Magazine article Ivey Business Journal Online

Commentary: The Strange World of Audit Committees

Magazine article Ivey Business Journal Online

Commentary: The Strange World of Audit Committees

Article excerpt

Audit committees are a strange invention. They are supposed to provide the independence that their master-the full board-does not provide, but their accountability is often unclear. So, how did this peculiar state of affairs come to be? And what are the chances of real change?

The search for independent oversight

Recent corporate scandals have highlighted the glaring lack of independent oversight at the board level, and as the search for an appropriate governance mechanism intensifies, the audit committee is taking centre stage. According to current wisdom, it is easier to make the audit committee independent than it is the board of directors.

When we speak of "independence" in the context of corporate governance, we usually mean "independent from management." The theory is that such independence is necessary because the interests of management and owners are not always the same; left to its own devices, management could further its own interests at the expense of shareholders. "Agency theory," which speaks to the gap between principal and agent, tells us that the bigger the gap between the owners of a company and its agents, the bigger the owners' need for independent monitoring and the greater the attendant costs.

This article explores the appropriateness and effectiveness of the audit committee as a source of unbiased information. It is my belief that an independent audit committee is not a panacea for what is wrong with corporate governance. Audit committees, too, are ultimately compromised because they are part of a complex web of dysfunction. In fact, focusing on individual mechanisms of financial oversight, like the audit committee, misses the crucial point that it is the entire system of corporate governance that is in need of a major overhaul.

The increasing importance of the audit committee

Evidence that the audit committee is becoming a touchstone for good governance is all around us. In Canada, Ontario Securities Commission chairman David Brown has said that the establishment of rules for audit committees is his first priority for board reform; the province's finance minister, Janet Ecker, has introduced a bill that will grant the OSC this power. According to a recent article in The Globe and Mail, Ontario is likely to introduce detailed new rules that will require audit committees to accept complete charge of the audit by taking full responsibility for hiring auditors, determining the scope of their work and supervising the process. In the United States, events are moving in a similar direction. Last year, the New York Stock Exchange proposed new listing rules requiring audit committees have greater authority and that both the audit committees and nomination and compensation committees be fully independent.

The seeming or desired independence of audit committees is not the only reason they are receiving so much attention. Audit committees also save the full board time and effort because the smaller groups can be constituted more easily. In addition, the audit committee brings a degree of financial expertise to the table that not all boards members may have. The Toronto Stock Exchange's Corporate Governance Guidelines, for example, require that all audit committee members be "financially literate." However, this requirement does not extend to the entire board.

Auditors and audit committees

Auditors are now more likely to be accountable to audit committees. The preamble of a 2001 SEC Final Rule says, "Among other things, an audit committee serves as the board's principal interface with the company's auditors..." And from The Globe and Mail last November: "The new Sarbanes-Oxley legislation in the United States requires disclosure of key issues to audit committees. For example, auditors must inform audit committees of any debates they have with management about alternative accounting methods that could be used. And auditors must give audit committees all correspondence with management. …

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