Role of Audit Committees in Managing Corporate Governance - Essay Example

?Introduction The last 15 years have witnessed some drastic changes in Corporate Governance across the companies of the world. One of the prominent features has been the incorporation of various corporate governance regulations and norms in various countries: Australia (BCA, 1991), UK (Cadbury Committee, 1992; CISCO; 1993; Hampel Committee, 1998; Turnbull, 1999) and US (NCFFR, 1987; Public Oversight Board, 1993, Sarbanes-Oxley, 2002). One of the major areas where there has been a significant change is the area of “Audit committees”. Audit committees have come to play a very prominent role in governing the way organizations do their business and report it to the world. In this context, it is very important that we understand the advantages and limitations of audit committees. Audit Committees Introduction An audit committee can be defined as a committee that generally comprise of non-executive directors and is responsible for liaising between the board of directors and the external auditors (Parker, 1992). The responsibilities of audit committee encompass matters related to audits, financial reporting and internal control (Spira, 1998). Because of the importance of audit committees, major stock exchanges across the world such as US, UK, Canada, India, France, Australia, Honk Kong, Japan and Germany have given significant importance as a part of their listing requirements. Audit committees started from the US and percolated to other countries of the world. Audit committee of an organization is expected to perform the following activities: Make recommendations in the area of external auditor to the Board of Directors. These include selecting the external auditor, deciding the audit fees, renew/terminate the contract with the external auditor, decide the scope of work done by external auditor and other liaising activities between the external auditor and BoD. Discuss the quality of the financial statements with the external auditor Review the company’s internal controls (the process on paper as well as on execution) Contribution of Audit committees Audit committees play a very important role in managing the corporate governance of organizations. The main reasons for which audit committees are set up differ from country to country. The four major contributions that an audit committee can make to the corporate governance of an organization are (Cobb, 1993): Reduction of board liability Establishing a link between the external auditor and the board Reduction of illegal activity and Proper representation of the financial statements Besides these, audit committees also reduce the agency cost of an organization. This is achieved by reduction in the information asymmetries between executive and non-executive directors (Eichenseher and Shields, 1985; Pincus et al., 1989). Audit committees also lead to reduction in the legal liability of the directors. Audit committees also help the process of corporate governance by: enabling BoD to meet their responsibility; improving auditor independence (Bradbury, 1990); and strengthening the role of non-executive directors (Porter and Gendall, 1998). Audit committees ensure that the external audit has performed its job well. At the same time they are also responsible for ensuring the reliability of the internal audit processes. This aspect of the audit committee will strengthen the overall audit process and positively impact the corporate governance of the organization. Audit committees also lead to generation of wealth for shareholders. This is based on the premise that non-executive directors are more likely to act in the interest of the shareholders (Rosentein and Wyatt, 1990). Limitations of audit committees Although audit committees play a very pivotal role in managing the corporate governance of an organization, there are certain areas which do not fall under the preview of the committee. An audit committee is not responsible to plan and conduct audits. At the same time, an audit committee is not responsible to determine if the company’s financial statements are correct. An audit committee can also not be expected to investigate if the company is meeting laws and the employees are adhering to the company’s code of conduct. Another problem that comes up with audit committees is the absence of clear statements of audit committee purpose, aims or objectives. Without clearly defined objective, audit committees can’t be Effectiveness of Audit committees Research on the effectiveness of audit committees has resulted in mixed findings. Some researchers concluded that audit committees are ineffective (Crawford, 1987; Jones, 1986). However, others suggest that having an audit committee prevented false representation of financial statements, reduced inconsistent accounting policies, and made a strong control mechanism on the external auditor (Kunitake, 1983; DeFond and Jiambalvo, 1991; McMullen, 1996). Collier (1996) in a study undertaken in UK concluded that there is limited evidence in the effectiveness of audit committees. Literature has suggested many factors that generally impact the effectiveness of audit committees. The three major characteristics that an audit committee should have in order to be effective are: Independence, expertise and diligence. However, research has suggested that mere existence of these three characteristics will not lead to an effective audit committee. An example in this case is Enron. Most of the directors at Enron were independent (Paredes, 2003) and were experts in their business field. However, the committee was not able to perform its job effectively. Certain companies such as Home Depot, Intel, Southwest Airlines and Microsoft that have board members as the audit committee member (Sonnenfeld, 2002) have been effectively managed. An audit committee will be effective its members are experienced in the area of financial reporting, attentive and proactive. Besides these, certain other factors such as: the number of members and the number of meetings in a year also impact the effectiveness of the audit committees. Effectiveness of audit committees has also been found to be impacted by behavioral factors such as groupthink. Conclusion Audit committees have come to play a very significant role in managing the corporate governance. Audit committees bring with them rigor in the external as well as internal audit process. These committees also reduce the burden and the legal liability of the Board of Directors. Existence of audit committee leads to increased wealth creation for shareholders. However, it is necessary that for an audit committee to be effective it is independent, the members are highly qualified, have knowledge of finance and audit process and are proactive. References Bradbury, M.E.: 1990, “The Incentives for Voluntary Audit Committee Formation”, Journal of Accounting and Public Policy 9(1): 19–36. Cobb, L.: 1993. An Investigation into the Effect of Selected Audit Committee Characteristics on Fraudulent Financial Reporting. Doctoral dissertation, University of South Florida. Collier, P.: 1996, “The Rise of the Audit Committee in UK Quoted Companies: A Curious Phenomenon?”, Accounting, Business and Financial History 6(2): 121–140. Crawford, J. G. (1987) An Empirical Investigation of the Characteristics of Companies with Audit Committees. Unpublished Dissertation, University of Alabama. DeFond, M. L. and Jiambalvo, J. (1991) Incidence and Circumstances of Accounting Errors, The Accounting Review, 66, July, 643–655. Eichenseher, J.W. and Shields, D. (1985). Corporate Director Liability and Monitoring Preferences. Journal of Accounting and public Policy, 4, 13-31. Jones, T. M. (1986) Corporate Board Structure and Performance: Variations in the Incidence of Shareholders Suits, Research in Corporate Social Performance and Policy, 8, 345–359. Kunitake, W. (1983) Auditor Changes by Audit Committees and Outside Directors, Akron Business & Economic Review, Fall, 48–52. McMullen, D. A. (1996) Audit Committee Performance: An Investigation of the Consequences Associated with Audit Committees, Auditing: A Journal of Practice and Theory, 15(1), Spring, 87–103. Paredes, T. A. 2003. Enron: The board, corporate governance, and some thoughts on the role of congress. Faculty Working Papers Series (February): 1-57. Parker, R. H. (1992) MacMillan Dictionary of Accounting, 2nd edn, London:MacMillan. Pincus, K., Rubarsky, M. and Wong, J. (1989). Voluntary formation of Corporate Audit Committees among NASDAQ firms, Journal of Accounting and Public Policy, 8, 239-265. Porter, B. and P. Gendall: 1998, “Audit Committees in Private and Public Sector Corporates in New Zealand: An Empirical Investigation”, International Journal of Auditing 2: 49–69. Rosentein, S. and J.G. Wyatt: 1990, ‘‘Outside Directors, Board Iindependence, and Shareholder Wealth’’, Journal of Financial Economics 26: 175–191. Sonnenfeld, J. A. 2002. What makes great boards great: It’s not rules and regulations. It’s the way people work together. Harvard Business Review (September):106-113. Spira, L.F. (1998). An Evolutionary Perspective on Audit Committee Effectiveness. Corporate Governance: An International Review, 6, 29-38. Read More