Best Practices for Internal Audit Committees – Six Basic Steps
Sept. 24, 2009
Author: Carlos Mendez. Permanent attendee and regular collaborator of IMEF’s National Technical Committee on Financial Information
The new Stock Market Act that came into force mid-way through 2006 includes a number of important changes that address how publicly-traded companies are run and managed. The goal of this new legislation was to make the stock market more attractive for investors by creating a setting of confidence and increasing oversight of the disclosures available to the public investor, and by establishing rights for minority investors and a clear set of rules for good corporate governance. Other objectives included redefining the duties and responsibilities of boards of directors, and defining committee misconduct and the appropriate sanctions.
One of the most important innovations in the new law is the addition of Best Practices for Corporate Governance, which are aimed at raising the level of transparency in how public corporations are run. This change was meant to bring Mexico’s corporate practices up to speed with those of other countries, and to increase overall investor confidence.
Minority shareholders need to know that the information they receive on the companies they invest in is reliable. They also want to know that they have rights to defend their interests against those of their majority counterparts.
Regarding the realignment of the duties and obligations of boards of directors, companies will be required to amend their by-laws so as to address i) the company’s overall business strategy, ii) oversight of the company’s management and the performance of its directors, iii) approval of substantial transactions and those with related parties, iv) having audit and business practice weigh in on officer appointments and executive compensation and v) enforcing the execution of resolutions adopted by the shareholders.
Now more than ever, capital markets tend to punish uncertainty in corporate performance. Unpleasant surprises caused by inaccurate financial statements, ethics scandals and unforeseen or mismanaged risks can damage corporate image and by extension, the value of a company’s shares.
This is why audit committees must move past simple compliance with their obligations, and find news ways to enhance corporate governance.
When they work effectively, audit committees play an important role in reducing the chance for uncertainty and the resulting impact on a corporation’s financial information.
Companies wishing to make their information more transparent by leveraging the structure and performance of their audit committees enjoy a number of advantages. Market communication should focus on how the company monitors the integrity of financial reporting, how it maintains strict supervision over risk management and internal control processes, and what steps it takes to ensure satisfactory performance of the company’s independent and internal auditors. All of this leaves companies in a better position to guarantee the effectiveness of their committees.
EFFECTIVENESS
An effective committee must have a solid structure and run efficiently. Committee members must ask themselves how the committee may be even more effective so as to strengthen its supervision over the most important aspects of the company’s business and to ensure that it obtains accurate information and maintains an adequate level of communication.
However, when a company has neither strong leadership nor a culture of challenge and commitment, its audit committee will not likely run effectively.
Based on examples of best practices of many companies around the world, we have found that there are six critical areas that must be addressed to improve the performance, leadership and dynamics of an audit committee. They are as follows:
- Control risks. One of the best practices for audit committees is to plan the performance of their supervisory and oversight duties throughout the year by keeping their calendars up to date while reflecting the progress of their work.
- Understand the business. Leaving the boardroom and getting personally involved in the company in order to understand the ins and outs of the business is one of the best practices and has already been adopted by the most effective audit committees.
- Keep reports objectively focused. The analyses and opinions of CEOs and CFOs regarding their companies’ financial information tend to suffer from a certain degree of subjectivity due to the close involvement of these executives in preparing the financial information. This is precisely why the audit committee’s role in overseeing reporting is so important, since it adds a more objective and independent focus to the decision-making of CEOs and CFOs.
Creating an Information Disclosure committee (as required by the Sarbanes-Oxley Act for companies registered with the Securities and Exchange Commission) made up of top executives and those in charge of the entity’s risk, internal audit, legal and regulatory areas, allows for a more objective evaluation of all information included in the entity’s financial reports, since this committee addresses all the aspects of the preparation of the information.
- Improve the head office. Recent corporate failures have once again shed light on the effect of management breakdowns. Audit committees play a key role in reestablishing investor trust, since their work as supervisors is aimed at preventing precisely the type of corporate disasters we have seen over the past ten years.
- Share and maintain effectiveness. It is not easy to stay on top of all market happenings. Audit committees can be effective only when they have enough background knowledge to evaluate the information on which they base their decisions.
A good practice for ensuring that committee members have solid knowledge of the company’s business is to allow the managers of each business unit to attend meetings so that they may provide information about the most important strategies, operations and risks of their units and in this way, make management aware that this additional data could affect their computations and accounting criteria.
- Disclose key aspects. An evaluation of the effectiveness of the audit committee is already a basic requirement in many parts of the world. However, few companies divulge the results of this evaluation or the improvements implemented as a result of it.
Any self-evaluation for audit committee members should include the following aspects:
- Independence
- Integrity
- Knowledge and specialization
- Participation and feedback
- Preparation
- Approach and teamwork
Once the evaluation is complete, we recommend that the audit committee president meet with each member to discuss possible areas of opportunity.
Communicating to the market the requirements for the audit committee and the overall result of its performance evaluation allows companies to reflect on the effectiveness of the committee in terms of real performance and future opportunities for improvement.
TIME TO ACT
These suggestions could be of great help for any company wishing to increase the effectiveness of its audit committee and reduce the level and impact of uncertainty in its business and financial reporting.
Those corporations that really strive to maintain and share the effectiveness of their audit committees and to communicate their efforts to the markets are uniquely positioned to move beyond simple compliance evaluations and to set themselves apart from their peers. This will undoubtedly lead to an important competitive advantage for these companies.
It goes without saying that by improving their reputations through reliable and effective corporate governance, these same companies will be able to attract the best candidates for their audit committees.
Author: Carlos Mendez. Permanent attendee and regular collaborator of IMEF’s National Technical Committee on Financial Information. This article does not represent FEI or IMEF opinion unless specifically noted above.