Audit Committee Formation in the Aftermath of 2007-2009 Global Financial Crisis, Volume I

Zabihollah Rezaee

• Publisher: Business Expert Press
• Year: 2016
• ISBN:
  9781631571572
• Topic: Business
• Subtopic: Auditing
• Index: Business

The audit committee has gained considerable attention in the aftermath of 2007-2009 global financial crisis. The audit committee's role has evolved from a voluntary liaison between management and external auditors to the standing committee of the board of directors in overseeing all aspects of corporate governance, financial reporting, internal controls, risk assessment, and audit activities. This book addresses the determinants of audit committee oversight effectiveness, including their composition, independence, authority, resources, diligence, and activities. The book is organized into three separate volumes and each volume can be utilized separately or in an integrated form. The first volume consists of five chapters, which examine the relevance and fundamentals of the audit committees as well as the determinants of audit committee effectiveness. The second volume consists of nine chapters on financial, auditing, internal control, risk management, ethics and compliance, antifraud, and other oversight functions of the audit committee. The third volume consists of five chapters on the emerging issues of audit committees pertaining to evaluation, education, reporting, and accountability as well as audit committees of private companies, governmental entities and not-for-profit organizations.

CHAPTER 1

Role, Foundation, Regulation, and Structure of the Audit Committee

Executive Summary

This chapter provides an introduction to the relevance and status of corporate governance and the audit committee in the financial markets. The audit committee as an integral component of corporate governance assumes oversight responsibilities on all aspects of corporate governance from financial reporting, to internal controls and audit activities. One of the key provisions of the Sarbanes–Oxley Act (SOX) of 2002, which seeks to restore investor confidence in public financial information, is that a properly constituted and effective functioning audit committee can improve the quality of financial reporting by acting as an effective arbitrator in management and auditor disputes. Audit committees operate in an environment of ever-increasing corporate governance reforms established to protect investors and the public from financial scandals. Audit committees, in complying with emerging corporate governance reforms, are striving to improve their oversight effectiveness. In the aftermath of SOX, every public company should have an audit committee composed of at least three independent directors with adequate financial expertise. Audit committee structures and practices should be implemented in protecting shareholders from receiving misleading and misstated financial information and in enhancing the company’s accountability to all stakeholders. This chapter examines the relevance and determinants of audit committee oversight effectiveness, including their composition, independence, authority, resources, diligence, and activities.

Introduction

The wave of financial scandals at the turn of the 21st century and the 2007–2009 global financial crisis brought corporate governance to center stage and encouraged massive regulations, rules, standards, and best practices that redefined the corporate governance structure. In the aftermath of the global financial crisis, public companies are closely scrutinized by regulators to improve their corporate governance in preventing further occurrences of financial scandals. The boards of directors of public companies are faced with challenges of governance, risk assessment, internal control, and financial reporting as well as compliance with rules, regulations, and standards. These ongoing challenges should be effectively addressed by the board of directors and its various board committees including the audit committee.¹ Public companies are also facing more challenges including the ever-increasing threat of cyberattack, globalization, and technological advances. In light of ever-increasing corporate governance reforms, the audit committee is redefining its structure and role of engaging in overseeing all aspects of corporate governance from financial reporting to internal controls, risk assessment, and audit activities.²

This chapter presents all applicable laws, regulations, rules, standards, guiding principles, and best practices affecting the operation, structure, resources, and functions of audit committees. The audit committee’s role in effectively overseeing the effectiveness of corporate governance, reliability of financial reporting process, effectiveness of internal controls, and proper assessment of risks and credibility of audit functions has become a norm and best practices for public companies. Investors demand, regulators require, and business organizations ensure vigilant audit committee in protecting investor interests and enhancing reliability of their financial reports.

In the past several decades, the audit committee has evolved from a decision to whether or not to voluntarily create audit committees to act as a liaison between external auditors and management to preserve auditor independence to the mandatory requirements for the establishment of audit committees, and their integration into corporate oversight functions. This chapter examines the relevance and importance of audit committees to our financial markets and the determinants of audit committee oversight effectiveness, including their role, composition, independence, authority, resources, responsibilities, diligence, and activities. It also presets audit committees’ working relationships with other participants in corporate governance including the board of directors, executives, governing bodies, standard setters, internal auditors, external auditors, financial analysts, legal counsel, investors, and other stakeholders. Over the past several decades, the business and investment communities increasingly have demanded the establishment of vigilant and diligent audit committees. In the aftermath of the 2007–2009 global financial crisis, an effective audit committee is deemed an essential component of corporate governance in improving a company’s strategic decisions, financial reporting, internal control, risk assessment, anti-fraud prevention, and audit functions.

The Role of the Audit Committee in Public Companies

More than half of Americans now participate in financial markets through either direct investments or through investments in mutual funds and pension funds. Investor confidence in efficacy and efficiency of financial markets is the cornerstone of our nations’ economic growth, stability, and prosperity. Public financial information plays an important role in providing investors with useful, reliable financial information in making sound investment decisions in achieving integrity and efficiency in the financial markets, and audit committees play an important role in overseeing the reliability of financial information disseminated to the financial markets by public companies. Misleading, misstated, and fraudulent financial information can diminish investor confidence and public trust in the financial markets and the public financial information disseminated to the market by public companies. Audit committees are key to regaining the public’s trust and investor confidence through overseeing the reliability of financial reporting process. Companies have started to disclose their audit committee charters for investors to learn about their responsibilities and functions of audit committees in improving both financial reporting and audit processes.

The audit committee is empowered to protect investors from receiving misleading and misstated financial information by helping public companies achieve high-quality financial reports, which contribute to the safety, integrity, and efficiency of our financial markets. The early 2000s witnessed an unprecedented decline in public trust and an erosion of investor confidence in public financial information and the same scenario was repeated during the global 2007–2009 financial crisis. The soundness, efficiency, liquidity, and safety of the financial markets have been threatened by the 2007–2009 financial crisis, which was caused by many macroeconomic and microeconomic factors. Macroeconomic factors include subprime mortgage crisis, ineffective regulation and supervision of banks, collapse in the asset-backed commercial paper (ABCP) market, unintended consequences of government policies promoting home ownership, and highly leveraged financials and expanded credit growth.³ Microeconomic factors consist of greed and incompetency of corporate and bank executives, inadequate risk assessment of business transactions, lack of transparency of public financial information, and ineffective audit committees in overseeing risk management and financial reporting and audit processes.⁴

Distrust in the reliability and quality of financial information may adversely affect the effective functioning of the capital markets and the public trust and investor confidence in public financial information. Audit committees are also being blamed for not preserving auditor’s independence from their clients’ management because of large fees that audit firms were earning from the non-audit services.⁵ In the aftermath of the 2007–2009 global financial crises, many suggestions and best practices for audit committees have been developed to rebuild investor confidence and public trust in public financial information and thus the financial markets. For example, Russell Novak & Co. LLP (2010) has found five ways that audit committees can contribute to rebuilding public trust in public financial information as summarized in Exhibit 1.1⁶ and described in the following paragraphs.⁷

First, the audit committee should assess the quality of the company’s financial reporting process. This assessment should gauge the financial reporting performance against entity-specific benchmarks, which proves important in managing investor expectations. There are five key determinants that are important in evaluating the quality of information according to the Statement of Financial Accounting Concepts No.2.⁸ One determinant is relevance, which is measured in terms of the information’s usefulness and whether it is current and timely. Timely information should be available to the users before it becomes irrelevant to decision making. Predictive value permits the users to evaluate the likelihood of recurring earnings and assess opportunities and risks associated with individual business units or geographic areas. The next factor is reliability, which ensures that transactions are verifiable and represent faithful representation of events. The components of reliability are measurability and completeness. Information must contain reasonably consistent interpretation by knowledgeable third parties, and it identifies and presents all aspects of events and transactions that could alter the users’ conclusions. Third, neutrality determines an aspect of quality. Neutrality is measured in terms of objectivity as information should be free from bias. Finally, when financial information is prepared and presented in a manner that allows informed comparison to other periods of time and to other companies, it is considered as being comparable, which is more relevant for decision making.

Next, audit committees should evaluate processes for reviewing financial information. Regular evaluations of the company’s and board’s processes not only make the audit committee aware of any weak reporting, but also inform the audit committee regarding the effectiveness of internal controls and quality financial reporting. This evaluation should suggest ways that the company can improve processes so that current or anticipated problems can be avoided. Third, conducting a group comparison among industry peers and among peer companies can help rebuild the public trust. Audit committees can greatly benefit from insights regarding matters such as relationships between financial statements that differ significantly from those of the company’s peers’ best practices. Audit committees should be able to identify key issues such as overly aggressive accounting principles or distorted comparisons with peer companies, and question the underlying management decisions that may have contributed to the situation.

Additionally, to enhance the audit committee’s understanding of appropriate reporting policies and best practices in the related industry, it is important to obtain tailored, industry-specific training for all audit committee members. Training enables audit committee members to develop the self-assurance needed to challenge management and outside auditor decisions on accounting and reporting choices they have made. This also provides additional assurance to outside investors. Finally, audit committees can rebuild public trust by consulting with an independent accounting and auditing advisor. Under SOX, as explained in the following section, audit committees have the right to obtain both legal and financial reporting advisors. An accounting advisor represents significant value in the appearance and substance of public trust and boosts confidence in the integrity of financial reporting systems and processes. Audit committees are advised to seek assistance in: (1) their financial literacy and expertise requirements under the rules of the exchanges and SOX; (2) the content of the audit committee report in the annual proxy statement; and (3) the committee’s discussion with the independent auditors regarding the auditor’s judgments on the qualitative characteristics of financial reporting and accounting information.

Regulatory Requirements for Audit Committee

In response to the wave of financial scandals (Enron, Global Crossing, WorldCom), several initiatives including the passage of SOX and listing standards by national stock exchanges have been taken to restore investor confidence and public trust in financial reports.⁹ Exhibit 1.2 presents some of the provisions of SOX relevant to the audit committee, and Exhibit 1.3 describes the audit committee in the pre- and post-SOX era. SOX and related Securities and Exchange Commission (SEC) implementation rules also significantly affect the structure, composition, functions, and responsibilities of audit committees. Underlying both SOX and the SEC-related regulations is the presumption that the presence of certain features in the audit committee is a prerequisite for the committee to effectively fulfill its oversight function. Specifically, the audit committee should be independent, competent, financi...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Preface
• Acknowledgments
• Introduction
• Chapter 1 Role, Foundation, Regulation, and Structure of the Audit Committee
• Chapter 2 Sources and Drivers of the Audit Committee
• Chapter 3 Framework for Audit Committees
• Chapter 4 Audit Committee Resources
• Chapter 5 Evaluation, Education, and Training of Audit Committee Members
• Index