Audit Committee

An audit committee is a body that takes care of a company's financial reporting with respect to the internal controls in place to ensure accuracy. This committee also monitors a company's overall processes and ensures they comply with the standards, guidelines, and industry regulations. Therefore, it is important to have external audit committee members as well to provide accurate and honest opinions.

This committee is part of the company structure and it ensures that the corporate players work per ethics and laws. In the United States, publicly traded companies must have an audit body. It is mandatory for them to have to be listed on the stock exchange. Ideally, a Certified Public Accountant (CPA) must chair this committee.

• An audit committee consists of non-executive directors of the company and it is 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.
• The committee is responsible for ensuring corporate accountability toward stakeholders.
• It must ensure that the company has programs and policies to prevent identity fraud related to financial statements, asset misappropriation, or corruption.
• It is one of the most important corporate governance teams that guarantees the fairness of financial statements and the appropriateness of the company's assets.

An audit committee works in alliance with the corporate units. Investors must ensure that the companies they invest in are on the right track and comply with industry regulations and standards. Hence, the presence of this committee keeps them free from the stress that arises from concerns regarding company ethics, compliance, and financial reporting.

The members of the board of directors constitute this committee whose presence helps investors trust their investments. When they know that the companies work ethically, and have ideal internal controls in place to detect inconsistencies, they feel secure.

According to the norms, a financial expert is supposed to attend every audit committee meeting, which ideally, must be a CPA, however, it is very rare that CPAs or board members are available for meetings. It is also important to keep in mind that these meetings have to be conducted at least 4 times a year to review the most recent audit report. The communication regarding developments from these meetings is relayed to the Chief Financial Officer (CFO) and controller.

Structure

Moving ahead to the audit committee composition, all audit committee members must be independent and prevent insiders from influencing the work of external and internal audit and the proceedings of the committee. The authorities review the committee's independence annually to ensure the members are working under no influence.

The committee members must comply with the financial literacy requirements of the relevant securities exchange.

In addition, at least one member must be a financial expert. Having this expert ensures that the committee effectively assesses every financial aspect of a company, both legally and technically.

The Sarbanes-Oxley Act of 2002 states that the US Securities and Exchange Commission (SEC) must adopt requirements for an organization to fulfill to be eligible for a stock exchange listing. The authorities form an audit committee and make it functional to ensure the exchanges allow the listing of a company's stocks. The SEC, therefore, must disclose if the members are qualified enough for the audit committee applicability per the following:

• Understanding of the generally accepted accounting principles (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
• Clarity about the audit committee functions
• Free from influences

It is significant to check and verify the qualification and eligibility of the individuals. The verification must convince the companies to finally assign a role of an audit committee member. In addition, one of these members must be financially sound to analyze things strictly from a financial perspective. This way, they can detect fraud or issues with implementing internal controls. In short, the members must be an expert in their respective roles in the committee.

Let us understand the composition of the audit committee members through the discussion below. This will help us understand the hierarchy and reporting structure of this group of people as well.

• The committee must comprise at least three members who are of non-executive background.
• Preferably, they must be independent members who shall show no leniency or allow any lapses in terms of ethical or moral gaps in the accounting of the company.
• The chair of the committee must be independent and cannot be the chair of the board of directors.
• It is compulsory for at least one member to have relevant qualification and experience in the field of finance and accounting.
• Occasionally, non-committee members would be invited to take part in the meetings if the chair of the committee thinks it is appropriate.

The committee's role depends on its members, who are responsible for better working and management of the investor protection system. It ranges from the members checking the financial reporting process during audit committee meetings to finding out whether the committee members remain influence-free. Under the CFO, the company prepares the financial documents that are further shared with the investors and the SEC. The monthly reports, quarterly reports, and annual reports are prepared under the supervision of the CFO.

Each and every committee member works independently and utilizes all their expertise in their relevant fields. They oversee the financial reporting system and check the internal controls in place to identify frauds or threats. The information received is huge. Thus, the committee emphasizes riskier areas of the financial statements more as that would raise doubts in investors.

A company hires an external auditor to skeptically investigate the reports to find loopholes. The final verdict comes from them. Therefore, they make sure they clear all the doubts before justifying the company's financial position to investors. These auditors, however, work per the rules the Public Company Accounting Oversight Board (PCAOB) lays down.

The members together ensure the maintenance of integrity in the financial reporting system. Moreover, they guarantee compliance and implementation of internal controls. In addition, the committee members also look into complaints and grievances as recorded.

Let us understand the composition, functions, and responsibilities of audit committee members with the help of a couple of examples. These examples will give us a practical overview of the concept and its related factors.

Example #1

ABC Inc., has a four-member audit committee who meet on a regular basis to oversee the accounting and other financial aspects of the company. During one of their meetings, they found that there were irregularities in the marketing budget and the execution of the same.

Upon further investigation and following the paper trail, they found that one of the executives presented over-inflated budgets and took a cut from the marketing expenses into a dummy vendor account held by the executive himself.

It was later found that the reporting manager of the executive was also involved in the fraud and therefore, both were fired and charges were filed against them. As a warning for the rest of the company, the marketing head was also fined for negligence and demoted.

Example #2

The audit committee report or charter might differ from company to company with respect to the information. However, the format is almost the same for all. Here is an audit committee charter example from Alphabet Inc.:

Setting up an audit committee is necessary for firms intending to issue shares to investors and list themselves on the stock exchanges. However, the functioning of the audit committee members involves various risks. The first challenge is the expense. The committee's composition requires expenditure, which might not be easy to handle for the companies.

As the committee has board people as members, the companies have to pay them more, which makes it a costly affair. However, as having the committee is always better, the management prefers forming it despite the expenses.

Besides the risks related to the finances involved, there are other challenges too that a company might face. These include cybersecurity issues, information redundancy problems, and technology risks. 

This article is a guide to the what is Audit Committee. Here, we explain its roles, responsibilities, requirements, risks, and examples. You can learn more about accounting from the following articles –

• Auditor Meaning
• Definition of Inventory Audit
• Statutory Audit
• Examples of Audit Report