How Audit Committees May Assists Organizations to Achieve Efficient Practices of Corporate Governance - Literature review Example

Audit Committee and Organization Name of the Student: Name of the Instructor: Name of the course: Code of the course: Submission date: Audit Committee and Organization Introduction Audit committees for a long time have been acclaimed as being fundamental in the efforts towards reliable and successful financial reporting mechanism in different companies. Diverse studies, for instance, Carcello and Neil (2000; 2003) and Klein (2002) have determined and supported the fact that independent directors who constitute the audit committees are the most ideal monitors of the financial reporting systems in diverse companies. On the other hand, many of their proponents of the audit committees have credited them as being the essence of corporate governance (Deloitte, 2012, p. 1). The core role of audit committees in cultivating corporate governance has seen a prerequisite for majority of the listed companies in Australia to have an audit committee. Against this background, this paper will explore the ways in which the audit committees may assists different organizations in their efforts towards achieving efficient and effective practices of corporate governance. On the other hand, it will analyze how the effective control environment at the organizational level might contribute to the effective functioning of the audit committee that may ensure the quality assurance engagements and stimulate implementation and recommendations. However, it is imperative to briefly expound on the actual definition of audit committees and their course of evolution in the corporate sector. Audit committees According to Gay & Simnett (2012, Ch. 3), audit committee can be perceived as a sub-committee of the board of directors or any other body mandated with governance, which constitutes predominantly of a majority of non-executive or independent membership of the body responsible with governing a specific entity. It is imperative to note that the audit committee represents the owners as opposed to the management. The prominence of the audit committees can be viewed to have been realized in the 1970 in the US, as they evolved into becoming formidable weapons against the financial scandals that plagued that particular epoch. Perhaps one of the most acclaimed scandals in that era is the one which involved the Equity Funding Corporation of America and as a result of these scandals, the New York Stock Exchange (NYSE) made the audit committees as a listing prerequisite in 1978 (Caput, Hotze & Golden, 2006, p. 7). The prominence of the audit committees has become widespread in the contemporary world in diverse countries around the globe. This is best epitomized in Australia whereby under the listing rule 12.7, the top 500 companies are obliged to comply with the audit committee requirements. This necessitates that all the entities which were incorporated in the S&P/ASX All Ordinaries index at the instigation of their fiscal years ought to have instituted an audit committee in that particular year (Gay & Simnett, 2012, Ch. 3). In addition, the operation, composition and role of the audit committee of the top 300 companies ought to be compliant with the best practice recommendations as underpinned in Principle 4 of the Principles of Good Corporate Governance and Best Practices Recommendations of the ASX Corporate Governance Council. Consequently, this has seen the elevation of the proportion of listed companies in Australia which have audit committees from less than 50% in the 1990s to almost 100% in the contemporary times. This fact is evidenced in the results of the ASIC Surveillance program. It is also imperative to note that the number of audit committees in the Australian public sector has also recorded some impressive growth in the recent past (Gay & Simnett, 2012, Ch. 3). It is fundamental to outline some of the chief responsibilities of audit committees at the organizational level in order to gain a comprehensive insight about the inherent relationship between these functions and other variables like corporate governance. Responsibilities of the audit committee Firstly, an audit committee is mandated with the role of monitoring the veracity of the financial statements in any given company (Smith et. al. 2003, p. 6). This fact is supported by Gay and Simnett (2012, Ch. 3) who determined that an effective audit committee ought to effectively oversee the accounting as well as the financial reporting functions at the organizational level. Secondly, an audit company in a company has a responsibility of reviewing the internal financial control systems of the firm. In a case whereby the risk management systems are not addressed by the board or a separate risk committee, the audit committee also undertakes this imperative responsibility (Smith et. al. 2003, p. 6). Thus, an effective audit committee can play a very integral role in facilitating the review of the risk management systems, either as an independent entity or assisting the board in organizational structures where the board is mandated with this role (Gay & Simnett, 2012, Ch. 3). Thirdly, the audit committee is responsible for making recommendations to the governing board in regard to the process of appointing the external auditors and proceeds to approve the terms of engagement and stipend of these external auditors after their due appointment by the company’s shareholders during the annual general meeting (AGM) (Smith et. al. 2003, p. 6). The independence of the external auditors is thus a vital component to the effective functioning of the audit board which was also vital in informing the process of their appointment. This link between the external auditors and the audit committee was underpinned by Gay and Simnett (2012, Ch. 3) who cited that the independent external auditors who have concrete knowledge of the financial affairs of a given company are endowed with extensive capacity of providing considerable input to the operation of the audit committee which is achieved through the process of reporting matters of organizational relevance to the committee. Therefore, independent external auditors have been viewed as being paramount to the achievement of effectiveness and efficiency objectives of the audit committee. In addition, these external auditors are also responsible of helping the audit committee through updating it with information on any developments, for instance, the release of new accounting standards or legislative transformations. The above fact has led to the inference that the major dealings between the auditors and the governing board in any given entity are often through the audit committee, with which they have constant interaction. This is based on the fact that the audit committee is expected to maintain a direct and efficient communication line between the auditors and the board (Gay & Simnett, 2012, Ch. 3). Another role of the audit committee is to discuss organizational issues which are sensitive in nature with the auditors, for instance, inadequacies of the internal controls, disputes with the management echelon and contentious accounting issues among other matters (Gay & Simnett, 2012, Ch. 3). This is supported by Smith et. al. (2003, p. 6) who determined that the generic role of the audit committee in addressing the sensitive issues in the organization in collaboration with the auditors is central to ensuring the effectiveness towards meeting the organizational goals and improving its reputation in the public domain. In addition, the audit committee fortifies the independence of the auditing team through being an independent linkage between the auditors and the management (Gay & Simnett, 2012, Ch. 3). This rudimentary function is similar to that cited by Smith et. al. (2003, p. 6) who revealed that the audit committee has the responsibility of reviewing and monitoring the independence of the external auditors in an effective and objective manner which is divorced from managerial influence. Lastly, the audit board is responsible for developing and executing policies in regard to the engagement of the external auditors in relation to them supplying other non-audit services (Smith et. al., 2003, p. 6). All the above are some of the responsibilities of the audit committee. Nonetheless, it should be noted that in a case where the activities of monitoring and reviewing undertaken by the audit committee unearth a cause of concern by the overall organizational management or a certain scope of enhancements, it ought to forward its recommendations to the board on the most ideal course of action to address the revealed issue or to make the enhancements. The adjustment level of the employees in the firm, either in the management framework or subordinate employees ought to be considered in the recommendations affecting the tenets aforementioned above. Audit committee and corporate governance Audit committees have been cited as being integral in assisting an entity towards attaining efficiency and effectiveness in its corporate governance practices. In this stance, corporate governance can be perceived as relating to the internal means through which the corporations are controlled and operated. Despite the fact that the government plays a primary role in the molding of the institutional, legal and regulatory atmosphere under which the individual corporate governance structures are developed, the chief responsibility is under the docket of the private sector (Gregory, 2002, p. 11). Thus, corporate governance has been viewed asreferring to that blend of regulation, law and suitable voluntary practices in the private sector which are key in enabling the company to attract both human and financial capital, attain efficient performance and eventually, perpetuate itself by producing economic value to its stakeholders on a long-term basis, while at the same time, respecting the interests of the stakeholders and the wider society (Gregory, 2002, p. 1). Audit committees in different organizations play a central role in the achievement of the above organizational goals. Some of these ways are explored in the subsequent analysis. Firstly, the audit committees are core in safeguarding the integrity in financial reporting practices in the firm. Cohen et. al (2004, p. 5) determined that an audit committee in any firm is an integral player in the larger corporate governance mosaic. All these players, in different magnitudes and levels, either collectively or individually, work towards ensuring that there is attainment of financial reports which are free from misinterpretation and material misstatement. Some of the other players include the board, the external and internal auditors. As mentioned above, the audit committee is mandated with the role of monitoring the integrity of the financial statements in the company which has instituted it and in the process, it acts as a core cog in producing economic value to the company’s stakeholders on a long-term basis which is central to the corporate governance undertakings of any company. The following figure shows the linkage between the various players who influence corporate governance at the organizational level, central to which is the audit committee. Figure 1.0: Corporate governance role in financial reporting Source: Rezaee, Z (2004). Another way in which the audit committees cultivate corporate governance is through the risk management practice previously mentioned in a situation whereby the risk management systems are not under direct address of the board or a separate risk committee. Most of the proponents have underpinned the component of risk management as being central to the profitability of any institution which increases the returns for the investors (shareholders) as well as surmounting financial challenges prompted by external factors like the recent global financial crisis (Tandelilin, Kaaro, Mahadwartha&Supriyatna, 2007, p. 24). The interrelation between positive risk management practices and the heightened effectiveness of corporate governance, mostly in the financial institutions has also been underpinned by Aebi, Sabato, and Schmid (2011, p. 6). Thus, based on the fact that the audit committees in particular organizations are mandated with the role of risk management, this is central in creating effective and efficient corporate governance which is core in maximizing the returns of the shareholders with minimum risks which can jeopardize the operations of an organization. Lastly, the audit committees act towards promoting ethical and responsible decision making, for instance, in the process of nominating external auditors as well as approving their terms of engagement and remuneration. This has been a trend of many multinational corporations expanding and entering the foreign market (Mahdavi, 2003, p. 2). Morf (1999, p. 265) perceived ethics as the moral principle which individuals and collectives infuse in their decision-making processes which assists in moderating the ultimate outcome to conform to the diverse norms as embedded in their societies. Thus, with the audit committee embracing ethics like transparency and accountability in undertaking the above mandate ensures that not only are the interests of the shareholders represented in these processes but also that the norms and values as perceived in the wider society are infused in these processes. This is central in elevating efficiency and effectiveness in corporate governance. The contribution of effective control environment in an organization towards effective functions of an audit committee The control environment in any organization has been cited as being integral in setting the overall tone in an organization through impacting on the conscience control of the people in these organizations. It is thus vital in instilling structure and discipline in the organization. Therefore, the control environment has been viewed as possessing extensive influence on the practices of risk assessment, monitoring activities and information and control systems among other undertakings which fall under the docket of the audit committees (Noorvee, 2006, p. 24). Thus, effectiveness of the control environment in any organization greatly contributes to the effectiveness of the audit committee. Some of these contributions are analyzed below. Firstly, this effectiveness ought to first emanate from the top management echelon of an organization, for instance, the board. In a situation whereby the board engages in unethical practices like fraud and nepotism in appointments can greatly undermine the effectiveness of the audit board. This fact is epitomized by Noorvee (2006, p. 24) who cited that weaknesses of the ‘tone at the top management’ has been credited for majority of the financial failures in the recent decades. Thus, in a case whereby the audit committee recommends certain competent individuals or collectives to be included in the external auditors, but the unethical board proceeds to appoint individuals of its preference and offer them hefty stipend, this can greatly undermine the effectiveness of the audit board, both in the short and in the long term as well as the quality assurance engagements in the company. On the other hand, if the control environment in an organization fosters effectiveness in terms of communications and information dissemination, this can increase the effectiveness of the audit board. For instance, if the board has instituted an effective channel of communication to the audit board, this can be vital to the effectiveness of both the audit board and the external auditors since the audit board acts as the linkage between the board and these auditors. Similarly, in a case whereby the board engages in widespread consultation prior to making decisions affecting a company, for instance, in issues related to investments, this can greatly harness the effectiveness of the audit committee. This is based on the fact that the audit committee will conduct extensive risk assessment prior to an investment venture and pass the recommendations to the board. If the board implements the recommendations forwarded from the audit committee, this will heighten the effectiveness of the committee as well as ensure efficiency in quality assurance engagements. Lastly, the generic independence the external auditors from managerial influence is key in ensuring quality assurance engagements. This is because these auditors are central in not only undertaking their auditing roles but also supplying other non-audit services. The implementation of their recommendations is thus paramount in fostering the effectiveness of the company’s financial operations. Based on the fact that the audit committee is responsible for reviewing and monitoring the independence of the external auditors, its effectiveness will thus be determined by the level to which the board is willing to uphold the independence of these auditors. Conclusion From this paper, it is evident that the audit committees have evolved into becoming integral in the financial reporting undertakings in different companies as well as being central to the effectiveness of corporate governance. The audit committees are mandated with diverse roles, most of which have been analyzed in the preceding analysis. Nonetheless, it is imperative to note that the effectiveness of the control environment in any institution greatly contributes to the effectiveness of the audit committees. References Aebi, V., Sabato, G., & Schmid, M., 2011, ‘Risk Management, Corporate Governance, and Bank Performance in the Financial Crisis’, retrieved 8th October, 2012 . Caput, V., Hotze, J., & Golden, R., 2006, ‘Corporate Governance: Audit Committees’ retrieved 8th October, 2012. Carcello, JV., &Neal, TL., 2000, ‘ Audit committee composition and auditor reporting’, The Accounting Review, Vol. 75, No. 4, pp. 453-467. Carcello, JV., &Neal, TL.2003, ‘Audit committee characteristics and auditor dismissals following “new” going-concern reports’, The Accounting Review, Vol. 78, No. 1, pp. 95-117. Cohen et. al, J., 2004, ‘The corporate governance mosaic and financial reporting quality’ Journal of Accounting Literature, Vol. 1,pp. 87-152. Deloitte, 2012, ‘Audit Committee’, retrieved 8th October, 2012, < http://www.corpgov.deloitte.com/site/sgeng/audit-committee/>. Gay, G & Simnett, 2012, Auditing & Assurance Services in Australia, 5th edn., McGraw Hill, Sydney, Australia. Gregory, H. 2002, Comparative Matrix Of Corporate GovernanceCodes Relevant To The European Union AndIts Member States, Weil, Gotshal & Manges LLP, London. Klein, A., 2002, ‘Economic determinants of audit committee independence’, The Accounting Review, Vol. 77, No. 2, pp. 435-452. Mahdavi, I, 2003, ‘International Business Ethics: Strategies and Responsibilities’, Journal of Academic and Business Ethics, pp. 1-6. Morf, D. A., Schumacher, M. G., & Vitell, S. J, 1999, ‘A Survey of Ethics Officers in Large Organizations’, Journal of Business Ethics, vol. 20, 265-271. Noorvee, L., 2006, ‘Evaluation of the effectiveness of internal control over financial reporting’, Masters Thesis, University of Tartu. Rezaee, Z, 2004, ‘Corporate governance role in financial reporting’, Research in Accounting Regulations, Vol. 17, pp. 107-149. Smith R, et. al. 2003, ‘Audit committeescombined code guidance’, retrieved 8th October, 2012, . Tandelilin, E., Kaaro, H., Mahadwartha, P., & Supriyatna, 2007, ‘Corporate Governance, Risk Management, and Bank Performance: Does Type of Ownership Matter?’, EADN working paper No. 34, Gadjah Mada University, Yogyakarta, Indonesia Read More