Key messages

• Audit committees – as the representatives of shareholders – are critical to the integrity and ultimately the quality of the audit. Quality has improved measurably in countries where audit committees have the authority and responsibility to oversee final preparation of the financial statements and the audit, including the appointment of the auditors.
• Providing more and better information to audit committees on a consistent basis will not only make them more effective, but will also help their decision-making around whether the audit firm should be reappointed.
• There should be more transparent reporting by audit committees to give regulators, investors and the market more insight into the audit and the appointment of the auditors.

Governance and transparency of the audit: A critical role for the audit committee

What is the challenge?
The market generally recognises the importance of the clear ‘pass/fail test’ applied by the auditors to a company’s financial statements, but many commentators believe that the audit could add more value and be better governed if there were more transparency between
the audit committee, the auditor and the public.

However, auditors are bound by strict client confidentiality which constrains, often under securities law, their ability to talk to anyone other than the shareholders as a collective, certain regulators and the company itself.

As the directly elected representatives of the shareholders, the non-executive directors comprising the audit committee (or the equivalent body charged with governance) already oversee their company’s financial reporting and the audit. Some do it very well, either reflecting local laws or regulations or simply because it’s good governance. The challenge is to have effective oversight that operates well everywhere, and to have appropriate transparency to prove that this is the case.

Why is this important?
Audit committees around the world have varying roles and responsibilities. It is generally accepted that, and responses to a recent PCAOB Concept Release in the US confirm, audit quality has improved noticeably in countries where audit committees have the authority and responsibility – either through laws or regulations – to oversee the preparation of the company’s financial statements, the conduct of the audit and to appoint the auditors. Having consistent high governance standards around the world would make corporate reporting significantly better.

Audit standards recognise that the information the auditor provides to the audit committee, and the quality of that information, is critical to the effectiveness of the audit committee – and to the quality of the audit. Providing better information to audit committees on a consistent basis will not only make them more effective and safeguard the quality of the audit, but will also help them evaluate whether the audit firm should be reappointed.

Communications by those charged with governance to the public, about the audit, will also enhance the understanding and confidence stakeholders have in the audit opinion.

Where are we now?
What audit committees do, what they report and what auditors tell them varies from client to client and from country to country. In some places voluntary or legal governance and transparency practices have improved the quality of financial reporting. For example, in the US, the Institute of Internal Auditors’ response to a PCAOB Concept Release underlined this, saying: “Audit committee reforms are rapidly improving the quality of publicly available financial information.’’ In the UK the Combined Code reflects the importance of an independent audit committee as the guardian of the shareholders interests.

In some countries much has been done to reinforce the importance of the role of the audit committee and its responsibilities including the need for it to be independent of management, have access to the right expertise and actively monitor and manage the external auditor and its work including any other services the auditor might provide. We have certainly seen audit committees increasingly involved in making careful decisions about the services their audit firm provides.

In addition, international auditing standards, local standards and auditors’ own internal policies, set out in detail the information that the auditors should provide to the audit committee. This includes the planning and scope of the audit, material judgments, accounting estimates and disclosures, significant issues discussed and communications with management (including disagreements), the company’s critical accounting policies and practices and the auditor’s independence.

Finally, in some countries audit committees – either because they have to or they choose to – publish their own report covering the annual financial statements, communications from auditors, independence, their charter and their approval of the audited
financial statements.

What does PwC propose?
We support changes that would improve audit quality and financial reporting. Strengthening the role of the audit committee and its relationship with and oversight of the auditor has already made audit quality and financial reporting noticeably better. This approach should be adopted around the world, where necessary enforced through regulation and a single set of standards that cover:

1. How the audit committee oversees the company’s financial reporting, the auditors and the audit.
We are convinced that audit committees with the right expertise and qualifications – and the right level of responsibility and oversight – can appropriately represent the interests of shareholders and investors. They’ll also contribute to the continuous improvement of financial reporting and audit quality.

2. Communications between the auditor and the audit committee.
We believe, and academic research has shown, that open and forthright dialogue between the audit committee and the auditor has gone a long way to improving audit quality. Research suggests that when well-informed, financially sophisticated audit committees, auditors – and in some cases the full board – communicate often, financial reporting quality improves¹. The information they already have to share could be expanded to include other matters that affect audit quality and would help the audit committee do its job.

3. Communications from the company or the audit committee to the public.
We believe that more information about audit quality should be available to investors, particularly if it gives them and regulators more insight into how audit committees oversee corporate reporting. Through its reporting the audit committee can highlight the key matters discussed with the auditor and how they have been resolved – the UK is but one example where this principle has been adopted in recent years.

In summary
To give people more confidence in the corporate governance and transparency of audits, more could be done to take proven good practices and apply them globally. Audit committees matter because they can and do contribute significantly to effective financial reporting and the performance of the audit. We now need to build on some effective existing frameworks  to make the process universal and even better.

PricewaterhouseCoopers
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¹ Auditor Communications with the Audit Committee and Board of Directors: Policy Recommendations and Opportunities for Future Research, Accounting Horizons, June 2007.