The Role of the Audit Committee and Financial Projection of Companies - Essay Example

THE ROLE OF THE AUDIT COMMITTEE Introduction This discussion is based on a comprehensive evaluation of the role of the audit committee reviewing and analyzing articles on the process of auditing and the audit committee's contribution to the management of taxpayers', corporations' and government's expenditures. The focus here could be on audit committee and its role in corporate governance or even the role of audit committee as it relates to financial projection of companies and government expenditure and the audit committee whether in private or public sector could be primary or central to the financial reporting of a company and is an essential part of maintaining open and transparent financial systems within any firm. The audit committee's role is equally important in both the private and public sector. The effectiveness of the audit committee, the various flaws and inconsistencies in their functions and theoretical underpinnings are all considered along with examples of corporate collapses due to audit committee faults. Audit committees' role in the United Kingdom's Parliamentary system of government stems from the concept of apt management and responsible expenditures considering that taxpayers' money constitutes the capital that must be appropriated for public services (Hollingsworth, and White 1999). So, all disbursements must be within the constitutional provisions of the legislative system. Relatively, legislated protocols are in placed to ensure consistency, and to avoid corrupt practices that may lead to waste. In addition to the department of budget, the office of the commission on audit was created to oversee and assure legitimate expenditures and to avoid deficits as much as possible. Chances are high, that the members of the audit committee are certified public accountants and lawyers considering the nature of the role that the audit committee plays in the configuration of appropriate budget consistent with interpreted laws. Importance of the Audit Committee As far as audit committee role in the Parliament is concerned, the United Kingdom Parliamentarians created a set of legal rules that must be observed by the audit committee in every evaluation of budget allocation proposals. These legal rules also include provisions that guide evaluation after expenditures are consummated. The set of legal rules are contained in the Supply procedure documents. Normally, an annual audit report is submitted to the legislative body at the end of the fiscal year (Hollingsworth, and White 1999). In the preparation of an annual budget that will cover expenditures for the subsequent fiscal year, the bureaucracy's independent subdivisions perform three general standard functions: 1) set the budget allocation for the year; 2) rank expenditures according to importance; 3) at the release of an approved budget for disbursement, asses, evaluate, and audit the values of the supposed expenditures. Subsequently, after the documents are submitted to the executive department, the senior management will collate and prepare to support the tentative annual budget. This annual budget will then be submitted by the senior management to the parliament. The legislative body will deliberate on the budget extensively prior to endorsement. Consequently, whatever part of the budget appropriation is found substantive the legislative body will cast their ballot on it, making the same available for disbursement. 4) Finally, after all the funds appropriated were approved and disbursed according to the plan, the accounting commission will issue a corresponding report which will be dully evaluated by the audit commission for proprietary considerations (Hollingsworth, and White 1999). However, the "constitutional analysis, especially by lawyers, has tended to underplay the significance of audit, especially the role of the Comptroller & Auditor General (Deloitte & Touche, 2009) and National Audit Office in the accountability of government" (Hollingsworth, and White 1999). Audit Committee and Corporate Governance The audit committee has an important role to play in corporate governance. The objectives of the committee have to be "geared toward effecting pragmatic, progressive changes in the functions and expectations placed on corporate boards, audit committees, senior and financial management, the internal auditor and the outside auditors regarding financial reporting and the oversight process." (Ramos, 2003, p.18). This means that all audit committees should have goals related to progressive and pragmatic changes in the management and work towards financial reporting that would be according to the expectations of corporate boards and auditors. According to the Committee's report as specified by Ramos, the responsibility for financial reporting is carried out by three groups: 1. The company's board of directors and this may include the audit committee 2. Financial management team, including the internal auditors 3. The independent auditors who may not be in the team but are nevertheless responsible for the reporting The audit committee does the monitoring of financial reporting as it is an extension of the board although it is also true that in order to maintain credibility committee members should be independent of the company and the management. Any member of the senior management should not be audit committee member although senior management should have significant interaction with audit committee members and an improvement of this interaction could mean a better and more decisive and organized audit committee. An audit committee is responsible for a company's financial reporting process and also upholds the quality of financial reporting striving to maintain transparency and accountability at all levels. An audit committee in a company is primarily responsible for the company's financial reporting process and also maintains the standards of financial reporting and thus in order to carry out its responsibilities, the committee must have good knowledge of the company's goals and strategies as also the issues related to achievement of company objectives. An audit committee thus not only oversees the maintenance of company goals and objectives but also provides support to the company strategies by providing insight into the links between company financials and company objectives. The audit committee might consider some of the following issues in its agenda - Risk identification and response - This deal with risks to the company workings and policies and in corporate governance identifying risks is one of the primary factors. Risk identification leads to risk response or how to overcome risks or security and other threats to the company. Pressure to manage earnings - The management of financials and earnings or profits in a company is done by the audit committee which is responsible for all financial accountability within a company Internal controls and company growth - This is also an important issue for the audit committee as any company growth should be complemented by the internal growth of the company and the audit committee helps to provide a balance between internal control and company growth. It is essential that an audit committee identifies risks and also understands or discovers ways to mitigate these risks which could be associated with internal controls and these risks could deal with external conditions such as rapid technological changes, downturns and recession and also unrealistic earning expectations. Risks could also be related to operating characteristics such as organizational change, complex transactions and organizational structures, rapid growth, inexperienced management and currency exposures or fluctuations. Risks that are related to financial information and internal controls would be associated with lack of management, inappropriate management, and inappropriate control of environment and reporting. The audit committee should try to seek a balance between company policies and management compensation levels. According to Ramos, 2003 who delineated the audit committee's role, audit committee members should: Recognize the sources of external and internal pressure to meet earnings projections and whether these can affect the company's accounting policies. Note and identify significant and unusual transactions, particularly those recorded near the end of a reporting period. Delineate the company's revenue recognition policies and whether they are consistent with other businesses in the same industry. Mark the significant estimates, deferred costs, and accruals. (Ramos, 2003) All financial and earning and profit and loss reporting should be based on the real underlying financial performance of any company rather than what the management wishes to project. Vanasco (1994) discussed the role played by Securities and Exchange Commission (SEC) the New York Stock Exchange (NYSE), the American Institute of Certified Public Accountants (AICPA), The Institute of Internal Auditors (IIA), the Treadway Commission, and other professional organizations in highlighting the importance of audit committees from an international perspective. Along with these organizations in the USA, the UK Cadbury Committee, the Australian Borsch Committee, and the Canadian Macdonald Commission are some of the other audit committees which are internationally important. The audit committees around the world follow similar guidelines so that they can work within a specified framework and have definite set of universal rules that would make accountability meaningful or understandable across nations. This means that if many countries follow the same auditing rules and regulations, it is easier to compare the auditing regulations internationally and thus judge flaws and advantages if any. Thus the guidelines for audit committees set by IIA, AICPA, SEC, and the Treadway Commission are rather influential. There may be cultural differences that could limit the effectiveness of the applicability of guidelines to all audit committees although auditing is generally considered a homogeneous profession with fixed and common rules and regulations even across cultures. There are common accounting practices and profits, losses, balances are all done within defined norms and limits of accounting principles so despite cultural variations there could be much common in accounting and audit committee working and functions worldwide, a fact that gives sufficient credibility to the profession as well. The Institute of Internal Auditors, is an international professional association, and it seems such organizations should consider the cultural dimensions of corporate governance in formulating professional standards of internal auditing even if these may have to deal with the structure and functions of audit committees on n international level (Vanasco, 1994). A study by Spira (1999) suggested that auditors' integrity as reflected in financial reporting could be influenced by the extent of independence they have at work. The findings show that auditors may be guided by codes that emphasize on independence and work ethics, yet this may not be effective in eliminating unethical practices. According to Spira (2002) the Code of Best Practice on the financial aspects of corporate governance (Cadbury Committee 1992) is seen as standardized board behavior and the code offers a mechanism for promotion of ethical behavior and tends to limit or prevent unethical practice by executive directors suggesting that auditors should have sufficient independence from directors and that independence is a prerequisite of ethical behavior (Spira, 2002). The role of the auditors and the audit committee in general and the importance of independence could be related and audit committees may need greater focus on matters related to independence of auditors. Corporate governance mechanisms tend to relate performance with independence and general functions of the audit committee however this a complex relation and needs to be better studied. There have been many regulatory changes in corporate governance recently and these reforms have redefined the roles of individual auditors and others involved in the financial reporting of companies and government organizations (Vera Munoz, 2005). The corporate audit committees work with greater expectations of upholding shareholder interests and maintaining investor confidence. Audit committees are faced with the challenge of financial reporting in corporate governance environments and there could be new expectations and responsibilities of the audit committee considering corporate governance reforms and challenges. The corporate and government audit committees have challenging tasks of providing fair and accurate financial reporting that would also uphold shareholder and investor interests and at the same time enhance company credibility by providing transparent financial accounts. Apart from identifying the regulations that are common for all audit committees and highlighting the need for identifying risks in practice, and for maintaining ethical practice, the audit committee has broader financial and economic roles as it could bring basic stability and provide a financial forecast for economic scenarios including recessions. There are other issues related to knowledge and information about company or government financials which are adequately provided by the audit committees so audit committees are seen as the face of economic or financial transparency and accountability and as such they are expected to work independently of the management board of a company and maintain a balance of interests as far the management of the company, the shareholders, investors and public are concerned. The audit committee thus helps to secure corporate accountability and transparency and makes the financial information of a company more accessible to investors and shareholders. It could also expose the flaws and weaknesses within a company thus all financial risks are also identified and in certain cases business organizations could collapse as in case of corporate scandals due to unethical practices of the audit committee. Porter (2009) distinguished between corporate accountability and corporate governance and explained the role of audit functions that helps secure the accountability. The growth of economic entities and organizations are facilitated by human and other technical resources and with the economic and social power of certain monitoring institutions and that of the public, managers of financial companies are held accountable for possible financial abuse and the audit committee prepares accountability reports in the form of financial statements. With the more public participation of companies, now large companies are considered to be necessarily accountable to the public and to society as a whole and respectable transparent and accountable corporate governance is an essential ingredient of the economy especially after several recent corporate failures that had a tremendous impact on the society and economy as well. In all accountability reports, corporate responsibility has been considered as important and all companies that maintain public accountability tend to have external and internal auditors and most activities of a company are seen as requiring accountability. In securing corporate accountability, the audit functions have to be carried out not just by the company's internal and external auditors but also by the audit committee and so the entire function is multidisciplinary in nature (Porter, 2009). The question of corporate accountability and the manner in which it is maintained is essential for study as it also explains the relationship between accountability and governance and highlights the role of the audit function providing insights into the changes of the functions and the audit processes in general and how these might develop in the future. The auditors have a supervisory and monitoring role as well as they are responsible for accountability and oversee financial transactions so that all regulations in accounting are met. . In recent years there has been some erosion of public confidence in certain high profile companies following financial statement fraud and problems with the financial reporting process and audit functions. Some of the recent scandals associated with Enron, WorldCom, Adelphia, Global Crossing have highlighted the dangers of fraudulent financial transactions and the need to restore public confidence in the larger organizations. The need for financial transparency is also as important and an essential aspect of consumer trust and public accountability of these companies. The Sarbanes-Oxley Act of 2002 was drawn in an attempt to regain trust in the corporations following the many scandals that hit consumer trust badly. The Act helped restore credibility in corporations and in accounting professions and addresses corporate scandals and crisis in the accounting and auditing profession apparently due to perceived lack of values and ethics in business accounting. Audit committee functions relate to corporate governance and internal control structure, as also internal and external audit functions and services. Rezaee et al (2003) discuss three types of audit committee disclosures that could provide financial clarity and accountability of many public accountable companies including the Fortune 100 companies. These three types of audit committee disclosures are: "the annual report of the audit committee; reporting of the audit committee charter in the proxy statement at least once every three years; and disclosure in the proxy statement of whether the audit committee had fulfilled its responsibilities as specified in the charter" (Rezaee et al, 2003, p.531) The Act and other regulations by audit monitoring institutions have emphasized on the need for transparent and ethical accounting and all financial accounts and transactions of large companies and governments are expected to be in accordance with the requirement of standards of practice. More than any other profession the ethical aspect of accounting is important as fraudulent auditing and accounting practices by large organization and corporations not only erodes public trust but also could be harmful for the economy and the global markets which tend to rely on certain large organizations for stability in financial transactions. Krishnan and Vishvanathan (2005) studied the role of audit committees and the functions of auditors for reporting internal control deficiency and especially how the roles have now changed with the Sarbanes Oxley Act. The paper reported some significant findings that firms with weaknesses of internal controls are more prone to report a higher number of meetings of the audit committee, fewer numbers of financial experts within the committee and more frequent auditor changes and all these characteristics would mean that the firm is financially weak or has internal audit problems and issues. When certain firms have more internal weakness when compared with certain others, the results and the manner of functioning could affect areas other than financial reporting and this could be related to complexity of operations, profitability and growth of the organizations and all these governance characteristics are also important along with reporting of internal control weaknesses so when internal control weaknesses of firms are identified a host of other factors are also predicted and this could also provide sufficient insight into the audit committee functions or audit relations in the firm. There are however internal strengths on the other hand or internal organizational drivers that could highlight the effectiveness of the audit process with the changes in internal auditing and with the central role of the objectives of corporate governance. Arena and Azzone (2009) have provided their thesis for the effectiveness of internal auditing highlighting the strengths rather than weaknesses of internal audit as they suggest that the effectiveness of internal auditing within a business organization are influenced by several factors of (1) the characteristics of the internal audit team, (2) the audit processes and activities, and (3) the organizational links. The internal audit team will have to be efficient and carry out audit processes and activities not just efficiently but also ethically and the links with other organizations and external auditors could help in making the system and process ore transparent and reliable. Arena and Azzone collected data from 153 Italian companies to study the effectiveness of internal auditing and the authors suggested that audit effectiveness could increase when the ratio between internal auditors and the employees increases. This means that when there are more internal auditors in larger organizations, it is expected that the financial accounting and auditing procedures will be more transparent. A large auditing team is required for a large organization to make the auditing process more detailed and thus more believable and true. Detailed financial reporting enhances transparency as there will be very few loopholes to cover or elude and all transactions could be traced and thus investigated on resulting in better financial accountability of the firms. However companies will have to adopt several effective measures including risk assessment techniques to make the auditing process stable. When corporate governance and audit committee roles are linked, the changing role of the external auditor shows how concepts of risk and control could be incorporated in corporate governance and what implications this could have for the functions of the external auditor. Holm and Laursen (2007) suggest that corporate governance has strengthened the role of internal auditors and they have an advantage over external auditors so more emphasis will have to be given in understanding the role of the internal auditor. The authors suggest that the determinants for the role of external auditors seem to be in conflict although some features could relate to risk orientation. It has been suggested that external auditors must be perceived as the experts in internal control and risk management and this is considered as part of the service as also nature of the audit only then external auditors could be considered as important as internal auditors, so external auditors will have to be well aware of the internal audit processes, results and systems as well. The transparency and communication processes of audit reporting are also equally important and it remains true that internal auditors tend to have several advantages when compared with eternal auditors especially as the internal auditors will have more facilities as they relate to internal systems of organizations and will also have better access to communication systems and processes. Internal and external auditors differ in their advantages and accessibility although they are driven by common objectives of increasing transparency in the financial accounting of organizations. The overall function of an audit committee will be however dependent on both internal and external auditors if the audit committee has to be accountable ad transparent and the external auditors will have to be well aware of the internal audit and vice versa. Turley and Zaman (2007) investigated the conditions and processes that affect the operations and effectiveness of audit committees, and have focused on the interaction between the audit committee, individuals from financial reporting and internal audit functions and the external auditors. The main focus of their study has thus been on the interaction and communication between internal and external auditors and individuals who are involved in financial reporting of companies. The process of interaction is significant as this could be related to the operational effectiveness of the audit committee in general. The study has been based on participants in the audit committee including the audit committee chair, external and internal auditors as also the senior management. According to their results, informal network and interaction between audit committee participants tend to have significant effects on the audit committee governance outcomes even though interactions may occur outside formal structures and processes. The behavioral effects of an organization could be used further to understand issues and conflicts although audit committee interaction and communication could be used to study organizational politics and communication processes, power plays and also for interpretation of events and cultural values and ethics. The communication processes and their study within the context of an audit committee could bring about the dynamics of relations between audit committee members, between internal and external auditors, between auditors and the senior management and also between the audit committee and the investors. In some cases the audit committee may well have to be accountable to the public and also the government and in that case interaction will have to be studied in accordance with the objectives of the committee and how these objectives could be met through interaction with other members within or outside the organization. The behavioral and interaction elements in the audit process could also help to determine the weaknesses and strengths of the audit process and also the audit committee and how far the audit committee could be affected by negative or positive interaction or how the internal strengths and weaknesses drive or affect the process of communication in general. Turley and Zaman (2007) write that further research on the audit committee and governance processes would be needed to understand how the audit committee could be effective or what essential elements are central to the effective working of the committee. The authors studied the historical and institutional contexts of these audit committees and their operational effectiveness and suggested that significant changes in the regulatory environments tend to affect current structures and processes of audit committees. As seen in the case of Enron or Worldcom when the economic climate was greatly affected by audit committee actions and decisions and all major corporate collapse that have been caused by financial fraud are affected by audit committee decisions and in turn affect future decisions. The authors present factors suggesting the importance of governance role of audit committees and the development of policy regulations and a relation between governance and auditing with the following statement: "The case analysis highlights a number of significant factors which are not fully recognised either in theorizing the governance role of audit committees or in the development of policy and regulations concerning audit committees but which impinge on their governance contribution" (Turley and Zaman, 2007, p.766). The paper highlighted these factors in understanding governance roles and in the development of policy regulations and these are related to (i) the importance of informal processes around the audit committee including interaction and communication ; (ii) the influence of informal processes and other elements in defining power relations between organizational participants; (iii) the relevance of the historical development of governance within an organization r how governance structures have evolved in time; (iv) and the possibility that the audit committee's impact on governance may be more in non-routine or extraordinary situations (Turley and Zaman, 2007). A recent paper by Collier and Zaman (2005) analyzed corporate governance codes issued by 20 countries and the convergence of corporate governance systems in Europe. There has been some convergence in cooperate governance concepts and mainly because the audit committee is widely accepted in the European countries with two tier governance systems as also as unitary governance systems. The audit committee system and concept is common through many cultures and the audit committees across cultures follow basic principles which allows for corporate governance systems to be studied systematically and using a common platform. The audit committee recommendations as well as governance codes highlight the importance of independence and financial expertise of committee members and this is applicable in the UK and US as well as European nations. However considering convergence of the corporate governance systems in Europe at an operational level, Collier and Zaman suggest that there is limited consistency in the structures and roles of audit committees despite common or similar regulations and corporate governance structures. '''' Lin et al (2006) discussed the effective practices of audit committees and emphasized on the role of the audit committees in ensuring quality financial reporting for corporations and the process of financial reporting and management has become especially important due to certain scandals in earnings management cases for high profile companies like Enron. The collapse of Enron is a historical incident for the accounting profession and the paper by Lin et al associated audit committee characteristics such as financial expertise, independence and stock ownership with earnings restatement and earnings management and the relations between earning management and auditing or financial reporting could be significant as this would emphasize on the central role of the committee in averting financial disasters of major business organizations. As Lin et al state "Evidence suggests a negative association between the size of audit committees and the occurrence of earnings restatement" (Lin et al, 2006, p.922). Thus when audit committees are large enough, earnings management are better, more transparent and more credible. Conclusion A well balanced and well proportioned audit committee when compared with the size of an organization could be essential for proper functioning of the committee and the financial system of the organization in general. For bigger organizations, the large size of the audit committee with clearly defined roles for the internal and external auditors and proper interaction between the audit committee members, financial reporters and the management are clearly some of the features that are important for the general financial managements of such companies and for the benefit of the larger economy. Various examples of Enron, Worldcom and other financial breaches and scandals have been discussed to highlight the central role of ethical practice in accounting and auditing and the role of the audit committee in implementing code of ethical practice as also other regulations that could increase the credibility of the profession. In this discussion several issues related to the audit committee and its role and importance in corporate governance and in government establishments have been suggested. The focus seems to be on enhancing the accounting and auditing systems in the private and public sectors to make financial reporting more transparent and more in accordance with what the public or regulatory bodies expect. The regulations and legal statutes that have emphasized on the need for more accountability in financial reporting have been especially significant since the collapse of Enron and financial breaches and scandals of all sorts could only be significantly avoided with increased monitoring of auditing systems and with more efficient, credible and transparent or detailed auditing processes. This is further enhanced if companies maintain a large audit committee with significant interaction between members of the committee, external auditors and the senior management. Bibliography: Arena, Marika;'Azzone, Giovanni (2009) Identifying Organizational Drivers of Internal Audit Effectiveness. International Journal of Auditing, Volume 13,'Number 1, pp. 43-60(18) B'dard, Jean;'Coulombe, Daniel;'Courteau, Lucie (2008) Audit Committee, Underpricing of IPOs, and Accuracy of Management Earnings Forecasts. Corporate Governance, Volume 16,'Number 6, pp. 519-535(17) Benston G.J.;'Hartgraves A.L. 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