By providing independent oversight and monitoring of the financial reporting process, audit committees can help to identify and mitigate potential areas of risk, prevent financial irregularities or misconduct and decrease the likelihood of corporate failures.
As established in the article by Carla Budricks titled ‘Comprehensive regulation of the financial reporting ecosystem’ in the June issue of Accountancy SA, there are various role-players within the financial reporting ecosystem. Included are the preparers of financial reports, those charged with governance (with specific focus on the audit committee) and assurance providers.
A significant concern of these parties is ensuring the integrity of the financial reporting process and thus, the reliability of the information presented to users of those statements, which in some cases includes the general public. Financial reporting is a means by which stakeholders are accounted to by those charged with managing the (financial and other) affairs of a company; that is, management. Management is overseen by the board of directors, which is typically composed both of executive (members of management) and non-executive directors. Included in the responsibilities of those charged with governance is oversight of financial controls, financial reporting, and assurance. Where an organisation has an audit committee, this particular responsibility is often-times delegated to such committee, the role and responsibilities of which are the focus of this article. However, before we get to that, we consider which organisations should have an audit committee.
The Companies Act 2008 stipulates that all public and state-owned companies must have an audit committee. Further to the Companies Act requirement, the Public Finance Management Act 1999 (PFMA) also requires for all public entities to have an audit committee. There are also statutory requirements as a result of industry (such as banking) or being listed (JSE LR). Outside of legislative requirements, the King IV Report on Corporate Governance (King IV) recommends that all entities, whether in the private, public or non-profit sectors, that prepare financial statements for a broad audience1 should have an audit committee. This recommendation is based on the understanding that financial reporting and risk management are important in all types of organisations, regardless of their structure or purpose. And that by having an audit committee, organisations can improve transparency and accountability, which can help to build trust with stakeholders and investors.
However, this is not a practical recommendation for all entities, especially when we consider small private-owned entities that may have small boards or even just one director (or member of the governing body). Therefore, this recommendation does have to be considered within the context of the entity. The Companies Act has taken this approach by mandating audit committees for entities that seemingly have a high level of public interest.
DUTIES AND MEMBERS
What are the duties of the audit committee, and who should be a member? In answering this question, we focus on public interest entities, which are typically the ones in which a corporate failure can have the most severe (and even catastrophic) effects on a greater populace. With such entities, the duties of an audit committee typically stem from statutory requirements, namely the Companies Act, and for state-owned companies also the PFMA. For companies listed on the JSE, there is a further requirement to apply King IV as per JSE listings requirements. From the study of these three documents, the duties of audit committees can be summarised to include oversight of the financial reporting process (including the audit process) and risk management and monitor internal control and compliance.
With the ever (and rapidly) changing regulatory, compliance and technological/IT environments, not only is it more important for audit committees to perform their duties with the necessary due care and diligence, but it is become more challenging. The technological landscape, in particular, is resulting in an ever-growing need for audit committees to move beyond keeping abreast of the latest development in the spheres of risk, financial reporting and compliance, but also in the realm of IT and cybersecurity. There are currently no prescribed minimum qualification requirements for audit committee members in the PFMA, Companies Act or King IV; however, the Companies Act states ‘relevant financial and other expertise’. One can appreciate that the lack of prescription of what these ‘other expertise’ are allows each entity the discretion to determine the skills, knowledge and expertise it requires to discharge audit committee duties effectively. However, the lack of prescription could also result in members with certain necessary skills missing from audit committees. And ultimately, this can compromise the ability of the audit committee to fully execute its duties.
This is not to advocate for yet another ‘add-on’ interim regulatory requirement on specific qualifications for audit committee composition, but rather that boards take a closer look at how global developments in areas affecting audit committees require a shift from focusing on financial skills required on an audit committee to also focusing on, and being specific about, ‘other’ skills.
CORPORATE FAILURES AND OTHER CHALLENGES FACED BY AUDIT COMMITTEES
Ensuring integrity of financial reporting, and therefore reliability of the process and the environment related thereto, also aids in decreasing the risk of corporate failures, or at least the ‘surprise’ ones. Through ensuring that effective financial management and reporting, internal controls, and risk management processes are in place, those charged with governance, and more specifically the audit committee, can play a significant role in avoiding corporate failures. However, various challenges are faced by audit committees in effectively discharging their duties. Although some organisations have been successful in placing appropriate safeguards in place to overcome these challenges, some are still struggling. Hence, we still do have instances where even with establishment of an audit committee, some organisations are unable to produce reliable and trustworthy financial reports with which to account to their stakeholders. Some challenges faced by governance bodies and audit committees include the following:
- A changing and more complex regulatory environment
- Keeping abreast of the latest developments in financial reporting, internal control and IT landscapes
- Balancing the independence of members with sufficient knowledge of a company’s processes and operations
- The sophistication of fraud perpetration
These challenges are not insurmountable; however, they require boards and their audit committee members to be alive and responsive to changing environments. This requires a proactiveness in monitoring trends and areas where they may need additional knowledge that can either be provided to existing members or require additional members with different expertise.
Ultimately, what is key is for those charged with governance to be aware that their role is not limited to only evaluating what they have been provided with by management, but to also equip themselves with adequate knowledge and information to be able to obtain what they require from management to fully discharge their duties.
Ultimately, the involvement of audit committees within the financial reporting ecosystem can help to ensure that companies operate in a financially sound and ethical manner, which benefits all stakeholders, including shareholders, employees and broader society.
1 Author’s addition.
2 As per King IV.
3 C Budricks 2023, Accountancy SA, June 2023.
4 KE Okpala 2012, Audit committee and integrity of financial statements: a preventive mechanism for corporate failure, Australian Journal of Business and Management Research, 2(8):32-40.
Tumeka Matshoba-Ramuedzisi CA(SA), RA, PhD is a senior researcher at the Albert Luthuli Leadership Institute at the University of Pretoria and runs an audit firm based in Johannesburg