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

Zabihollah Rezaee

• Publisher: Business Expert Press
• Year: 2016
• ISBN:
  9781631571558
• Topic: Negocios y empresa
• Subtopic: Auditoría

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

Corporate Governance Oversight Function of the Audit Committee

Executive Summary

As the standing committee of the board of directors, the audit committee is an integral component of corporate governance. The corporate governance oversight of the audit committee is defined in its charter in participating with others in charge of governance in ensuring corporate governance effectiveness. Recent corporate governance reforms require that the audit committee interact with the board of directors, management, internal auditors, external auditors, legal counsel, financial advisors, regulators, and investors as discussed in this chapter.

Introduction

The analysis of the reported financial scandals of the late 1990s and the early 2000s as well as the 2007–2009 global financial crises points to a consistent pattern of lapses in the audit committee oversight function. This raises the question: Where was the audit committee? Audit committees should function to protect investors’ interests’ by taking the lead on oversight responsibilities in the areas of financial reporting, internal controls, risk assessment, audit activities, and compliance with applicable laws, and regulations. Recent corporate governance reforms have provided new challenges and opportunities for audit committees. To address these challenges and opportunities effectively, audit committees are seeking an appropriate balance between advising management and overseeing its performance in the areas of financial reporting; internal controls; risk management; audit functions; legal compliance; and the establishment of a whistle-blowing program and codes of business conducts.

Corporate Governance Oversight Function

The company’s board of directors as the representative of shareholders has the ultimate fiduciary responsibility for safeguarding and advancing the interests of shareholders and thus creating shareholder value. As one of the three mandatory standing board committees (audit, compensation, and nominating committees) and in representing the board of directors, the audit committee often participates in establishing corporate goals and policies and reviewing management’s execution of those policies in achieving the company’s goals. The entire board of directors, including the audit committee, usually assesses the company’s strategic decisions and actions in creating and enhancing sustainable shareholder value while protecting the interests of other stakeholders including creditors, suppliers, customers, employees, society, and the environment). An effective audit committee should understand the company’s corporate governance structure, including the business, economic, social, and political environment performance. Representing shareholders, the audit committee should understand the company’s major operating, investing, and financing activities while taking care not to usurp managerial prerogatives. The audit committee should oversee management’s operating, financing, and investment activities by reviewing significant and potential opportunities and challenges facing the company in pursuit of the creation of shareholder value.

Financial reporting information risks are usually affected by business risks that are associated with the company’s business problems. Thus, the audit committee should review the company’s major contracts, investments, and expenditures for various divisions and plants, which might cause problems and analyze management’s responses to those challenges. Recent corporate governance reforms (Sarbanes–Oxley Act of 2002 [SOX]¹, Dodd–Frank Act [DOF]², Securities and Exchange Commission [SEC]³) implementation rules) have created more oversight responsibilities for audit committees and their involvements in corporate governance activities, including accepting more fiduciary and accountability responsibilities.

The audit committee is considered an integral component of the company’s corporate governance, and, as such, the audit committee interacts with other corporate governance participants including management, the internal auditor, the external auditor, legal counsel, users, and standard-setting bodies. The remainder of this chapter explores the audit committee’s interactions with others typically involved in a company’s corporate governance oversight function.

Audit Committee Interactions with the Board of Directors

The board of directors bears full responsibility for the company’s decisions, actions, and affairs. An audit committee represents the board of directors in that the former serves as a standing committee of the latter. The establishment of the audit committee as the standing committee of the board is based on the premise of the need for specialization within the board of directors. The board of directors is ultimately accountable to investors for the company’s performance, affairs, business, and financial reports. Thus, the audit committee, on behalf of the board of directors, represents investors and is accountable for protecting their interests. In this respect, an audit committee represents both the board of directors and the shareholders. The audit committee assists the board of directors in fulfilling its responsibilities by bringing specialization and expertise to the board in the areas of financial reporting, internal controls, and audit activities. The board of directors typically appoints members of the board to the audit committee, thereby reinforcing the committee’s ultimate responsibility to the board of directors.

Effective compliance with new corporate governance reforms, complexity of business, globalization, and technological advances have encouraged the board of directors to more effectively utilize the expertise, knowledge, and efforts of its audit committee. Boards of directors are ultimately responsible for overseeing firms’ strategic decisions, financial reporting procedures, internal control systems, risk assessment activities, audit practices, and corporate governance systems to protect interests of shareholders. The board generally delegates its financial reporting oversight function to the audit committee, with the full board maintaining responsibility and accountability for the delegated function. The board normally establishes the audit committee to assist in effectively fulfilling its fiduciary duty of protecting investor interests with the keen understanding that the entire board is responsible for the company’s oversight function.

The audit committee should regularly report its activities to the board of directors and get board approvals for its agendas. Although many audit committees may employ self-evaluating mechanisms for their performance, the board of directors is ultimately responsible for the annual evaluation of the audit committee and its members.

Audit Committee Interaction with Other Board Standing Committees

In order to better discharge its responsibilities, an audit committee often will work with other standing committees of the board of directors. These other committees may include governance, compensation, finance, budget, investment, and the nominating committee. Productive working relationships among the audit committee and other standing board committees can greatly assist a board of directors in effectively coordinating its overall oversight functions. The audit committee’s understanding of executive compensation and incentive plans can assist the audit committee in assessing management’s motivations for aggressive earnings management or the use of aggressive accounting policies and practices for meeting earnings targets. The relationship between the audit committee and nominating committee can help in assessing professional qualifications, personal integrity, ethical behavior, and the management and operating style of senior executives, as well as the leadership philosophy of directors. The audit committee’s relationship with other standing committees of the board is explored below.

Audit Committee Interaction with Compensation Committee

Public companies should establish a compensation committee with a written charter specifying the purpose and responsibilities of the committee. The purpose of the compensation committee is to assist the board in establishing fair and rewarding compensation for the company’s directors and officers. Responsibilities of the compensation committee are to: (1) establish a compensation plan consistent with the company’s goals; (2) recommend to the board of directors the CEO’s compensation; (3) recommend to the board a non-CEO compensation plan; and (4) prepare the compensation committee report to be included in the proxy statement. The compensation committee can play an important role in corporate governance because of substantial increases in executive compensation during the past several years and public interest in and scrutiny of executive compensation. The audit committee should interact with the compensation committee to obtain an understanding of executive compensation and incentive plans and their impact on the fair presentation of the company’s financial statements. The audit committee may interact with the compensation committee in several ways: (1) both committees are mandatory standing board committees, and, as such, participate in activities requiring the entire board’s deliberation; (2) the compensation committee may seek the advice of the audit committee pertaining to the tax, audit, and reporting requirements of directors’ and officers’ compensation plans (long-term incentive plans, stock options); (3) the entire board, including the audit committee, normally evaluates the performance of mandatory standing board committees; and (4) in a small-sized board (e.g., less than seven directors), an audit committee member may also serve on the compensation committee.

Audit Committee Interaction with Nominating Committee

Public companies should establish a nominating committee comprised solely of independent directors. The nominating governance committee should have a written charter specifying the purpose and responsibility of the committee. Suggested oversight functions and responsibilities of the nominating governance committee are to: (1) recruit candidates qualified for board membership according to board-approved criteria; (2) identify the qualifications and expertise needs of the board of directors; (3) select and recommend nominees to the board of directors; (4) present the selected director nominees at the next annual shareholders meeting; (5) establish and recommend to the board of directors a set of appropriate corporate governance principles; (6) participate with other committees of the board (compensation, audit) in the evaluation of the board and management; and (7) submit the committee’s annual report to the board.

The nominating committee should also nominate candidates for the audit committee and assist the board of directors in appointing audit committee members. Although legally permissible, the appointment of audit committee members by the company’s CEO may compromise the member’s objectivity and independence. The audit committee often assists the board of directors in evaluating members of the nominating committee. In a board of directors with a small number of directors (fewer than seven) and several standing committees (more than two), a director may serve on both the audit committee and the nominating/governance committee. A collegial relationship between the nominating and audit committees can improve the effectiveness of both. Nevertheless, no director should chair both committees.

Audit Committee Interaction with Management

An effective audit committee oversight function requires considerable interaction with management and can only be achieved by an audit committee forging a close working relationship with management. The audit committee oversees financial reporting, internal controls, and risk assessment functions. Management should provide the audit committee with adequate information involving the financial condition, results of operations, financial statements, estimates, reserves, accruals, financial reporting risk assessment, internal control over financial reporting, significant deficiencies, material weaknesses in internal controls, and management’s interactions with both internal and external auditors.

A close working relationship between management and the audit committee can substantially improve the effectiveness of corporate governance. The audit committee may meet privately with management, particularly financial managers, to discuss matters pertaining to the appointment and evaluation of the independent auditor, the appointment, compensation, and evaluation of internal auditors, internal controls, risk assessment, whistle-blower programs, and the financial reporting process.

Audit Committee Interaction with Internal and External Auditors

Audit committees have traditionally been formed primarily to function as a liaison between management and auditors to preserve the auditors’ independence. This role remains essential. However, recent corporate governance reforms (SOX, SEC rules, listing standards, best practices) have expanded and improved the relationship between the audit committee and both internal and external auditors. The audit committee is directly responsible for appointing, retaining, compensating, and overseeing the work of the independent auditor. The audit committee is also responsible for approving all audit and permissible non-audit services in compliance with provisions of SOX 2002. This makes the independent auditor ultimately accountable to the audit committee. The audit committee is also directly responsible for hiring, firing, and compensating the chief audit executive (CAE, the director of the internal audit function) and other key internal audit personnel, as well as approving the budget, staffing, and audit plans of internal auditors. Thus, both internal and external auditors essentially work with management for the audit committee. The audit committee relationship with external and internal auditors is further discussed in Chapters 4 and 5, respectively.

Audit Committee Interaction with Legal Counsel

An audit committee should establish strong and candid relationships with the company’s legal counsel (both internal general counsel and outside legal counsel). These relationships can provide the audit committee with useful information regarding any possible violations of applicable rules and regulations, noncompliance with the company’s code of conduct, and high-risk business and financial areas. For example, an audit committee may learn from the company’s general counsel about significant or unusual transactions that the company is contemplating. On the basis of this information, the audit committee can investigate whether these transactions will be structured or might be viewed as being structured inappropriately to manage earnings or achieve financial targets. By intervening early enough, the audit committee might prevent the company from taking steps that could otherwise result in misleading financial reports. The company’s general counsel should assist the chairperson of the audit committee in preparing meeting agenda, should attend meetings of the audit committee, and should review at least the final draft reports of meetings. If possible violations of laws, rules, and regulations surface, the audit committee should work closely with legal counsel to investigate them.

Conclusion

Effective compliance with new corporate governance reforms, complexity of business, globalization, and technological advances have encouraged the board of directors to establish standing co...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Acknowledgments
• Introduction
• Chapter 1 Corporate Governance Oversight Function of the Audit Committee
• Chapter 2 Financial Reporting Oversight Function of the Audit Committee
• Chapter 3 External Auditor Oversight Function of the Audit Committee
• Chapter 4 Internal Audit Oversight Function of the Audit Committee
• Chapter 5 Risk Management Oversight Function of the Audit Committee
• Chapter 6 Antifraud Oversight Function of the Audit Committee
• Chapter 7 Ethics and Compliance Oversight Function of the Audit Committee
• Chapter 8 Tax Oversight Function of the Audit Committee
• Index