An overview of audit committees Example For Free - Free Essay Example

Sample details Pages: 9 Words: 2680 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? Good corporate governance is vital to the efficient operation of the financial markets. Investors need to feel confident that organisations are suitably managed and controlled and that the levels of risk within the organisation are carefully managed in a way that minimises many of the financial and operational risks to which the investors would otherwise be exposed. Corporate governance covers a wide range of issues. Don’t waste time! Our writers will create an original "An overview of audit committees Example For Free" essay for you Create order For example, majority shareholders can exercise undue influence over the minority shareholders; therefore, there are legislative requirements in place to ensure that this power is not abused. The entire issue of corporate governance can be largely attributed to the principal / agency problem that exists where the directors are responsible for the day to day running of the company, yet this is carried out on behalf of the shareholders and not for their own good. Governance is, therefore, required to ensure that the directors do not act for their own benefit in favour of the benefits of the owners. Corporate governance principles are based on the four key concepts of responsibility, accountability, transparency and fairness. In an attempt to fulfil these requirements the financial reporting council has brought in a combined code dealing with the key issues of reporting, remuneration of directors, accountability and audit within the company. It is the area of audit management upon wh ich this analysis is focussed and will discuss in more depth. What is an Audit Committee? As part of the combined code established by the financial reporting council, every publicly listed company must have an audit committee as a committee of the board of directors and it is specifically charged with the role of overseeing financial reporting and the way in which disclosures are made[1]. For all companies within the FTSE 350, it is necessary to have at least three non-executive directors on the committee; for other companies there must be at least two non-executive directors. Within the committee the combined code requires that at least one member of the committee must have à ¢Ã¢â€š ¬Ã‹Å"relevant financial experienceà ¢Ã¢â€š ¬Ã¢â€ž ¢, although it is not entirely clear what this relevant experience entails. For smaller companies, the company chairman can be on the committee but is prohibited from being the chair. As well as managing the internal reporting and disclosure, the auditing committee is charged with maintaining the relationship between the company and the auditors. Every audit committee will have terms of reference to work within but there are also generic requirements as laid down in the in combined code to which every audit committee must adhere. Firstly, it is required to monitor and manage the integrity of the financial statements. Any announcements that the company makes in relation to its financial status as well as any other significant judgments must be considered and approved by the audit committee to ensure that they are as accurate as possible. As well as monitoring the financial statements themselves, the audit committee is responsible for considering the internal controls that the company has in place. In many companies there is a board risk committee that considers the risk management. However, where the issues are more financially specific there will be involvement by the audit committee. These controls are regularly chec ked to ensure that they retain their effectiveness. The audit committee deals with the external auditors including making recommendations to the shareholders in terms of which auditor should be retained or removed as well as dealing with the terms of engagement of the auditors and the related remuneration for the auditors[2]. Once the external auditors have been appointed, the audit committee will act as the main point of contact and will work with the auditors to ensure that independence, objectivity and efficiency of the external auditors is maintained. The issue of external auditors also providing non audit services is a matter that is dealt with by the audit committee. This is potentially an area of considerable controversy and strict ethical rules are put in place to ensure that independence is maintained. As the external auditors provide a necessary check and balance to the accuracy of the financial accounts and ensure that they show a true and fair view of the underlying f inancial position of the company, the relationship between those responsible for the audit and the management team of the company is vital. However, a degree of independence is required if the auditors are to feel that they are able to suitably explore all of the companyà ¢Ã¢â€š ¬Ã¢â€ž ¢s issues and for this reason the audit committee is considered a suitably independent point of contact that can fully support the efficiency of the auditors role. Scope of the Audit Committee Whilst the concepts and principles of the audit committee are detailed above, the relationship between the audit committee and the management board is often finely balanced and can be a source of conflict. The management board cannot delegate all aspects of financial control and must retain the power to approve the annual financial accounts, to ensure that a framework is in place to manage internal control and risks and to be the ultimate body to approve policies or transactions that have a substantial im pact on the financial position of the company. The role of the audit committee should be clearly defined in the terms of reference. It is a danger that a management board will attempt to delegate all corporate governance issues to the audit committee, which is not within the remit of the combined code. Critically, the audit committee is responsible for managing the controls within the company not for carrying out the control themselves and this distinction is vital. Further guidance has been established from the Financial Reporting Council as part of the Turnbull guidance[3] which suggested key areas for which the audit committee is responsible. A degree of flexibility is necessary but clear terms of references are also required. Typically, terms of reference will include phrases such as advice, review and assessment making up the foundations of their role. The report of the audit committee should be given considerable importance by the board and should form a central part of the boardà ¢Ã¢â€š ¬Ã¢â€ž ¢s discussion when the report is given to the board. It will highlight areas where there are internal controls that are lacking and monitoring issues that need to be dealt with and these should be targeted by the board. As well as entering into regular discussions with the management board, the chair of the audit committee will have private discussions with the internal and external auditors. These meetings are conducted in private away from any of the executive management board so that the auditors can feel free to express their true opinions without feeling the pressure of the executive member of management listening to all discussions. Ensuring that the lines of communication between the internal and external auditors are open and professional is critical to the quality of the audit report and, as such, the audit committee is critical as a forum for discussion. Facilitating this independence is crucial and should be the cornerstone of the role of the audit committee[4]. Auditing Risks Before considering how effective an auditing committee is in managing and controlling issues in relation to auditing (both internally and externally), the risks related to the process need to be considered. Audit risk, or the risk that the auditor fails to make the correct determination in relation to a set of company accounts, is made up of several different factors. Firstly, there is the inherent risk associated with the process of auditing financial accounts. This is based on the idea that certain companies operate in inherently risky industries, for example, banking or financial institutions. The level of inherent risk does not take into account any internal controls that may be used. The second element of risk is that of control risk and is much more closely linked to the role of the audit committee. The level of control risk is based on the way in which the company is dealing with its inherent risk. When ascertaining the level of con trol risk an auditor will place a great deal of emphasis on the information received from the company and the audit committee in terms of how risks are managed and controlled. Thirdly, there is the detection risk which refers to the risk that if an event does in fact happen, that it is detected by the company. When considering the level of this risk, the auditors will consider the strength of the checks and balances within the company including the power of the audit committee itself. Based on the perceived risk levels of the company as a whole (taking into account the inherent, control and detection risks), the auditor will make their judgment as to how rigorous their testing needs to be. Auditors will always tend to take a cautious approach due to the fact that they have traditionally had a substantial risk exposure if they give an incorrect opinion. The auditors are considered joint and severally liable and often find themselves facing large claims. The recent Companies Act 2006 allows the auditors to enter into an agreement with the company to limit their liability to the company for errors in auditing. The level of this limitation is also likely to be a matter for discussion between the audit committee and the auditors, with the risks that the auditors are facing playing a fundamental role in this discussion[5]. Efficiency of the Audit Committee Having established the role of the audit committee the question of how effective it is in achieving its aims is a natural next step for the analysis. One thing that seems reasonably standard is that very few companies regularly undertake any evaluation or monitoring of the performance of the audit committee itself. This makes ascertaining the efficiency of audit committees in general particularly difficult to undertake and in itself highlights a weakness in the audit committee process. Evaluation and regular review is essential for any committee and the audit committee should be no exception. The Au dit Quality Forum, as part of the Institute of Chartered Accountants of England and Wales, has undertaken considerable research into this area. Through panel discussions, the forum ascertained that the effectiveness and quality of the audit committee is almost entirely down to the way in which the audit committee is instructed[6]. Clear terms of reference and information in relation to its role are essential. Where there are very broad terms, the audit committee is likely to be considerably less effective. As well as the formal role definition, it has been recognised that the informal processes undertaken by the audit committee are equally important to the overall efficiency of the process. As previously suggested, the relationship on an interpersonal level between the audit committee and the internal and external auditors is critical to the success of the auditing process, as a whole. Therefore, the interpersonal and behavioural relations should not be ignored when considering t he efficiency of the audit committee overall. In accordance with recent research, the interpersonal relationships and the behavioural approach of the committee members is the most influential factor in determining the efficiency of the committee, as a whole[7]. Depending on the informal networks, the audit committee may take the approach of adviser, deterrent or controller and the chosen approach will have a much greater impact than the strict terms of reference. Further research into the way that a committee must operate in order to be effective has revealed that the make up of the committee is much more critical than originally thought. Research indicates that audit committees essentially must be independent and willing to challenge all internal activities. They must be inherently sceptical and lacking this independence or financial ability to probe deeply would have a substantially detrimental impact on the effectiveness of the audit committee, overall[8]. Research, therefo re, indicates that audit committees are not operating entirely efficiently and, in reality, the informal networks surrounding the committee produce the most effective controls and not the strict formal controls. Future Recommendations for the Audit Committee One of the key weaknesses with many audit committees is that they are simply not monitored for effectiveness. Therefore, it is suggested that a scheme of reviewing the audit committee itself should be undertaken. In order to improve the effectiveness of the audit committee, it is necessary to ascertain how it is currently performing. To do this, the following factors should be considered: How well the audit committee is performing in relation to its terms of reference. Is it meeting all laid out criteria such as timely reports to the board? Querying with the external auditors how useful they feel the audit committee is being in supporting their role; Asking the management board how much confidence they have in the audit committee and the quality of the guidance they produce; Asking the individual members of the committee how they feel the chair is performing; Analysing the quality of the recommendations produced by the committee; and Analysing the level of the changes that are implemented following the recommendations of the audit committee. These checks are absolutely essential and should become standard process within any company that has an audit committee. By evaluating the role of the audit committee, not only will any weaknesses by unveiled but it will also naturally encourage the committee to perform more effectively, knowing that it will be monitored and evaluated[9]. As well as monitoring the activities of the committee, more attention should be given to ensure that the correct people are appointed to the committee. Relevant financial knowledge should be more closely defined to ensure that there is suitable expertise as part of the committee to allow for sufficiently directed probing of the management board. A combination of these two factors will improve the effectiveness of the role of the audit committee, as a whole. Conclusions Audit committees are a vital part of all large companies. They act in a vital corporate governance role to ensure that the financial reporting and auditing functions are un dertaken, efficiently. Stakeholders place a great deal of reliance on the audited accounts; therefore, ensuring that the relevant controls are in place is absolutely essential. Despite the importance of the audit committee, there is currently no widespread check on the efficiency of these committees and informal channels are perceived to be more important than the official terms of reference. In order to achieve the greatest possible value out of these committees, further regulation and monitoring is required. Bibliography Braiotta, Louis, Braiotta, Louis, Jr., The Audit Committee Handbook, John Wiley and Sons, 2004 Corgel, Richard, Geron, John, Riley, John, CEO leadership in improving corporate governance: the significance of CEO support to the effectiveness of the audit committee, Handbook of Business Strategy, 5, 1, 2004 Financial Reporting Council, Turnbull Guidance on Internal Control, Financial Reporting Council, October 2005 Hemraj, Mohammed B., Corporate go vernance: directors, shareholders and the Audit Committee, Journal of Financial Crime, 11, 2, 2003 Hicks Midanek, Deborah, An inside look at audit committees, Journal of Investment Compliance, 2004 Lin, Jerry W., Li, June F., Yang, Joon S., The effect of audit committee performance on earnings quality, Managerial Auditing Journal, 21, 9, 2006 Soltani, Bahram, Auditing: An International Approach, Pearson Education, 2007 Spira, Laura F., The Audit Committee: Performing Corporate Governance, Springer, 2002 Turley, Stuart, Zaman, Mahbub, Audit committee effectiveness: informal processes and behavioural effects, Journal: Accounting, Auditing Accountability, 2007 Footnotes [1] Spira, Laura F., The Audit Committee: Performing Corporate Governance, Springer, 2002002 [2] Lin, Jerry W., Li, June F., Yang, Joon S., The effect of audit committee performance on earnings quality, Managerial Auditing Journal, 21, 9, 2006 [3] Financial Reporting Council, Turnbull Guidance on Internal Control, Financial Reporting Council, October 2005 [4] Soltani, Bahram, Auditing: An International Approach, Pearson Education, 2007 [5] Braiotta, Louis, Braiotta, Louis, Jr., The Audit Committee Handbook, John Wiley and Sons, 2004 [6] Corgel, Richard, Geron, John, Riley, John, CEO leadership in improving corporate governance: the significance of CEO support to the effectiveness of the audit committee, Handbook of Business Strategy, 5, 1, 2004 [7] Turley, Stuart, Zaman, Mahbub, Audit committee effectiveness: informal processes and behavioural effects, Journal: Accounting, Auditing Accountability, 2007 [8] Hicks Midanek, Deborah, An inside look at audit commit tees, Journal of Investment Compliance, 2004 [9] Hemraj, Mohammed B., Corporate governance: directors, shareholders and the Audit Committee, Journal of Financial Crime, 11, 2, 2003