Audit Committees: Can They Really Work - Article Example

INTRODUCTION 1 I have been requested by a partner in my audit firm to brief her before her presentation to the local district society of charted accountants on the issue; 'Audit Committees: Do they really work'' 1.2 The report will provide focus for questions and debates by members of the local district society of Charted Accountants. 1.3 Included in the report is an introduction to the topic with some history and background on Auditing Committees and some examples of when auditing committees have worked and situations where they have not. 1.4 All the information came from creditable sources. I used ACCA web site, many journals and browsed the Internet for up to date information. INTRODUCTION TO AUDIT COMMITTEES 1.1 One of the main elements of the corporate governance process of an organisation is its audit committee. Effective Corporate Governance to me is the only way that investors can protect them selves from executives that make mistakes and try and cover them up. An Audit Committee is an operating committee of the Board of Directors, typically charged with oversight of financial reporting and disclosure. A key element in the corporate governance process of any organisation is its audit committee (Source: aicpa.org) Audit Committees can be seen as a means to enhance the independence of the auditor, and also seen as an important role in reviewing and monitoring the 'external auditors' independence, objectivity and the effectiveness of the audit process. (Source: The Audit Process pg. 669) 2.1 The compositions of audit committees are very important. The majority of non-executive directors should be independent and free from any financial relationship, which could interfere with independent judgement. To qualify as "independent," the Act states that an audit committee member cannot accept any fees from the company other than for serving as a director, and cannot be an affiliated person of the company or any of its subsidiaries (Source: nysscpa.org). According to the Combined Code (which lists sets of requirements and sets the frame work for auditors (Source: The Audit Process)) its says that committees should comprise of at least three non-executive director and that it highlights certain duties for external auditors, internal auditor and the internal controls that have been put in place. (Source: The Audit Process pg. 669) Non executive director should be selected through the formal process and there subject to election by shareholders. 2.2 Audit Committees have many authorities and duties, they have clear rights to seek information and make decisions and carry out prescribed duties. In the UK the roles of audit committees is still evolving, but the smith guidance (the guidance on Audit Committees) is a step towards greater consistency in there duties and roles (Source: frc.org.uk) For an audit committee to fulfil its new and continuing obligations, asking the tough questions, understanding the answers, and properly disseminating information are crucial. The basic responsibilities include adopting a charter, monitoring the reporting process, overseeing the outside auditor, and paying attention to management and employees. (Source: nysscpa.org) 2.3 Audit Committees Roles in Financial Reporting Process. According to the Blue Ribbon Report, Audit Committees do not prepare financial Statements or become in the details of the decisions required to prepare them, but they are responsible for monitoring and overseeing the financial reporting process. To meet its duties they must ensure that internal control are established properly and they must be familiar with the companies risk assessment. (Source: A Guide For Directors, Management, And Consultants, Frank M. Burke) 2.4 Since the 1940's audit committees have provided an important role ultimately necessary function ensuring that publicly traded business financial statements are accurate. In the 1970's, the NYSE (New York Stock Exchange) required board of directors of all the listed companies to appoint an audit Committee, subsequently the NASDAQ and AMEX (American Stock Exchange) followed in the 1980's (Source: nysscpa.org). In February 1999 individuals composed a report, and from the report they recognised that an audit committee has a fundamental role in ensuring high quality financial reporting. Shortly after this report was published new rules and regulation came out for audit committee members. ( Source: nysscpa.org). Today, there are countless practices and regulations dictate the composition, roles, and responsibilities of audit committees. 2.5 The most important quality an audit committee posses is the independent and unbiased approach. In many cases self-interest has been considered as the main hindrance in the independent and fair approach of audit committees. Many regulations have been introduced in order to ensure the independence of auditors. The Sarbanes-Oxley Act of 2002 is considered as an important addition to the regulations ensuring auditor's independence. The act suggests undertaking continuous rotation of audit partners. It also emphasises increased financial reporting and imposes limits on certain non-audit services. 2.6 The Sarbanes-Oxley act suggests reducing the economic interdependence of audit committees and client. The economic rent provided to the auditors can only be gained as a result of long lasting relation ship between the auditor and the client, this condition in turn acts as a hindrance in the way of audit committees to act independently. The threat of lawsuits often act as a motivator for the auditors to act independently as inefficient or unfair performance can result in shape of judicial action against auditors. "IAS/IFRS are standards for the preparation of general-purpose audit statements, aimed at meeting the needs of a wide range of users, but predicated on the assumption that placing primary emphasis on the needs of shareholders will result in measurement, recognition and disclosure requirements that also meet the needs of other users. However, significant other users of audit statements need not necessarily share this view, and where they have the power and authority to do so, frequently impose different special-purpose audit reporting obligations designed to meet their specific needs (e.g., reporting for taxation purposes, or reporting for prudential and supervisory purposes)." (Hegarty et. al., 2004) 3.1 Importance of Fair Audit: Investors need to assess risk as part of their investment decision-making process. One common criticism of audit statements prepared by these Audit committees is that they lack adequate disclosures about risks and uncertainties (Schrand and Elliott, 1998). This cannot be considered as the intended misconduct of Audit committees. Most often this weakness of Audit statements is a result of provision of low quality pre-audit committee meeting materials by the management of companies. In order to avoid the situation the audit committees should develop working relationships with the CEO and CFO. In order to undertake effective auditing procedure the company should inform the audit committees regarding the significant issues in the financial reporting. 3.2 An independent audit committee plays a central role in ensuring the credibility of financial reporting and reducing the possibility of management fraud. The responsibilities and requirements placed on audit committees have been strengthened over time, especially with the passage of SOX in 2002. 3.3 Auditing Committees have strong responsibility of ensuring the effectiveness of internal control with in the organisations and to provide services of fraud detection. Through the introduction of audit regulations at domestic and international levels although these aims are not completely met but the many gaps in the process have been covered. 3.4 In most of the studies undertaken it has been observed that the higher degree of threat to the auditors independence leads to authentic opinion. Its also found that auditor does not tend to change their decision with the varying degree of independence but change the decision process. The level of threats vary in different countries due to following reasons: i) Difference in the social and cultural values: Standard setting is a crucial process, which includes change. Some societies have open and flexible culture, which keeps on transforming with the time. But on the other hand closed societies have relatively rigid culture. The acceptance level of change in these societies is very low. In the case of the global harmonisation of standards a country adopting the International standards cannot complete the picture. It is equally important for the other countries to accept and implement the same standards in their economic system then only the target of attracting large number of investors and lowering the financial reporting costs can be achieved. ii) Hindrances due to jurisdictional disputes: "When Power is vested in multiple law-making and standard-setting bodies, jurisdictional disputes may arise in areas where the bodies interests overlap."(Taylor & Pincus, 2002; p.41) iii) Pressure form the lobbyist and special interest groups: The main aim of the standards is to cater the needs of the information users and creditors but very often the group of information preparers prepares the standards. Although the lobbyists group can pose detrimental effects if taken to extremes. These can pose negative impacts on the process of internationally accepted standard setting. (Taylor & Pincus, 2002; p.42) 4.1 Role of Audit Committees in Financial Scandals: The scandals as World Com and Enron have promulgated the role of audit committees. There are several weaknesses in the processes of corporate governance, internal control and auditing which lead to an increase in the corporate scandals. The degree of disclosure of financial information is also a main reason. Mostly the corporate running bodies do not find them answerable in front of any one therefore they keep on trying 'innovative' ideas for which others have to pay (Maclean, 2005). Financial information in the form of audited accounts can prevent the system slipping into corruption (Sunlight is the best detergent), but it is not clear why, for example, a superior US financial reporting infrastructure did not help detecting the Enron scandal. Again in case of Enron the Audit committee played its role but the main problem was the provision of incorrect information. 4.2 Regulations regarding the improved role of Audit Committees: "Recent efforts to improve the independent audit, such as Public Company Accounting Oversight Board Auditing Standard 3, Audit Documentation, focus on extended documentation and review. Other efforts, such as the proposed Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees, adjust the incentive system." (Blay) Although many steps have been taken to improve the level of auditor's independence but there is still some room for improvement in order to ensure unbiased and fair auditing practices. A change is required in the regulations. The accounting firm should not perform the consulting and auditing services both. The Companies should be required by the Government to increase their degrees of disclosure. The top-level management should be held more responsible by tightening up the regulations. They should also be held responsible in case of any frauds and regulatory violations of their subordinates. This in turn will give rise to the sense of responsibility in the people related at all levels. (Hanson, 2002) 5.1 Areas of improvement: Effective leadership is an important quality, which should be possessed by the chairman of the audit committee. Financial literacy and independence are also important for the members of the audit committees. The overall performance review covering all the aspects can only be undertaken if the audit committee chairman should have the experience and the leadership to insist on full and complete discussions. Although the audit committee members should establish strong working ties with the management of the company but their ultimate responsibility lies towards the audit committee. Higher degree of independence is required for the audit committees as for the board, in order to ensure their proper working. Having no uninformed ties to the company should eke the authenticity of the independence of the auditors. The members of the audit committees should be restricted to have any other undisclosed relationship with the company. Prohibiting the company from hiring audit firm personnel for three years after the person has left the firm can also prevent the problem. The audit partner must be continuously rotated. 5.2 Steps for the betterment: The imposition of the same fiduciary duties at the audit committee's members as other directors can minimise the breach-of-loyalty risks. "Because of the committee's special functions (and although an accounting background is not prerequisite for membership on an audit committee), duty-of-care concerns predominate over breaches of loyalty in any assessment of potential fiduciary liability. Informed judgement thus becomes the graven of the member's responsibility. A constructive scepticism should inform the director's approach to analysing data that management formulates." (Olson et. al., 2002) 5.3 Meetings of the audit committee should start and end with an executive session without the management, and the committee, as part of these sessions, should meet alone with its auditors. The degree and quality of information provided by the management should be improved. Different alternative techniques provided by the GAAP should be revealed that would result in different accounting outcomes and with figures outlining those differences. Any change undertaken as a result of the auditor or management's recommendations needs to be revealed publicly through financial statements. It should be the responsibility of the audit committee to review all the press reports containing the information about the company's accounting and disclosure reviews. The areas criticised should be addressed by the management and the audit committee and changes should be undertaken accordingly in order to improve the performance of the company. 5.4 Audit committees are the instruments through which the quality of financial reporting can be improved. It is not obligatory for the audit committee or the board to ensure perfect accounting or disclosure but it is their ethical responsibility to make the procedure more transparent. To accomplish this the audit committee must have the leadership, independence and information to oversee the auditors and their relationship with the management. Without them, the scandals like Enron and world COM cannot be avoided. (Lorsch, 2002) Conclusive Remarks: Although a number of regulations have been issued regarding the effective role of audit committees, still there are significant barriers, which need to be addressed. These include heavy reliance on a financial expert, lack of information provision to the audit committees and a significant compliance burden. Although much of this has been addressed in the SOX which has increased the power of the audit committees to participate in the financial reporting process, still there are some questions which need to be answered. Although audit committees may not be able to stop management fraud but a diligent audit committee can be able to deter management fraud and may currently be the best friend an investor has. References Blay, Allen D. , Independence Threats, Litigation Risk, and the Auditor's Decision Process, available at http://www.caaa.ca/CAR/CurrentIssue/exeartUKeoVsOTbt.html Hanson, K., (2002). Lessons from the Enron Scandal, interview about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei, March 5, 2002, Retrieved 03/04/08 from http://www.scu.edu/ethics/publications/ethicalperspectives/enronlessons.html John Olson, Ronald Mueller, Stephanie Tsacoumis, and Amy Goodman, Gibson Dunn & Crutcher, (2002). After Enron: Issues For Boards And Audit Committees To Consider, Insights: Corporate & Securities Law Advisor, Vol. 16, No. 4, Pgs. 2-8 Lorsch, J., (2002). "The Cure for Creative Accounting," Financial Times, April 10, 2002, available at http://hbswk.hbs.edu/item/2929.html Maclean, P., (2005). Power Play - Robert McCullough was interviewed for an article covering Enron's role in the California power crisis and its aftermath, Portland Monthly, May 2005, Retrieved from http://www.mresearch.com/pdfs/102.pdf Schrand, C. M., and Elliott, J. A., (1997). Risk and audit reporting: A summary of the discussion at the 1997 AAA/FASB Conference. Accounting Horizons. 12 (3) 271-283. Taylor, D., W. & Pincus, K. V., (2002). Core Concepts of Accounting Information: A New Introduction to Accounting, Australia, Irwin/McGraw-Hill, pg. 39-42. Read More