Corporate Governance Essentials: The Audit Committee
Image credit: Piqsels
All publicly traded companies listed on the New York Stock Exchange (NYSE) or Nasdaq must have an audit committee. It is an essential committee of a company’s board of directors that provides risk oversight over financial reporting. The committee is also responsible for maintaining adequate internal controls and overseeing independent auditors.
Audit Committee Charter
Under NYSE and Nasdaq rules, the board of directors of every public company must adopt an audit committee charter. The charter is a formal written document. It outlines the purpose, organizational structure, authority, and responsibilities of the company’s audit committee.
Purpose of the Audit Committee
The audit committee has an obligation to prevent financial statement fraud. It oversees the company’s ethics and compliance functions. Part of the committee’s role is to prevent intentional material misstatements or omissions in financial data reporting. In addition, it appoints an outside independent public accounting firm to provide audit services to the company.
Regularly scheduled meetings are held at least 4 times per year and are used to discuss matters of concern. This helps bring to issues to light early on. These discussions can help deter bad actors from misappropriating corporate funds or engaging in corrupt practices like kickback schemes or contract manipulation.
Organization and Membership
Both NYSE and Nasdaq have strict standards when it comes to the composition of the audit committee members. Key highlights include:
- The committee must have at least 3 members, and all members must be independent directors [NYSE Listed Company Manual Section 303A.07(a); Nasdaq Listing Rule 5605(c)(2)(A)].
- For NYSE-listed companies, all the members of the audit committee must be financially literate and at least one member must have expertise in accounting or financial management.
- For Nasdaq-listed companies, all the members of the committee must be capable of reading and understanding financial statements and at least one member must be an “audit committee financial expert.” This entails having “financial sophistication” from past employment experience, such as having been a chief financial officer or other senior officer of a company with a substantial role in financial oversight and compliance.
Rules Governing the Responsibilities of the Audit Committee
In addition to the rules of the NYSE and Nasdaq stock exchanges, several U.S. laws and regulations play a role in enforcing the committee operations of U.S. public companies.
The Sarbanes-Oxley Act of 2002 increased the oversight and responsibility required by audit committees. For example, Section 407 of the law mandates that public companies disclose on an annual basis whether they have at least one “financial expert” on their audit committee. Section 301 of the Sarbanes-Oxley Act prohibits U.S. stock exchanges from listing public companies that fail to comply with audit committee rules.
The Public Company Accounting Oversight Board (PCAOB) is responsible for the review and inspection of independent auditor firms. Since the audit committee appoints independent audit firms to prepare accurate reports on behalf of the company, the PCAOB’s inspection of audit firm quality extends to whether the audit committee performed proper diligence in selecting the audit firm.
Regulation S-K, which lays out a series of rules under the Securities Act of 1933, provides guidance on SEC rules for public companies. Item 407 of Reg S-K outlines corporate governance requirements for U.S. public companies. Specifically, Item 407 details requirements for director independence, board meetings and committees, shareholder communications, and board leadership structures.
Periodic reports, such as annual and quarterly reports, filed with the SEC under Section 13(a) of the Securities and Exchange Act of 1934 have certain standards related to audit services. Some tips for audit committees preparing these reports include:
- Review and discuss annual audited and quarterly unaudited financial statements with management.
- Review with company’s independent auditor to make the financial statements meet Generally Accepted Accounting Principles. To learn more about Generally Accepted Accounting Principles (GAAP), see our blog. To the extent alternative accounting treatments were used, provide adequate explanation for the reasoning behind. This includes the use of non-GAAP financial measures and other “adjusted” metrics.
Finally, proxy advisory firms such as ISS and Glass Lewis monitor the corporate governance practices of U.S. public companies. These proxy advisory firms make recommendations for shareholders to vote against companies with poor corporate governance practices. For example, they would be likely to recommend a shareholder vote against a company whose audit committee members owned at least 20% of the company’s stock.