What is an Audit Committee?
The audit committee is a committee consisting of non executive directors of the company set up by the board of directors to ensure that corporate governance and accountability is maintained in financial reporting and its associated disclosure by the company.
Post-Enron scam period, the US government and SEC have put enormous pressure on corporates on accountability and corporate governance. As a part of corporate governance, all the companies will have to follow the Sarbanes Oxley Act. As a part of the same, such committee formation and its monitoring are now mandatory for all the listed companies in the united state.
Need for the Audit Committee
The basic need of audit committee arises, as discussed earlier, is to ensure the accountability of corporate 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 management’s responsibility for preparing 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., structuring and managing 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 verifying the effectiveness of ICFR.
It is the independent auditor’s responsibility to express an opinion about the fairness of the financial statements and on the effectiveness of ICFR.
To oversee ICFR successfully in place in an organization, the audit committee is needed. This committee will understand the processes and controls the management of the company 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 GAAPGAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors. methods on the financial statements, the information presented by management should be in sync to the same. The committee should ensure that management has identified and implement 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 will be useful to prepare for these discussions, and management should analyze to highlighted changes by the audit committee and include new or unusual items.
#3 – NYSE Requirement
NYSE listing standards require the audit committee 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 management’s analyses for these material control deficiencies, including the effects of alternative GAAP methods.
It is also needed 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.
#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 accounting and financial reporting processes of the company and audits of the financial statements.
#5 – Ensure avoiding Financial Fraud
The committee has to ensure that the company has programs and policies to prevent and identify fraud. It also has to ensure that the organization has implemented an appropriate ethics and compliance program and established a reporting of the same on the website.
This committees member 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 –
- 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 Board
Qualities of the Audit Committee
It has some qualities which are as follows.
- Highly experienced
- Professionally skepticism
- Confident, with 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 needed to prevent insiders from influencing the work and oversight of the committee and the work of the external auditors.
- 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 the ability to read and understand financial statements like Balance sheet, Profit and Loss statement, cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities., etc. However, there should be at least one member of the committee 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 to audit or evaluating financial statements.
- Understanding of committee functions.
Examples of Audit Committee Functions
Below are some examples.
#1 – Amazon.com, Inc: Audit committee
Amazon.com, Inc is a listed company in the USA. 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 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 USA. 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, Alphabet Inc. has adequately disclosed.
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
Thus, the Audit Committee is one of the most important corporate governance team that ensures the fairness of financial statement and appropriateness of the assets of the company.
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 –