related documents
ORP35 - Public Policy on Corporate Audit Committees - Case Study Evidence of Current Practice
ACCA Occasional Research Paper No. 35
Corporate failures and malpractices have led to an increasing emphasis on the governance role of audit committees. The Smith report Audit Committee Combined Code Guidance and the Higgs Review of the Role and Effectiveness of Non-Executive Directors (now incorporated in a Revised Combined Code) represent further attempts to strengthen corporate accountability in the UK. Although the regulatory focus on audit committees indicates confidence in their role as part of the solution to governance failures, questions remain about their efficacy in practice.
Turley and Zaman, 2003
Executive summary
Corporate failures and malpractices have led to an increasing emphasis on the governance role of audit committees. The Smith report Audit Committee Combined Code Guidance and the Higgs Review of the Role and Effectiveness of Non-Executive Directors (now incorporated in a Revised Combined Code) represent further attempts to strengthen corporate accountability in the UK. Although the regulatory focus on audit committees indicates confidence in their role as part of the solution to governance failures, questions remain about their efficacy in practice.
Against the background of the publication of the Smith report and the wider reliance on audit committees in several countries to help improve corporate accountability, this paper provides research evidence, drawn from an ACCA-sponsored project, on the processes and effects of the audit committees in three UK companies.
This study complements other research on audit committees by adopting a case study approach, in order to reflect the importance of investigating audit committee operations from within the organisation and to develop a closer understanding of audit committee impact than is available from generally observable data. The empirical evidence for the case studies was obtained from semi-structured interviews with personnel involved in the audit committee process, internal documents made available by the companies, and publicly available information, including annual reports.
Specifically, this paper:
- considers the Smith recommendations, in the context of evidence of audit committee operation and effects in practice, including the recommendations on membership, remuneration and meetings of audit committees
-
provides evidence of audit committees¿ impact on financial reporting, internal control and internal audit, and the external audit process
and - identifies areas where actual practice meets the Smith guidelines and suggests aspects of audit committee roles which may need further consideration by companies and regulators.
Some key findings
- Audit committees¿ duties are formally discharged through highly structured meetings where the agenda is set by either the internal audit or the financial reporting function with varying involvement of the audit committee chairman. Executive management and external auditors always attend audit committee meetings and potentially have a significant affect on the deliberations. There is evidence of varied amounts of preparation for, and follow-up to, these meetings. Although the regular meetings provide the formal discharge of responsibilities, however, the substantive governance contribution of the audit committee is often made in informal processes outside the regular meeting calendar.
- Audit committees give varying degrees of attention to items in their terms of reference such as internal audit, financial reporting and external audit. This variation may be attributed to the role and activity of various agencies and structures within companies and their interaction with the audit committee.
- The audit committee is essentially a responsive body and is highly dependent on what information is provided to it. In routine situations, both internal and external auditors seem concerned primarily with their interaction with executive management and seek to ¿manage¿ the formal process of the audit committee, a position that could be considered to undermine the audit committee¿s contribution. In unusual situations, the committee could be significantly involved in mediating organisational outcomes, but primarily through informal processes rather than the programme of meetings and topics provided in the formal constitution.
- Power relations between relevant organisational participants are significantly affected by the audit committee. It can serve varied roles, acting as an ally in certain circumstances, as an arbiter in others and being used at times as a source of threat to support the authority of other organisational participants. The committee¿s existence and operation also has other pervasive behavioural effects, for example in influencing the way in which those engaged in internal audit perceive the status and importance of their own, and others¿, functional activities.
- It appears that audit committees could be influenced by considerations regarding the perceived impact of financial reporting choices on share prices. Faced with two choices, one potentially maintaining the share price and the other perceived as threatening a reduction, audit committees tend to prefer the former, suggesting that the transparency of annual reports and adoption of best practice could be secondary concerns.
The evidence from the cases suggests that many of the Smith recommendations concerning membership and the responsibilities of the audit committee are already met in practice. The following are some of the issues which will need further consideration in at least some organisations.
- There is some evidence that audit committees could become more proactive elements of governance. In the case companies, they tended not to initiate action, and membership remained relatively fixed, a situation which could lead to some inertia and less active execution of responsibilities.
- The composition of the audit committee, in particular with reference to the extent to which members have relevant, recent, financial expertise and the requirement that, for the independence of the committee, members¿ period of service should not exceed nine years, may involve significant change to practice in some companies.
- Greater involvement of the audit committee in the appointment of both the external and internal auditors, in determining the external auditors¿ remuneration for audit and non-audit fees, and in reviewing policy on the provision of non-audit services by the auditor will represent significant changes in audit committee responsibilities in many organisations.
- The attendance and participation of non-audit committee members in audit committee meetings, and the potential in practice for this to constrain the committee¿s discussions and decisions, suggest that reliance on recommendations regarding membership alone may not guarantee that the audit committee is able to form a view that is independent of management.
These findings are relevant to the development of policy on audit committees in the following ways.
- Owing to the nature of processes associated with audit committees, increasing harmonisation and codification of governance may generate unintended consequences. Reliance on a relatively standardised structure and formal features such as terms of reference are unlikely to deliver a uniform governance contribution. The terms of reference, for example, may increase the formal power of audit committees but cannot guarantee that such powers will be actualised in practice.
- There remains a potential conflict of interest in the non-executive directors¿ role on the audit committee. On the one hand non-executive directors as board members are expected to act with management to try to meet shareholder expectations and maximise share price and, on the other, as members of the audit committee they are also expected to act independently of management and represent long-term shareholder interests. This potential conflict of interest in the present system of governance in many countries needs to be recognised when formulating public policy on audit committees.