What is an Audit Committee?

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This committee is part of the company structure and it ensures that the corporate players work per ethics and laws. In the United States, publicly traded companies must have an audit body. It is mandatory for them to have to be listed on the stock exchange.

Key Takeaways

  • An audit committee consists of non-executive directors of the company and it is set up by the board of directors to ensure that corporate governance and accountability are maintained in financial reporting and its associated disclosure by the company.The committee is responsible for ensuring corporate accountability toward stakeholders.It must ensure that the company has programs and policies to prevent identity fraud related to financial statements, asset misappropriation, or corruption.It is one of the most important corporate governance teams that guarantees the fairness of financial statements and the appropriateness of the company’s assets.

Audit Committee Explained

An audit committee works in alliance with the corporate units. Investors must ensure that the companies they invest in are on the right track and comply with industry regulations and standards. Hence, the presence of this committee keeps them free from the stress that arises from concerns regarding company ethics, compliance, and financial reportingFinancial ReportingFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more.

The members of the board of directors constitute this committee whose presence helps investors trust their investments. When they know that the companies work ethically, and have ideal internal controlsInternal ControlInternal control in accounting refers to the process by which a company implements various rules, policies, or procedures to ensure the accuracy of accounting and finance information, safeguard the various assets of the business, promote accountability in the business, and prevent the occurrence of frauds in the company.read more in place to detect inconsistencies, they feel secure.

Structure

Moving ahead to the audit committee composition, all the committee members must be independent and prevent insiders from influencing the work of external and internal auditInternal AuditInternal audit refers to the inspection conducted to assess and enhance the company’s risk management efficacy, evaluate the different internal controls, and ensure that the company adheres to all the regulations. It helps the management and board of directors to identify and rectify the loopholes before the external audit.read more and the proceedings of the committee. The authorities review the committee’s independence annually to ensure the members are working under no influence.

The committee members must comply with the financial literacyFinancial LiteracyFinancial literacy refers to an investor’s knowledge and understanding of various financial products that help him with money management, personal finances, investment, and tax planning. It examines how prudently an individual manages his finances, therefore building the necessary requirements such as an emergency fund, a retirement fund, and how they plan to handle insurance, estate planning, paying for education, etc.read more requirements of the relevant securities exchange.

In addition, at least one member must be a financial expert. Having this expert ensures that the committee effectively assesses every financial aspect of a company, both legally and technically.

Requirements

The Sarbanes-Oxley Act of 2002 states that the US Securities and Exchange Commission (SEC) must adopt requirements for an organization to fulfill to be eligible for a stock exchange listing. The authorities form an audit committee and make it functional to ensure the exchanges allow the listing of a company’s stocks. The SEC, therefore, must disclose if the members are qualified enough for the audit committee applicability per the following:

  • Understanding of the generally accepted accounting principles (GAAP) and financial statements Ability to assess how GAAP applies to account for estimatesAccount For EstimatesA change in accounting estimate occurs when there is the appearance of new information, which replaces the current data based on which the company had taken an earlier decision, resulting in two things – changing the carrying amount of an existing asset or liability and alteration of subsequent accounting for recognition of future assets and liabilities.read more, accruals, and reserves. Experience in preparing audits or evaluating financial statementsClarity about the audit committee functions Free from influences

It is significant to check and verify the qualification and eligibility of the individuals. The verification must convince the companies to finally assign a role of an audit committee member. In addition, one of these members must be financially sound to analyze things strictly from a financial perspective. This way, they can detect fraud or issues with implementing internal controls. In short, the members must be an expert in their respective roles in the committee.

Role & Responsibilities

The committee’s role depends on its members, who are responsible for better working and management of the investor protection system. It ranges from the members checking the financial reporting process to finding out whether the committee members remain influence-free. Under the CFO, the company prepares the financial documents that are further shared with the investors and the SEC. The monthly reports, quarterly reportsQuarterly ReportsQuarterly reports are unaudited financial reports that are summarized versions of financial statements released by public companies every three months (quarter) to comply with compliance requirements.read more, and annual reports are prepared under the supervision of the CFO.

Each and every committee member works independently and utilizes all their expertise in their relevant fields. They oversee the financial reporting system and check the internal controls in place to identify frauds or threats. The information received is huge. Thus, the committee emphasizes riskier areas of the financial statements more as that would raise doubts in investors.

A company hires an external auditor to skeptically investigate the reports to find loopholes. The final verdict comes from them. Therefore, they make sure they clear all the doubts before justifying the company’s financial position to investors. These auditors, however, work per the rules the Public Company Accounting Oversight Board (PCAOB) lays down.

The members together ensure the maintenance of integrity in the financial reporting system. Moreover, they guarantee compliance and implementation of internal controls. In addition, the committee members also look into complaints and grievances as recorded.

Example

The audit committee report or charter might differ from company to company with respect to the information. However, the format is almost the same for all. Here is an audit committee charter example from Alphabet Inc.:

Risks

Setting up an audit committee is necessary for firms intending to issue shares to investors and list themselves on the stock exchanges. However, the functioning of the committee involves various risks. The first challenge is the expense. The committee’s composition requires expenditure, which might not be easy to handle for the companies.

As the committee has board people as members, the companies have to pay them more, which makes it a costly affair. However, as having the committee is always better, the management prefers forming it despite the expenses.

Besides the risks related to the finances involved, there are other challenges too that a company might face. These include cybersecurity issues, information redundancy problems, and technology risks. 

This article is a guide to the what is Audit Committee. Here, we discuss how it works along with its roles, responsibilities, requirements, risks, and an example. You can learn more about accounting from the following articles –

It prepares the financial documents and keeps a check on how ethically the company functions so that it can share the information with the stakeholders, SEC, or whoever it may concern.

The SEC adopted the rules and regulations per the Sarbanes-Oxley Act of 2002, according to which all committee members would work independently without getting influenced by each other’s inferences.

It is a document that specifies the process adopted by the audit committee to identify and review the issues and the ways to resolve them. The information ranges from the type of auditor to be hired to how things have to be tackled. The charter details differ from company to company, but the format is similar.

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