Who Needs To Form An Audit Committee?

Audit committees are operating committees of a company's board of directors that oversee financial reporting, compliance, and risk management activities. They are typically composed of independent directors, with at least one financial expert, and are subject to rules and standards set by relevant regulatory bodies. The requirement for companies to constitute an audit committee varies across jurisdictions and is dependent on factors such as the company's listing status, size, and industry. For example, publicly traded companies in the United States are subject to the rules of the Securities and Exchange Commission (SEC) and the listing standards of stock exchanges such as the New York Stock Exchange (NYSE) or Nasdaq. Similarly, in India, the Companies Act, 2013, mandates that specific classes of listed and unlisted public companies form audit committees. These committees play a crucial role in ensuring the integrity of financial statements, compliance with regulations, and the independence of auditors.

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Publicly traded companies

Audit committees in publicly traded companies are responsible for overseeing the integrity of financial statements, compliance with legal and regulatory requirements, the independence and qualifications of auditors, the performance of internal audit functions, and the compensation of company executives. They interact closely with senior financial management and can initiate special investigations into accounting practices if significant problems are identified. External auditors are required to report to the committee on matters such as accounting principles, adjustments, disagreements, and any identified fraud or illegal acts.

The Sarbanes-Oxley Act of 2002 significantly impacted audit committees, increasing their responsibilities and authority. It raised membership requirements and emphasised the inclusion of independent directors. Companies were mandated to disclose the presence or absence of a financial expert on the committee. The Act prompted the SEC and stock exchanges to propose new regulations and rules to strengthen audit committees further.

To maintain their independence, audit committee members should not receive certain forms of compensation from the company or its subsidiaries. They must also be free of affiliations with the company or its subsidiaries. Companies should implement policies to identify and address any relationships or circumstances that may compromise independence.

In India, the Companies Act 2013 mandates that listed companies and specific classes of public companies constitute an Audit Committee. These classes include public companies with substantial paid-up capital, turnover, or outstanding loans. The Audit Committee must consist of a minimum of three directors, with independent directors forming the majority.

Director independence

In the United States, publicly traded companies' audit committees are subject to the rules of the Securities and Exchange Commission (SEC) and the listing standards of stock exchanges such as the New York Stock Exchange (NYSE) and Nasdaq. Under NYSE and Nasdaq requirements, audit committees should consist of three or more directors who are independent. This independence is determined by the board, and members must comply with the independence and financial literacy requirements of the SEC, NYSE, and Nasdaq.

The independence of audit committee members is crucial as it ensures unbiased decision-making and oversight. Directors must be free from any conflicts of interest that may arise due to relationships with the company, its subsidiaries, or its management. Section 10A of the Securities Exchange Act of 1934 specifies general criteria for audit committee independence, including restrictions on compensation and affiliations. For example, an audit committee member can receive director fees and meeting fees but must not accept other consulting or advisory fees from the company or be affiliated with the company or any subsidiary.

To maintain director independence, companies should implement policies that identify and address any relationships or circumstances that may impact a director's independence. Directors are often required to complete independence questionnaires annually and disclose any changes that may affect their independence. The board should review these disclosures and assess whether they impair or could be perceived as impairing a director's independence. Additionally, legal counsel may be involved in assessing and maintaining director independence.

The importance of director independence is further emphasised in studies examining audit committee independence and auditor reporting. These studies suggest that audit committees with a larger proportion of independent directors are more likely to act in the best interests of shareholders and support auditors in their dealings with management. This is particularly relevant for financially distressed companies, where a lack of independent directors can lead to conflicts of interest and a decreased likelihood of challenging management's policies.

Financial reporting

Every listed company is required to establish an audit committee as per the provisions of the Companies Act, 2013, and the Listing Regulations stipulated by the respective stock exchanges. This is a mandatory requirement and plays a vital role in ensuring the integrity of a company's financial reporting and compliance with various regulations.

The audit committee is responsible for overseeing the financial reporting process, reviewing the company's financial statements, and ensuring the effectiveness of internal controls and risk management systems. It acts as a liaison between the company's management and its external auditors, providing an additional layer of oversight and expertise in financial matters.

Here's an overview of the key aspects of financial reporting in relation to the audit committee:

The audit committee should establish a robust process for financial reporting, including the preparation and presentation of financial statements. They should review and approve significant accounting policies, changes in accounting estimates, and the application of new accounting standards. The committee ensures that the financial statements are prepared in compliance with generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), depending on the jurisdiction and requirements applicable to the company.

Interaction with External Auditors:

The committee is responsible for appointing, compensating, and overseeing the work of the external auditors. They should assess the qualifications, independence, and performance of the external audit firm annually. The audit committee meets privately with the external auditors to discuss matters relating to financial reporting, audit findings, and any concerns or disagreements between management and the auditors. The external auditors report directly to the audit committee and provide their opinion on the company's financial statements.

Internal Controls and Risk Management:

Ensuring effective internal controls and risk management processes is a key responsibility of the audit committee. They should review and assess the adequacy of internal control systems, including financial controls, operational controls, and compliance controls. The committee evaluates the company's risk management framework, identifies key risks, and ensures that appropriate systems are in place to manage and mitigate those risks. This includes oversight of the internal audit function, if established by the company, which provides independent assessments of the effectiveness of internal controls and risk management processes.

Disclosure and Transparency:

The audit committee plays a crucial role in ensuring transparency and adequate disclosure in financial reporting. They review and approve the company's annual and quarterly financial reports, ensuring that they are accurate, complete, and provide a true and fair view of the company's financial position and performance. The committee also reviews disclosures related to related-party transactions, significant accounting judgments, and estimates to ensure they are appropriately presented and understood by investors and stakeholders.

Whistleblower Mechanisms:

Establishing a mechanism for employees and stakeholders to raise concerns about financial reporting or other misconduct is often within the purview of the audit committee. They should oversee the establishment of whistleblower policies and procedures, ensuring confidentiality and protection for those who report potential issues. The committee addresses reported concerns, investigates them, or directs management to initiate appropriate investigative processes.

By diligently fulfilling these responsibilities, the audit committee contributes to the reliability and credibility of the company's financial reporting, thereby enhancing investor confidence and ensuring compliance with regulatory requirements.

Please note that the specific duties and practices may vary based on regional regulations and the company's governing laws. It is important to refer to the applicable laws and regulations for detailed information.

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Committee composition

The composition of an audit committee is subject to rules and standards set by the relevant stock exchange and securities regulator. For example, in the US, the Securities and Exchange Commission (SEC) and the New York Stock Exchange (NYSE) or Nasdaq set the standards for publicly traded companies. These standards include requirements for committee composition, such as the number of members, their qualifications, and their independence.

Audit committees typically consist of a minimum of three directors, the majority of whom must be independent. For example, the NYSE and Nasdaq require audit committees to have three or more independent directors. Similarly, in India, the Companies Act 2013 states that audit committees should consist of a minimum of three directors, with independent directors forming the majority, including the Chairperson.

The independence of audit committee members is crucial and should be continually maintained, monitored, and reviewed regularly. To ensure independence, members are prohibited from receiving certain types of compensation from the company or its subsidiaries and cannot be affiliated with the company or its subsidiaries. They must also meet heightened standards of independence compared to other board members.

In terms of qualifications, audit committee members should have the knowledge and experience necessary to effectively perform their roles. They should be financially literate and have the ability to read and understand financial statements. Additionally, audit committees should periodically review their composition to confirm that members possess the required expertise.

Some jurisdictions may have specific requirements for the inclusion of financial experts on the audit committee. For instance, the Sarbanes-Oxley Act of 2002 in the US increased the membership requirements, emphasizing the inclusion of independent directors with financial expertise. While the SEC does not mandate the presence of a financial expert, companies are required to disclose whether they have one on their audit committee.

Regulatory compliance

In the United States, publicly traded companies are subject to the rules of the Securities and Exchange Commission (SEC) and the listing standards of exchanges such as the New York Stock Exchange (NYSE) or Nasdaq. These rules encompass committee composition, the charter, and committee evaluations. The Sarbanes-Oxley Act of 2002, for instance, mandates requirements related to the independence of audit committee members, the selection and oversight of independent accountants, and procedures for handling complaints about accounting practices. The NYSE also requires the audit committee charter to cover key areas such as the company's compliance with legal and regulatory requirements and the independent auditor's qualifications.

Similarly, in India, the Companies Act 2013, specifically Section 177, outlines the formation and responsibilities of audit committees. This includes specifying a minimum of three directors, with independent directors forming the majority, and ensuring that the majority of members, including the chairperson, are financially literate.

Audit committees are responsible for overseeing regulatory compliance and risk management activities. They assist boards of directors in fulfilling their governance duties by providing advice and recommendations within their scope of reference. This includes overseeing financial reporting, internal controls, audit functions, ethics, and compliance. Committees also discuss litigation and compliance risks with management and ensure that the company's operations, accounting practices, and regulatory compliance are properly controlled.

To ensure effective regulatory compliance, audit committees may engage objective third parties to assist in the evaluation process. They can also consider additional practices, such as performing post-acquisition reviews to assess the reliability of assumptions and adjust future acquisitions accordingly. By proactively addressing compliance, audit committees help companies maintain legal and regulatory adherence.

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