Audit, Compliance and Risk Blog

Boards of directors are responsible for governing their corporations. Many boards divide their work among committees that are assigned specific tasks. Standard committees include an “audit committee,” with responsibilities that may include:

• Usually – overseeing financial reporting, internal controls, business risks, and internal and external audit processes.

• Sometimes – monitoring compliance with laws and regulations, the company’s code of ethical conduct, and dealings between the company and its Chief Executive Officer (CEO) and other officers and directors.

The US Securities and Exchange Commission (SEC) and national securities exchanges impose minimum responsibilities and specific selection criteria for public company audit committees, including requirements for individual members, and responsibilities and performance standards for committees overall. In the decade since the Sarbanes-Oxley Act of 2002 (SOA) set the structure for these requirements, similar approaches have spread to many non-public corporations, and to limited partnerships and other enterprises.

What Standards Must Public Company Audit Committees Meet?

SOA introduced the following definition:

The term ‘audit committee’ means–
(A) A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer.
(B) If no such committee exists with respect to an issuer, the entire board of directors of the issuer.

SOA also set standards for audit committees. As reflected in SEC rules and exchange listing standards, these include the following:

• Responsibility for auditors and audits. The audit committee must be directly responsible for the appointment, compensation, and oversight of the public accounting firm employed to prepare or issue an audit report or to perform related work. The registered public accounting firm must report directly to the audit committee. Specific responsibilities with respect to selection and oversight of audits and the preparation of SEC-required financial reports include to:

• Ensure that these tasks are performed only by public accounting firms registered with the Public Company Auditing Oversight Board (PCAOB), and in compliance with auditor independence requirements. 

• Preapprove all audit and non-audit services to be performed for the company by a registered public accounting firm (de minimis exceptions are available). 

• Receive reports from auditors who identify “illegal acts” with “material effects,” and respond appropriately. The committee must notify SEC and provide a copy of the report, within one business day. 

• Receive reports from company management about any fraud or significant deficiencies in the company’s accounting or financial controls.

• Receive reports from the auditors addressing; all critical accounting policies and practices to be used all alternative treatments of financial information within Generally Accepted Accounting Principles (GAAP) that have been discussed with management, the implications of each use of such alternatives, and the auditor’s recommendation; and other “material” correspondence between the auditor and management, such as any management letter or schedule of unadjusted differences.

• Receive reports from legal counsel (corporate counsel or outside counsel), of any “material violation of securities law or breach of fiduciary duty or similar violation.” The audit committee may serve as the initial recipient for such reports, if the board has designated it to function as the company’s “qualified legal compliance committee (QLCC)” for SEC compliance purposes; otherwise, the audit committee is to be informed by the company’s chief legal officer or QLCC after investigation of such reports, or to receive follow-up reports from the attorney making the initial report of violations if no investigation is made.

• Independence of audit committee members. Every audit committee member must be an “independent” member of the board of directors, meaning the member must not:

• Accept consulting, advisory, or other compensatory fees from the issuer (except that due as a board member).

• Be an affiliated person of the issuer or any subsidiary.

• Complaint procedures. The audit committee must follow procedures to receive, retain and respond to complaints about accounting, internal accounting controls, and auditing matters, including confidential and anonymous submissions by company employees.

• Authority to seek independent advice. The audit committee must have authority to engage independent counsel and other advisors, as it finds necessary.

• Funding. The issuer must provide the audit committee adequate funding to cover services of the registered public accounting firm and any independent advisors.

In addition, each audit committee should include at least one “audit committee financial expert.” Each annual report must disclose whether the company complies with this guideline. SEC regulations define an “audit committee financial expert” as someone with the following:

• Understanding of GAAP and financial statements.

• Experience applying GAAP in connection with the accounting for estimates, accruals, and reserves.

• Experience preparing auditing of financial statements of generally comparable issuers. 

• Experience with internal accounting controls.

• Understanding of audit committee functions.

If a company has no financial experts on its audit committee, it must disclose and explain that shortfall. SEC’s regulations also provide that designation as an audit committee financial expert does not add to that person’s standard of care or presumption of expertise for purposes of evaluating his or her potential liabilities.

Self-Assessment Checklist

Does my company’s board of directors have an audit committee?

• If so, how is it constituted?

How many board members serve on the audit committee? 

Are all audit committee members “independent” of the company and its management?
If not, how many are independent? 

Are all audit committee members “financial experts”?

• If not, how many are financial experts? 

• If so, is the audit committee responsible for overseeing auditors?

Are auditors hired, managed, and compensated directly by the audit committee?

Are auditors instructed to report all pertinent information, including those routine to the audit and preparation of audit reports, as well as any apparent accounting irregularities and/or securities law compliance violations, to the audit committee directly?

Does the audit committee require that public company accounting firms be registered with PCAOB?

Is the audit committee adequately funded?

Is the audit committee funded to hire, manage and pay auditors?

Is the audit committee authorized and funded to hire, manage and pay outside consultants and attorneys if it considers them necessary?

• PCAOB “Information for Audit Committees” webpage 

• SEC website (no separate webpage, but searchable for many documents) 

• Association of Audit Committee Members (membership nonprofit)

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