What is an Audit Committee?
An audit committee consists of non-executive directors of the company set up by the board of directors to ensure that corporate governance and accountability are maintained in financial reporting and its associated disclosure by the company.
Post-Enron scam period, the U.S. government and SEC have put enormous pressure on corporations for accountability and governance. As a part of corporate governance, all the companies have to follow the Sarbanes Oxley Act. Such committee formation and its monitoring are now mandatory for all the listed companies in the United States.
Need for the Audit Committee
The basic need of an audit committee arises, as discussed earlier, to ensure corporate accountability towards stakeholders. For this, various statutes have been amended and made it mandatory for the formulation, which is as follows:
#1 – ICFR Requirement
It is a manager’s responsibility to prepare the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., structure, manage adequate internal control over financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. (ICFR) and verify the effectiveness of ICFR.
It is also an independent auditor’s responsibility to express an opinion about the fairness of the financial statements and the effectiveness of ICFR.
The audit committee is required to oversee ICFR in an organization successfully. This committee will understand the processes and controls of the company’s management and will ensure whether they have been put in place effectively or not.
#2 – Regulation S-X, Rule 2-07
As per this regulation, the independent auditor has to discuss the effects of alternative GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting. methods on the financial statements. The information presented by management should be in sync with the same. The committee should ensure that management has identified and implemented all significant accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level., estimates, and judgments made. Quarterly analysis of these areas is useful while preparing these discussions, and the management should analyze changes highlighted by the audit committee and include new or unusual items.
#3 – NYSE Requirement
NYSE listing standards require the audit committees to review essential issues relating to accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. and the fairness of the financial statements. These also include significant changes in the company’s selection and application of accounting principles, the adequacy of internal controlInternal ControlInternal control in accounting refers to the process by which a company implements various rules, policies, or procedures to ensure the accuracy of accounting and finance information, safeguard the various assets of the business, promote accountability in the business, and prevent the occurrence of frauds in the company., and any special steps adopted in response to the NYSE terms “material control deficiencies.”
This committee is needed to check the management’s analyses for these material control deficiencies, including the effects of alternative GAAP methods. They are also required to review below off-balance-sheet transactions:
- Pending technical and regulatory matters that could affect the financial statements;
- Review of management’s discussion and analysis in the annual and quarterly reports.Quarterly Reports.Quarterly reports are unaudited financial reports that are summarized versions of financial statements released by public companies every three months (quarter) to comply with compliance requirements..
#4 – NASDAQ Requirement
NASDAQ listing requirement states that there should be adequate disclosure of the audit committee’s purpose, as prescribed in its charter, of monitoring its accounting and financial reporting processes and audits of the financial statements.
#5 – Ensure avoiding Financial Fraud
The committee must ensure that the company has programs and policies to prevent identify fraud. It also must ensure that the organization has implemented an appropriate ethics and compliance program and established its reporting on the website. The committee members should be aware of three main areas of fraud risk:
- Financial statement fraud
- Asset misappropriation
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Audit Committee Responsibilities & Functions
Here we can see some responsibilities & functions of the audit committee –
- Oversight of ICFR
- Review of filing and earnings release
- Risk oversight
- Oversight of independent auditor
- Ethics and compliance
- Oversight of internal auditInternal AuditInternal audit refers to the inspection conducted to assess and enhance the company's risk management efficacy, evaluate the different internal controls, and ensure that the company adheres to all the regulations. It helps the management and board of directors to identify and rectify the loopholes before the external audit.
- Other interaction with management and the board
Qualities of the Audit Committee
It has some qualities which are as follows.
- Highly experienced
- Professionally skepticism
- Confident and strong integrity
- Organized and proactive
- Strong communication and interpersonal skills
- Willing to devote the time and energy necessary
Independence and Qualification of Audit Committee
- All the members must be independent. Independence is required to prevent insiders from influencing the work of both internal and external auditors and oversight of the committee.
- Independence should be continuously maintained and reviewed at least annually. For committee members, these questionnaires should be tailored to reflect the independence criteria of either the NYSE or NASDAQ.
- All members must comply with the financial literacyFinancial LiteracyFinancial literacy refers to an investor's knowledge and understanding of various financial products that help him with money management, personal finances, investment, and tax planning. It examines how prudently an individual manages his finances, therefore building the necessary requirements such as an emergency fund, a retirement fund, and how they plan to handle insurance, estate planning, paying for education, etc. requirements of the relevant securities exchange.
- Financial Literacy means reading and understanding financial statements like balance sheets, profit and loss statements, cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business., etc. Nonetheless, at least one committee member should have accounting or related financial management expertise.
- As per SEC, the company should disclose whether a member of the audit committee is qualified to do the following attributes or not:
- Understandability of GAAP and financial statements
- Ability to assess how GAAP applies to account for estimates, accruals, and reserves
- Experience in preparing audits or evaluating financial statements
- Understanding of committee functions
Examples of Audit Committee Functions
Below are some examples.
#1 – Amazon.com, Inc:
Amazon.com, Inc is a listed company in the U.S. Hence, it has to comply with all the committee requirements.
In the link above provided, one can observe that as per the rule of SEC disclosure requirement, NYSE and NASDAQ listing requirement, Amazon.com, Inc has adequately been disclosed.
We can observe that the below details are provided on its website:
- Organization and Membership
- Statement of Purpose
- Duties and Responsibilities
- Qualifications, Independence, and Performance of the Independent Auditors
- Performance of the Internal Audit Function
- Legal, Regulatory, and Compliance Oversight
- Other Duties
#2 -Alphabet Inc.
Source: Alphabet Inc
Alphabet Inc is a listed company in the U.S. Hence, it has to comply with all the committee requirements.
In the link above, one can observe the rule of SEC disclosure requirement, NYSE, and NASDAQ listing requirement.
We can observe that the below details are provided on its website:
- Appointment and Membership Requirements
- Restrictions on Independent Auditors Services
- Meetings and Minutes
- Delegation of Authority; Chair of Audit Committee
The audit committee is one of the most important corporate governance teams that ensure the fairness of financial statements and the appropriateness of the company’s assets.
This article has been a guide to Audit Committee and its definition. Here we discuss the need, responsibilities & functions, qualities, and examples of Amazon and Alphabet Audit Committee. You can learn more about accounting from the following articles –