handbook, and Corporate Governance guide as this basis. Some journals and newspapers have been used, but as the majority of this report is regarding the different aspects of the role of the audit committee, the handbooks were the most up-to-date and reliable information.

Introduction

'The audit committee of the board of directors, executive managers, external auditors and internal auditors are the cornerstones of the foundation upon which effective corporate governance must be built, '(Bishop, 2002).

In the Audit Committee handbook of 2007 by the HM Treasury, it was stated that the role of the audit committee was to 'support the Board and Accounting Officer by reviewing the comprehensiveness of assurances in meeting the Board and Accounting Officers' assurance needs, and reviewing the reliability and integrity of these assurances'.

Discussion

History

The Audit Committee was first endorsed by the New York Stock Exchange in 1939. But it was only in 1972 that the Security and Exchange Commission (SEC) recommended that all publicly held companies should establish audit committees. This was promptly emulated by the stock exchanges who advised and required that companies establish audit committees. They enforced a 'comply or explain' policy, which instructed companies listed to comply with the requirements set or explain valid reasons why requirements had not been complied with. The National Commission on Fraudulent Financial Reporting investigated ways to prevent and detect fraudulent financial reporting in 1987, this was known as 'The Treadway Commission'. They along with the 'Blue Ribbon Committee' of 1999 made audit committee recommendations. This showed early signs that setting up and Audit Committee was not enough and that guidelines needed to be followed in order to strengthen them. After the scandals of Enron and WorldCom in the USA, acts such as the Sarbanes Oxley Act came into place in 2002 and developments were made to the Combined Code in order to increase audit committees' responsibilities and authority, and bring about membership requirements and committee composition to included independent directors.

The Cadbury, Greenbury and Hempel reports all led to the production of the Combined Code, which was published in 1998. The Combined Code is 'inextricably linked with the Listings Rule published by the UK Listing Authority', but it is not legally binding (Drennan O, Cole M, 2002)

The Sarbanes Oxley Act is much stricter than the Combined Code. According to the Combined Code, the Audit Committee should consist of no less than three non-executive directors, and they have to review the auditor's work. Unlike the Sarbanes Oxley however, the Combined Code does not state that the committee is responsible for the appointment of those auditors. It also states that when an auditor provides a large amount of non-audit work, it would then need to approved by the Audit Committee.

Objectives Of The Audit Committee

The role of the audit committee is so important to good governance that it was subject to a separate review in 2003. The Smith Guidance on Audit Committees, produced by Sir Robert Smith, is annexed to the Combined Code. (The Director's Handbook, Martin Webster of Pinsent Masons, 2007)

The Combined Code States that an Audit Committee should consist of at least three non-executive directors. It also states that the board should have at least one member of the audit committee who has recent or relevant financial experience.

The main roles of the Audit Committee were set out in the Combined Code. It stated that the Audit Committee should monitor the integrity of the financial statements, review the company's internal financial controls, monitor the effectiveness of the company's internal audit function, make recommendations in relation to appointment, re-appointment and removal of the external auditor and to review and monitor the external auditor's independence, objectivity and effectiveness of the audit process. When monitoring the external auditor's independence, the audit committee is to develop and implement a policy on the engagement of the external auditor to supply non-audit services.

Issues With Audit Committee

Although the Combined Code states that the Audit Committee should consist of at least three non-executive directors, as this is not regulatory it does not have to be adhered to. An Audit Committee may also appoint affiliated directors if the board determines that it is in the best interests of the company. This means that firms still have flexibility in determining Audit Committee composition. In a situation like this, Audit Committee independence, as well as other issues such as the trustworthiness of the Audit Committee and bias decision making in the Audit Committee come into play, as businesses may put people who have personal interest in the company into the Audit Committee therefore defying the purpose of making the Audit Committee team in the first place.

In 2009, Sport Direct, UK's leading sports retailer, stated in their company report that their Audit Committee consisted of two non-managerial directors and the acting chairman, who was in fact the owner of Sports Direct. This led to controversy, as talks of scare mongering were also present, with owner/acting chairman supposedly putting pressure on the other two members' of the audit committee. This raises major trust issues about the Audit Committee.

The Audit Committee also commission assurance work from appropriate sources when it identifies any significant risk, governance and control issues, which are not being subjected to sufficient review so that all discrepancies are effectively remedied. The problem with this is that not all Audit Committee's put this into practice some do and some do not.

Requirements Affecting The Role Of The Audit Committee

There are a number of requirements affecting the role of the Audit Committee within and organistaion. These include statements regarding attendance and quorum. An Audit Committee should have between three and five members depending on the size of the business. They should meet at a minimum four times a year and there shall be at least one meeting a year where the Committee meets the external and internal auditors, if any, without executive members present. If there are not enough non-executive board members to form the Audit Committee, the appointment of independent external members is allowed.

Audit Committee members must be both independent and objective. Thus, Audit Committees should be independent non-executive board members.

There should be no executive responsibilities for the Audit Committee and they cannot make or endorse any executive decisions. However, they may be able to draw attention to any strengths and weaknesses in control and suggest how these can be dealt with.

The Audit Committee cannot have executive members of the organisation in its structure. For particular agenda items though, the executive may attend the Audit Committee meeting to provide information.

Other people who can be present at the Audit Committee meetings are the accounting officer, the finance director, the head of internal audit and a representative of the external auditor. Any conflicts of interest in the audit committee have to be declared and a each member has to take personal responsibility to pro-actively declare it. These will be dealt with by the Chair of the Committee.

Current Issues (Recession)

The high profile failures of corporate governance such as the collapse of Enron and WorldCom showed that a change was needed. In the case of Enron, it had been a spectacular failure resulting from unethical and fraudulent behaviour. Senior management played a huge part in fraudulent financial reporting, leading to Enron's demise. For some of the corporate failures the Audit Committee ended up being directly blamed, as a result of being either too closely involved with the corporation or for being oblivious to financial reporting situations. (Rockness and Rockness, 2005)

The collapse of Enron directly led to the introduction of the Sarbanes Oxley Act in 2002, which legislated ethical behaviour for firms and their auditors. It recommended that Audit Committees should monitor all financial information communicated to the public to ensure that investors were not receiving misleading information.

In the UK, the government has commissioned the Smith Report in 2003, the Higgs Report in 2006 and the Walker review in 2009. These all emphasised various items about the Audit Committee and were made to restore investors' confidence in the market.

When Lehmann Brothers collapsed in 2008, an accounting principle called 'repo 105' had been used which had temporarily boosted the balance sheet of the company. By lowering its leverage ratio, a key measure for credit rating agencies, through 'repo 105', it provisionally sold assets with a duty to repurchase them days later, at the end of financial quarters, in order to get a temporary flood of cash. This shows that even with the strict rules of the Sarbanes Oxley Act, more improvements need to be made regarding the financial accounts of the company, to avoid further business collapses.

Improvements

Corporate scandals such as Enron and Worldcom prompted legislative and regulatory reforms by the Securities and Exchange Commission, such as the Sarbanes Oxley Act of 2002. These reforms have radically redefined and re-emphasised the roles and the responsibilities of all participants in a public company's financial reporting process, including that of the Audit Committee. The Audit Committee's role as the 'protector of investors' interests' is now substantially clearer and expectations of them are now much more higher (Vera Munoz, 2005).

Under Sarbanes Oxley, Audit Committees' responsibilities and authority were increased. Membership requirements and committee composition were also raised to include more independent directors. Audit Committee members now have to be qualified with recent experience and companies are required to disclose whether or not a financial expert is on the committee. All of this was done to strengthen the Audit Committee, in the hope that a strengthened Audit Committee would mean a Strengthened firm.

Best practices of the audit committee

Sarbanes Oxley introduced Audit Committee best practices. These were made to strengthen Audit Committee composition and authority, to improve the Audit Committee's monitoring role and to increase audit committee responsibilities.

- Oversee the financial reporting process

Quarterly and annual financial statements are used by the stockholders to evaluate how well the business is doing. The audit committee should review these financial statements with the management and with external auditors.

- Monitor choice of accounting practices and policies

What accounting principles a firm uses affects its financial statements. Under Sarbanes Oxley, the Audit Committee needs to be given a statement from the accounting department detailing what policies they have used, what effects other policies have made on the financial statements. The Audit Committee must then review these with the external auditor and management.

- Monitor internal control process

The audit committee has to ensure that management have followed a proper internal control process, by monitoring the internal control system.

- Open communication

It is the responsibility of the Audit Committee to ensure that there is open communication between management, internal auditors, external auditors, and the audit committee. To do this the audit committee has to meet separately with the three groups, both regularly and on a need to know basis. Any disagreements between the management and the external auditors need to be resolved by the Audit Committee.

- Oversee hiring and performance of the external auditors

Under Sarbanes Oxley, the Audit Committee are responsible for the hiring of the external auditors. They are also responsible for approving any non-audit work that the external auditor does for the company.

Conclusion

The Audit Committee have taken on more of a monitoring role, where they monitor management as well as relaying all the information obtained in the external audit. Studies show that very few best practices are actually put into practice by Audit Committees. However, the Combined Code and Sarbanes Oxley Act have been excellent for business as the strict regulations means chance of failure or fraud are minimised. Whilst human error can still be a problem within the Audit Committee, the fact that members of the Audit Committee will be seen as liable means that they will be more diligent in their work. Since the disasters of Enron/Worldcom, the role of the Audit Committee has increased and more power and responsibility have been given to them. The future sees the role of the Audit Committee only growing, not depleting. The danger however lies in giving the Audit Committee too much responsibility and not enough help in compiling the require information.

Recommendations

The audit committee is the ultimate monitor of the financial reporting process. Thus, they should be vigilant, informed and effective when overseeing the financial reporting process. Individual committee members must have relevant financial experience, and be qualified enough to know what they are reviewing. They should also have a general understanding of the company's economic, operating, and financial risks. Members should also have a wide understanding of the interrelationship of the company's operations and its financial reporting. The Audit Committee should also have the ability to probe and question about the company's financial reporting process, and be able to formulate the answers. At present the codes followed by the Audit Committee to improve efficiency and performance that will eliminate issues of trustworthiness are minimal. Therefore, they should enhance the code of ethics, making stricter rules and passing them as legislation as currently the Audit Committees are regulating themselves instead of being regulated.

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