Updated July 17, 2023
Definition of Audit Committee
Federal law requires the formation of an audit committee composed of various directors to obtain and maintain a listing on stock exchanges. Most directors must be independent to undertake major business work processes such as communication with auditors, the appointment of auditors, approval of financial reports, other financial reporting and disclosure requirements, etc.
The Board of Directors creates the audit committee alongside other directors independent of the company. In layman’s language, the independent director indicates a person unrelated to the senior management and does not have a significant relationship with the company. The primary work of the audit committee is to oversee the financial process and other ancillary work such as financial reporting, disclosures, handling audits and auditors, providing recommendations to the board, and other ancillary work, etc.
The audit committee is also responsible for communicating the financial information to the external auditors and handling matters related to the Generally Accepted Accounting Standards. Other relevant measures the committee absorbed are information technology, security, and other operational issues.
How does it Work?
The board of directors creates the audit committee, sometimes formed under the respective law or regulation. For instance, listed companies or companies must be listed on the stock exchange to have a working audit committee. The committee comprises directors of different backgrounds, most of which should be literate in financial terms. Once constituted, the committee initiates work on multiple processes related to accounts, finance, auditing, shareholder grievances, Corporate Social Responsibility, etc. The committee reports to the directors and becomes the one-point contact for communication-related to the external auditor and other ancillary parties. The committee can hire experts who deem fit and approve their remuneration or emoluments.
The Audit Committee, as we see it today, has come into existence from the inspiration of the Sarbanes Oxley Act 2002. The Sarbanes Oxley Act has come into the picture since the debacle of Enron in the United States. Due to a couple of liquidations arising from the issues related to corporate governance, SOX has come into the picture. As per the Sarbanes Oxley Act, to resolve the issues related to corporate governance, a committee must take care of primary functions related to finance and the auditors. Again, there need to be directors who do not work under orders from the board. So, the concept of the independent director has evolved.
Role and Responsibilities of Audit Committee
There are various roles and responsibilities to exercise due care and diligence, and skill in multiple areas:
- We assist the board in fulfilling their duty of care and skill toward users of financial reports.
- To manage the policies regarding the accounting estimates and procedures, financial management, Internal control system, risk management system, Business practices, Protection of an entity’s assets, compliance with regulations, the board of directors and senior financial management, etc.
- It improves communication among the board of directors and internal and external auditors.
- It facilitates communication between the board of directors, senior financial management, and senior management.
- Facilitating communication and internal and external auditors. Reducing the maintenance of independent external auditors.
- We recommend the rotation of the external audit engagement partner to the board.
- Consideration of significant matters that were raised during the process.
Requirements of Audit Committee
Since 2003, the Securities and Exchange Commission has required companies listed on national securities exchanges to adhere to the compliance requirements of the Audit Committee. It prohibits the listing of securities without such adherence. The needs of the Audit committee demand the independence of the audit committee members to oversee and select the independent accountant, handle issues related to the accounting practices of the issuer company, have any authority to hire and take opinions of the advisors or subject matter experts and to fund the independent auditor and the advisors engaged by the audit committee.
There are various benefits of the Constitution and its existence. A few of the pertinent ones are as follows:
- The independent auditor creates it beside the board members, which helps take unbiased opinions.
- The Audit Committee has been involved in multiple works, such as overseeing financial statements, handling auditors’ queries, the auditors’ appointments, etc. Resultantly, a significant burden of the official world has been shifted from the board of directors to the Audit Committee.
- The independent nature of the Audit Committee boosts investor and stakeholder morale and faith.
- The company helps oversee the board and assists in financial reporting, internal control, handling of auditors, and compliance with relevant laws and regulations.
Some of the disadvantages are:
- Despite multiple benefits entailed by the audit committee, there are also some disadvantages. The audit committee’s foremost shortcoming is the company’s cost increase.
- It requires members from the board, and these people are highly paid employees, which increases the company’s cost.
- Another disadvantage is the absence of independent directors, as independent directors are pretty rare because of the requirement of multiple qualifications such as non-pecuniary relationships, no relation with the senior management, etc.
Despite having shortcomings such as increased expenditure, difficulties in hiring quality personnel, lack of independent directors, etc., the audit committee is one of the most excellent tools to maintain transparency in the corporate world and enhance the faith of the stakeholders in the company.
This is a guide to Audit Committee. We also discuss the definition, role, and responsibilities with advantages and disadvantages. You may also have a look at the following articles to learn more –