The Role of the Audit Committees - Essay Example

?Audit & Assurance Contents Contents 2 Introduction 3 Objectives of the Paper 4 Rights and Responsibilities of the Audit Committee 4 Assurance & Audit Process 6 Discussion & Analysis 8 Conclusion 9 References 11 Introduction This paper is an attempt to provide the understanding of the audit process and the role of the audit committees in post-crisis financial markets and how effectively they have been supervising the audit process and bringing transparency in financial disclosures. At the turn of 21st century, there happened a number of scandals such as WorldCom, Enron which made people question the integrity of the audit profession. The most respected firm Arthur Anderson, which was the audit firm for Enron, was finished. This led to a stronger demand for supervision of auditing practices. Therefore US introduced the Sarbanes Oxley Act in 2002 and UK, in 2003, set up two reviews- RRAP (Regulatory Regime of Accountancy Profession) and CGAA (Coordinating Group on Audit and Accounting) (Gray & Manson, 2007, p.140). The audit committee consists of board of directors who are entrusted with the oversight of financial reports preparation and disclosures. The more reliable the information is the more it is useful and through the auditing this purpose is achieved. The shareholders of a company are its owners who appoint the stewards in the form of directors and managers to manage the company on their behalf. The problem arises when the stewards place their personal interests before the owners’ interests. And as the managers are at an advantage over shareholders in terms of information the auditing (both internal and external) functions become all the more important. The recent financial crisis has led to the requirement of enhancing the transparency on the manager’s activities and their risk management. The identification, analysis and management of the operational as well as strategic risk are the key to avoid failures of firms if the crises were to occur in future. The audit committee alone is not responsible to prevent the economic downturn but plays an important role by challenging the assumptions and estimates the auditors undertake as part of the audit process as the economic environment changes with time (FRC, 2011). Objectives of the Paper This paper has mainly five objectives. Firstly, to understand the rights and responsibilities of the audit committee and their importance in today’s volatile financial environment. Secondly, why firms need audit committees and what they are doing to improve audit committees’ effectiveness. Thirdly, the meaning and importance of Audit Assurance has been explained. Fourthly, there is an explanation of the audit process both internal as well as external. Fifthly, the role of regulators and audit firms in bringing more effectiveness in audit process and transparency in financial disclosures so that the investors able able to take informed decisions. Rights and Responsibilities of the Audit Committee The Financial Reporting Council has provided the guidelines on Audit Committees. The rights of audit committee are as follows: 1. All the directors and management staff are obligated to keep the audit committee properly informed even if not asked. They must be cooperative with the audit committee. 2. The opinions of the audit committee should be listened and discussed by both the management and the board. 3. The audit committee has a right to intervene if it finds any discrepancy in the audit and financial controls process. And if not satisfied by the explanations given by the management then it may seek independent advice. 4. The work of the audit committee gets time consuming and intensive; therefore management must provide them with the necessary resources including the payment. There should also be a provision of induction and training of the new audit committee members in the company. The training may be continued if required. The board of the company should establish an audit committee with at least two to three members in consultation with the nomination committee (if it exists) and the audit committee chairman. The appointments should be for a period of three years which can be extended by further two three-year terms. The main responsibilities as given by Financial Reporting Council are: 1. Monitoring the integrity of announcements regarding financial performance and the reported financial statements. 2. To review the significant judgements pertaining to financial reports. 3. To review the company’s risk management systems and internal controls unless a separate risk committee addresses it. 4. To monitor and review the internal audit process. 5. To recommend the appointment of external auditor to the board and approve his/her remuneration. 6. To check the external auditor’s independence, with due consideration to the UK’s regulatory requirements. 7. To develop and implement the provisions regarding the non-audit services by the external auditor. 8. Finally, suggesting actions for improvement if needed to the board (FRC, 2010). Figure 1: Accountability of the Audit Committee (Source: Braiotta et al, 2010, p.33) Assurance & Audit Process Assurance is a service usually provided by Certified Public Accountant (CPA) to make sure the dissemination of verified information in the form of financial reports. In a way they aim to decrease the information risk the investors face. Audit is a type of assurance service. Other assurance services include comfort letter, customer satisfaction survey. The audit process consists of four stages: Planning: In this step the auditor plans the audit, notifies the firm of the same, and discusses the objectives and scope of the audit. He/she also evaluates the existing control system and processes. Fieldwork: During this step the auditor evaluates whether the internal control system is operating properly and in the manner described by the firm. At the end of this stage the auditor summarises his/her findings on which the draft of the audit report will be based. Audit Report: Here the auditor will prepare the rough draft of the report and discuss it with the firm prior to preparing the final audit report. The final audit report will contain the auditor’s findings and recommendations for any improvements. The opinion which the auditor will give will be one of the three- Unqualified, Qualified and Adverse. Unqualified means that the financial statements are prepared with due diligence and represent the true and fair view of the firm’s financial position. Qualified and Adverse represent negative opinions (Braiotta et al, 2010, p.331). Audit Follow-up: Within one year of giving the final audit report, the auditor will conduct a follow-up review to verify the report findings. On the basis of functions there are basically two types of auditing: External Audit: External auditing is conducted by an independent auditor and is conducted periodically. Its main purpose is to know whether the financial statements give a fair and true view of the financial health of the company. Internal Audit: Internal audit is conducted by the audit department of the firm. In internal audit, the accounting transactions as well as the systems are examined. It includes both the operational audit and the audit of the management. The internal audit is an integral part of the internal control process (Basu, 2009, p.2.4). Discussion & Analysis In 1999, the Blue Ribbon Committee (BRC) issued guidelines to improve the corporate governance practices with increased audit committee independence, effectiveness and accountability between the audit committee, management and external auditors. It said that every member of the audit committee should have sound financial knowledge and at least one of them should be an expert in accounting management preferably holding a certification in accountancy. The major development following a lot of scams such as the bankruptcy of Global Crossing, Enron and WorldCom have been the introduction of Sarbanes Oxley Act, 2002 in USA, which was based on the BRC recommendations (Chen & Zhou, 2009, p.1).. The Act changed the regulation of audit firms, corporate disclosures and other corporate governance issues. The Act talks of the auditor’s independence and objectivity, enhanced disclosures and the responsibilities of the directors and management (Lander, 2005, p.1). In UK, the new regulatory framework was based on these principles: Independence, Transparency and Openness, Public Interest and Integrity and Review. In recent times, the audit committee’s responsibilities have increased because of changes in legal, regulatory and risk environment. Risk management is an important part of corporate governance. The board of directors and the audit committee members together are responsible for providing assurance that the risk management framework in the company is managed well. In essence, the audit committee functions objectively between the external auditor, management and stakeholders to ensure that the timeliness, transparency and integrity of the financial reporting are maintained. In order to do so it mainly focuses on two aspects- oversight of internal control and external auditing. In a study on effectiveness of audit committee in China, it was found that the companies that have large chairman ownership, large number of total assets, independent accounting expert director and Big Four auditors (Deloitte, KPMG, PWC, Ernst & Young) were more likely to have effective audit committee (Chen & Zhou, 2009, p.14). According to Alleyne and Howard, those companies which have sound internal audit system and effective audit committee are in a better position to prevent accounting frauds (Alleyne & Howard, 2005). As the regulators, investors and other stakeholders are demanding more financial disclosures, within seven years the annual reports have gotten lengthy. The UK Government is planning on limiting the annual reports to the essential and material information and key messages and rest to be transferred online (Pilot, 2011). This may pose challenges to the regulators but this is an indication that financial markets understand the importance of fair and transparent corporate governance practices in order for them to be strong. Conclusion This paper has tried to explain the audit committee’s rights and responsibilities and how it can be an effective tool in conducting a fair and transparent audit process. It has also tried to present the audit process and types of audits. It is very important to restore investors’ confidence during the financial crisis. This emphasizes the importance of auditing and assurance in the financial markets. Many firms’ management feel that if they have a strong and effective internal control system, there can be more transparent disclosure and the frauds can be prevented. There had been significant developments in early 2000s with introduction of Sarbanes Oxley Act, 2002 and the reviewed corporate governance policies by Financial Reporting Council in UK. But the recent financial crisis has led to shattered investor confidence and the regulators have understood the importance of increased corporate disclosures and supervised audit process. This has led to the increased responsibilities of the audit committees in the firms. The audit committee plays an important role as an oversight committee to the audit process and hence has the right to bring out any discrepancies in the same. Recently both the government and regulators in developed economies are trying to regulate the auditing requirements of the firms and increase the relevant disclosures in order to gain stakeholders’ confidence. Studies have shown that those firms which have sound internal control process and effective audit committees are less prone to accounting frauds. References Alleyne, P. & Howard, M. (2005). An exploratory study of auditors’ responsibility for fraud detection in Barbados", Managerial Auditing Journal, Vol. 20 Iss: 3, pp.284 – 303. [Online]. Available at: http://www.emeraldinsight.com/journals.htm?articleid=1463715&show=abstract. [Accessed on October 25, 2011]. Basu. (2009). Fundamentals of Auditing. Pearson Education India. Braiotta, L. et al. (2010). The Audit Committee Handbook. John Wiley and Sons. Chen, X. & Zhou, N. (2009). Audit Committee Effectiveness: Evidence from a Government Inspection in China. [Pdf]. Available at: http://sm2.xmu.edu.cn/xxjjt/paper/Audit%20Committee%20Effectiveness%20Evidence%20from%20a%20Government-Inspection%20in%20China%E3%80%90%E9%99%88%E6%AC%A3,Nan%20Zhou%E3%80%91.pdf. [Accessed on October 27, 2011]. FRC. (2010). Financial Reporting council Guidance on Audit Committees. [Pdf]. Available at: http://www.frc.org.uk/images/uploaded/documents/Guidance%20on%20Audit%20Committees%202010%20final1.pdf. [Accessed on October 25, 2011]. FRC. (2011). Effective Company Stewardship Enhancing Corporate Reporting and Audit. [Pdf]. Available at: http://www.frc.org.uk/images/uploaded/documents/Effective%20Company%20Stewardship%20Final2.pdf. [Accessed on October 25, 2011]. Gray, I. & Manson, S. (2007). The Audit Process: Principles, Practice and Cases, 4th ed. Cengage Learning EMEA. Lander. (2005). What is Sarbanes-Oxley? Tata McGraw-Hill Education. Pilot, S. (2011). Annual reports: the quest for clarity. [Online]. Available at: http://www.accountancylive.com/croner/jsp/Editorial.do?contentId=1995120&BV_SessionID=@@@@0700152866.1319689465@@@@&BV_EngineID=cccfadfemjkfgefcflgceggdfnfdgfh.0&channelId=-601065. [Accessed on October 27, 2011]. Read More