Role of the audit committee in corporate governance

By Alex Tawanda Magaisa

IN the previous articles we saw that the board is the centre of power in the public company. The board normally carries out its functions through different committees, three of which

are the audit committee, the remuneration committee and the nomination committee.


In assessing the role of the non-executive director (NED) we noted that good practice requires that independent NEDs constitute these three committees.


This article profiles and assesses the role of the audit committee in corporate governance structures.


The audit committee is at the nexus of the interests and concerns the company’s auditors, the non-and executive management and the shareholders. Primarily, it is intended to protect shareholders in respect of financial reporting and internal controls within the company. Its functions can be best understood by profiling the role of the auditors and their relationship with the company.


Role of auditors

Alongside regulators, the board and various others, auditors form part of the watchdog mechanism for companies operating in the market. Auditors have specific legal roles and powers provided for in terms of the law. Their primary function is to report to shareholders on matters relating to the management of the company’s affairs. The proper exercise of this role is meant to protect the interests of shareholders as they act as watchdogs against the excesses of the executive management.


By properly exercising their skills auditors should be capable of detecting any impropriety regarding the financial affairs of the company. Laws control the admission of auditors and their professional conduct and also provide the necessary legal powers to enable them to perform their tasks.


In addition, although exceptionally, the common law also provides for their liability if they negligently perform their duties.


Need for protection against auditors


Nonetheless, despite these legal provisions the auditors do not always perform the watchdog role to perfection. In the US case of Enron Corporation, which collapsed in 2002, the auditors, Arthur Anderson were found guilty of obstructing the course of justice for shredding documents relating to Enron’s affairs.


They were also found to have lacked independence and objectivity because of conflicts of interest in the work they were doing for Enron. The executive management of the company can be so overbearing on the auditors to adopt reporting policies that will not accurately reflect the true picture of the company’s state. Although the law provides that auditors are appointed or removed by shareholders, in reality the passivity of shareholders means that in practise the executive retains the power to do this.


They give work to and pay the auditors. It is suggested that the board should have a greater role in the appointment and removal of auditors. Unlike shareholders that are often dispersed and averse to spend much time tending to the corporate affairs because of the free-rider problem, the board has more time and resources at its disposal. Since the board has both executive and NEDs it is necessary to assign this role to a special committee known as the audit committee so that NEDs who are presumed to be independent from the executive can constitute the committee.

What then are the responsibilities of this committee?


Useful developments on the role of the committee


It is necessary to emphasise the creation of the audit committees should not be seen as cosmetic additions to the company’s governance structure. Recent developments indicate that if properly applied, this committee can play an important role.


In the UK a committee of the Financial Reporting Council produced the Smith Report that was presented in January 2003 and it concentrated on the role of the committee. Already the Combined Code, created after the Cadbury Reports, required listed companies boards to create audit committees comprised of at least three non-executive directors.


The new guidance in the Smith Report recommends the strengthening of the audit committee and requires that all NEDs be independent. It is also necessary that at least one member of the committee should have recent and relevant financial experience. This is to enable it to competently carry out its task of reviewing the “significant reporting issues and judgements made in connection with the preparation of the company’s financial statements”.


The audit committee should also develop measures to ensure the independence of auditors particularly in relation to the provision of non-audit services. It may be that other than usual pressure, the executive management may compromise the independence of the auditors through giving them other non-audit work and thereby induce them to behave favourably. It is common practice for audit firms to perform various tasks such as management and tax consulting, human resources recruitment, accounting work for the same company other than the audit services.


It is the role of the audit committee to ensure that the auditor’s performance is reviewed annually. It is given the primary responsibility to recommend to shareholders in respect of the appointment, renewal or removal of the auditors. The role of the committee in this respect is to ensure the protection of shareholders on matters of financial reporting by ensuring that the auditors are performing their work properly.


The Smith Report also recommended that the annual directors’ report should contain a special section documenting the activities of the audit committee. In addition the chair of the committee should be present in the annual general meeting to respond to any questions from shareholders.


Limitations


The success of these measures depends on the technical competence of members of the audit committee as well as the existence of their presumed independence from the executive. If as we saw in the last article NEDs may be nothing more than a veil of independence, then it is unlikely that the committee will add much to this role. It may also depend on how independent directors in general are from auditors. Indeed if the NEDs are auditors it may be that they will seek to protect the interests of their profession first and they have no incentive to harass fellow members lest the same treatment may be meted on them where they are acting as auditors. In addition the same back-scratching and brotherhood networks might influence the efficacy of the committee.


The emphasis on independence from the executive also creates a gap and division between NEDs and executives, which may lead to internal conflicts. Are executives prepared to stand such scrutiny?


Conclusion


Theoretically the audit committee plays an important role in good corporate governance. It gives teeth to the board and ensures that both the management and the auditors properly represent the affairs of the company.

Auditors have a crucial legally recognised role in respect of financial reporting for purposes of shareholder protection. However various factors discussed in this article indicate that it may be misleading to rely on the auditor’s reports without checks and balances. In particular there is always the risk that the auditor’s independence and objectivity may become compromised and shareholders will be at risk.


Despite the availability of legal powers shareholders are often so disintegrated that they do not keep the auditor in check. It is therefore necessary to include the board and to do so by creating this special committee with greater responsibility to ensure that auditors do their work satisfactorily. As with all things theoretical there are always downsides but international corporate governance has long recognised the significance of these committees that any self-respecting company should have one or should seriously consider putting one in place.


The recent developments in the UK and elsewhere may be of use in that respect.


-Alex Tawanda Magaisa is Baker & McKenzie lecturer in Corporate & Commercial Law at The University of Nottingham. Can be contacted at alex.magaisa@nottingham.ac.uk or alexmagaisa@hotmail.com

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