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EVOLVING ROLE OF THE AUDIT COMMITTEE (1of 2)

With the increasing importance of corporate governance, the market worldwide is witnessing changes in existing governance practices. This in turn is leading to the development of new practices or enhancing existing ones. Audit committees are receiving the highest share of such developments. Risk management and compliance oversight are examples of the additional roles that are assigned to audit committees. Let us look at the areas of focus of audit committee and highlight the changes that are taking place and how regulatory and board attention is directed towards these areas. Audit committee areas of focus are:

  • financial reporting
  • compliance with regulatory and legal requirements
  • risk management
  • external audit
  • internal audit

Developing practices in the above areas of focus can be summarized as below.

4.1 Financial Reporting

The audit committee will continue to work closely with executive management and external auditors to ensure that the financials of the company are prepared in accordance with accepted international accounting standards. Complying with the standards is an important element of the oversight provided by the audit committee but it is not the only one. Ensuring that the necessary and relevant accounting policies and procedures are present and followed, due segregation of duties, roles and authorities are as important as is the accuracy of the financials. Regulators are becoming more involved in the issue of the financials of companies and banks and at a level and intensity not known before. Prudential meetings, new guidelines and inspections are the tools of regulators. Central banks now demand that financial reports are not made public before they review them. The regulators' review includes accuracy, sufficiency of provisions and compliance with standards of accounting and corporate governance. While their role is viewed by some as an intrusion into the affairs of companies, the regulators at the end of the day have a duty to protect the public. To strike the balance between public interest and the interest of companies is a delicate task.

Current corporate governance practices are changing the landscape of business for good. The hierarchy that we have been used to in which you have top and bottom levels of authority is changing. The principle of stakeholders is rightly creating a middle level of authority that cannot be ignored. In fact, stakeholders’ authority is not limited to only the middle but penetrates from all sides dismantling a long known influence and authority pyramid. The demands and needs of stakeholders are explicitly stated in all corporate governance guidelines and are enshrined in all disclosure statements in the annual reports of companies. This is a trend that is very likely to increase and to expand as part of the public's right.

Central Bank of Bahrain provides the following guidelines relating to the responsibilities of audit committees concerning financial reporting in banks:

  • Monitoring the financial reporting process and its output
  • Overseeing the establishment of accounting policies and practices by the bank and reviewing the significant qualitative aspects of the bank's accounting practices, including accounting estimates and financial statement disclosures
  • Monitoring the integrity of the bank’s financial statements and any formal announcements relating to the bank’s financial performance
  • Reviewing significant financial reporting judgments contained in the financial statements
  • Reviewing arrangements by which the staff of the bank may confidentially raise concerns about possible improprieties in matters of financial reporting.

4.2 External Audit

Until few years back, the responsibility of monitoring the work of the external auditors rested with executive management. This included recommending their appointment or removal to the board, negotiating and fixing their remuneration and supervising their work. It was a common knowledge that for the external auditors to have the chance to be re-elected for further periods, they needed to create a comfortable way of working relationship with executive management and in short to please them. This was also a time when external auditors were allowed to perform other consulting work in addition to auditing the financial reports and with no limitations.

Thanks to the regulatory requirements vis-a-vis corporate governance practices, the formation of audit committees has become mandatory. This in turn, has changed the reporting line of external auditors from executive management to the audit committee and in the process enhancing the independence. The external auditors have now to be aware of the tone at the level of the audit committee and perform accordingly. The audit committee's role is gaining more and more importance in giving the board, shareholders and various other stakeholders a certain assurance of the soundness of the control environment in the company. The audit committee is also called upon to be represented in each meeting of the shareholders - ordinary or extra-ordinary - to provide any clarification sought by shareholders on matters relating to its scope of responsibilities including the external auditors work and performance. The shareholders will only approve financial reports submitted by external auditors if they carry the recommendation of the audit committee.

In addition to the submission of financial reports, the external auditors are requested to submit a management letter with their observations on the control aspects of the company. The management is expected to review those observations, provide responses and corrective action plans. The management letter used to be submitted by external auditors directly to executive management. There is a positive change to the process of submission. The external auditors are now required to provide a copy to the audit committee of the management letter at the same time they issue it to the management. The audit committee will then follow up with management to obtain their comments and action plan for any points that might be raised. The audit committee will also get a copy of the final version of the management letter and compare it with the draft copy to check the changes between the two versions. This is a very important development as the audit committee can deduce from the process the performance of the external auditors. If for example, the first draft copy carried twenty points and the final version had only five then the committee needs to know why.

The following issues need to be looked at by audit committee to address such situation:

  • Whether the external auditors have overstated these points
  • Whether the right competent auditor has been assigned to the job of preparing the management letter
  • Why the number of points were drastically reduced. Is it due to the fact that external auditors did not communicate enough with management before issuing the letter or simply did not understand the business and control aspects of the company?
  • Was there undue influence by executive management on the external auditors

Checking the above issues will certainly make the evaluation of the performance of external auditors by audit committee handled in a better way and it will add to the soundness of the process.

It will also make the selection of the external auditors, and for that matter re-election and dismissal based on more solid grounds. We all know that, with limited number of external auditors, what is known as the Big Four or Five, companies will continue to be pressed for choice. Companies and banks need them to handle the financial reporting audit and they have a continuous need for other consulting services. The more their work is streamlined and scrutinized the better results can be achieved. The board of directors represented by audit committees will continue to play a leading role in this respect. Which in our view, will lead to a better understanding between external auditors and the parties they audit or provide consulting services which, in turn, will enhance and create more professional relationships.

The Basel Committee of Banking Supervision from the Bank of International Settlement recommends following guiding principles on relationships between a bank’s audit committee and external auditors:

  • The audit committee should have a robust process for approving, or recommending for approval, the appointment, reappointment, removal and remuneration of the external auditor
  • The audit committee should monitor and assess the independence of the external auditor
  • The audit committee should monitor and assess the effectiveness of the external audit
  • The audit committee should have effective communication with the external auditor to enable the audit committee to carry out its oversight responsibilities and to enhance the quality of the audit
  • The audit committee should require the external auditor to report to it on all relevant matters to enable the audit committee to carry out its oversight responsibilities

Second part of this article will be published in first quarter of 2015.

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