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Chapter 10 - Audit Committee
Listed companies should be required by law to establish an audit
committee
10.1
An amendment moved in the Senate during debate
on the Company Law Review Bill 1997 concerned the requirement that listed
companies must establish an audit committee.[1]
10.2
The amendment reads as follows:
Audit committees
- The Directors of a listed company must establish
and maintain an audit committee with functions that include:
- assisting the directors of the company to ensure
that financial reports comply with the requirements of this Law; and
- assisting the directors of the company to ensure
that the company at all times has a proper system of management and financial
controls; and
- providing a forum for communication between the
directors, the senior managers of the company and auditors of the company.
- A majority of the members must be persons who
are not executive officers of the company.
- An audit committee must be established and
maintained on such a basis that a meeting cannot be held unless there are at
least 2 members who are not executive officers of the company.
- The chair of an audit committee must be a member
who is not the chair of the board of directors of the company.
10.3
Few submissions to the PJSC supported a
requirement in the Corporations Law for listed companies to establish an audit
committee.
Arguments in favour of a statutory requirement for listed companies to
establish an audit committee
The consequences of inadequate
audit systems
10.4
The PJSC was told that it was preferable for
listed companies to determine their own arrangements regarding auditing. On
balance, however, the deficiencies with auditing were such that a compulsory
audit committee should be considered. Such a committee should consist of
independent, non-executive directors with sole power to appoint the auditor and
with sole responsibility for the auditor and audit:
On the other hand, with the failure of many public companies
toward the end of the eighties and the beginning of the nineties, billions of
dollars have been lost by investors and creditors. Many of these losses were
caused to some degree by inadequate audit and judgments have been given. Many
are alleged to have been caused by inadequate audit, and litigation is still
continuing. The mistakes by auditors in court judgments, or Royal Commission
Reports are egregious, and could not have happened except for overweening
influence exercised on the auditor by management. That is, the auditor did what
he was told, otherwise he would lose his appointment.[2]
Improving company efficiency
10.5
The PJSC was told that the establishment of an
audit committee comprising non-executive directors would increase public
confidence in the company. It would ensure that the company was operating
within the appropriate legal framework and that adequate controls were in place
to prevent fraud, embezzlement and other criminal conduct. An audit committee
would also give advice on improvements in company efficiency. While some costs
would be incurred the benefits gained from an effective audit committee will
exceed the costs.[3]
Composition of audit committees
10.6
Arthur Anderson submitted that all listed
companies should be required to establish an audit committee but its
effectiveness depended on the presence of a significant number of independent,
non-executive directors with relevant financial expertise. Arthur Anderson
noted that the auditor should be able to communicate with the main board
irrespective of the presence of an audit committee.[4]
No exceptions to requirement
10.7
The Accounting Bodies submitted that the requirement
should apply to all listed companies irrespective of the size of the company.
Where it is impracticable for a company to establish an audit committee, the
duties of an audit committee should be undertaken by the entire board:
In terms of audit committees, the accounting bodies support the
concept that listed companies should be required to establish audit committees
and that this should be best practice for other forms of disclosing entities.
This would also bring Australia into line with the requirements in major
overseas jurisdictions in capital markets where mandatory audit committees are
a requirement. In situations for perhaps the smaller listed companies which may
run the argument that it may be impractical or inappropriate to establish a
separate audit committee, we believe that the board, as a whole, could really
undertake the functions that an audit committee would ordinarily perform.[5]
Arguments against a statutory requirement for listed companies to establish
an audit committee
Requirement not appropriate given
the diversity of companies
10.8
The Australian Law Reform Commission (ALRC)
noted that a statutory requirement for all listed companies to establish an
audit committee would be costly and unnecessary for some companies. The
appropriateness of an audit committee for a listed company depended on the
company’s size, structure, diversity and area of operation. For some companies,
it would be redundant or of very limited value. The ALRC preferred the
alternative of requiring listed companies which choose not to have an audit
committee to report that fact and to describe the internal audit and
accountability processes that render an audit committee unnecessary.[6]
10.9
The Australian Stock Exchange (ASX) opposed the
requirement for an audit committee. Given the amendment provides for the
appointment of at least two non-executive directors, the ASX advised that this
would impose a substantial cost burden on the majority of small to medium sized
listed companies.[7]
The ASX argued that emphasis should be placed on greater disclosure rather than
the prescription of specific governance structures, which took no account of
the differing circumstances of listed companies.[8]
10.10
The Association of Mining and Exploration
Companies Inc (AMEC) also opposed a statutory requirement on the grounds that
it was contrary to the corporate law simplification process. Further, AMEC
pointed out that in small companies audit matters are addressed by the board.
On the other hand, many larger companies have voluntarily established audit committees.[9]
Present arrangements are adequate
10.11
The Accounting Association of Australia and New
Zealand (AAANZ) did not support a requirement that listed companies establish
an audit committee, preferring measures to ensure the independence of the
auditor:
It is unclear, however, whether the requirement is necessary.
The current Australian Stock Exchange disclosure requirements, which require
reporting entities to disclose specific details concerning their audit
committee, or disclose the reasons why an audit committee has not be formed,
appears to work well in practice.[10]
10.12
The Australian Listed Companies Association Inc
advised that PJSC that the top 200 companies already have an audit committee.
Many of the other thousand or so other listed companies often have only 3 to 4
directors who act as the audit committee.[11]
Similarly, the Group of 100 Inc did not believe there are compelling reasons to
mandate existing arrangements without proper due process.[12]
10.13
The Law Society of Western Australia noted that
the present arrangements are flexible and take account of the diversity of
listed companies:
There is always a difficulty in trying to find a
one-size-fits-all solution for companies that range from junior Western
Australian explorers to the BHPs, Tesltras and so on. A general statement
requiring fairness and equality of opportunity and then leaving the company to
work out a system within that is probably the best solution, until it is proven
that that does not work. One then needs to get more prescriptive.[13]
Diminution of board
responsibilities
10.14
The Law Society of Western Australia cautioned
that the introduction of a statutory requirement for an audit committee would
inevitably lead to the diminution of the main board’s responsibilities in
reviewing the effectiveness of internal controls. The audit committee functions
would therefore need to be carefully defined:
Mr Young-I have come to the view that it is inevitable
that the audit committee takes a wider role. I suppose it therefore follows
that if the audit committee is mandated then, to a degree, the role is mandated
and that could be a wider role than merely technical. You would have to be
careful in deciding how wide that role is, otherwise I think you have some
potential for taking from the board what is the board’s responsibility
generally within the myriad of control mechanisms that exist.
The audit committee is always a committee of the board. It only
recommends to the board; it investigates on behalf of the board; it gets its
hands dirty, if you like, for the board-so the board knows that somebody has
done it. It is not in any way superior to the board; it is a creature of the
board. The design criteria would have to be very carefully worked out.[14]
ASX Indicative List of Corporate
Governance Matters
10.15
As noted in Chapter 9 of this Report, the
Appendix 4A of the ASX’s Listing Rules provides an indicative list of corporate
governance matters when companies prepare a statement for the purposes of
Listing Rule 4.10.3. The seventh item on the ASX’s Indicative List of Corporate
Governance Matters requests disclosure of the main procedures that a
company has in place for the nomination of external auditors and for reviewing
the adequacy of existing external audit arrangements, with particular emphasis
on the scope and quality of the audit.
If any of these procedures involves an audit committee, a
summary of the committee’s main responsibilities and rights, and the names of
committee members. If one or more members are not directors of the company,
their positions in the company.
10.16
The accompanying ASX Guidance Note further
provides that:
It is considered best practice for a company with an audit
committee to state its policy regarding the committee’s composition.
Furthermore, there is considerable support in guides to best practice for the
proposition that audit committees should be comprised of a majority of
non-executive directors (preferably independent directors), including an
independent chair (who is preferably not chairman of the board). Where
executives participate in audit committee discussions, it is normally
considered appropriate that, at a minimum, non-executive directors on the
committee should have an opportunity to discuss matters with the auditors in
the absence of members of management.[15]
10.17
ASX Listing Rule 4.10.2 requires companies
without audit committees to disclose the reasons for not having such a
committee. According to the ASX, a common explanation by smaller companies is
that a separate audit committee cannot be justified on the basis of a
cost-benefit analysis. In some cases smaller companies have advised the ASX
that certain practices are considered inappropriate for that company.[16] This conclusion was supported
by a survey of large, medium and small West Australian listed companies
undertaken in 1995 which was presented to the PJSC for its consideration.[17] Of the 16 companies surveyed,
10 were small companies with a market capitalisation of less than $250 million
and a workforce of less than 1,000.[18]
10.18
The survey found that the size of each company’s
board had considerable influence on the composition of the audit committees and
consequently the number of directors available for selection. For the large
companies there was awareness of a need to only use non-executive directors on
the audit committee. A typical audit committee comprised 4 non-executive
directors (2 with an accounting background) and by invitation, the external
auditor, company secretary, chief accountant and executive finance director or
managing director.[19]
On the other hand, for the small listed companies all audit committees were
either made up of either solely non-executive directors or the board as a whole
fulfilled this role. The committee memberships were as follows (E = executive
director; N = non-executive director):[20]
Board 1E/2N - Audit Committee 2N
Board 1E/3N - Audit Committee 2N
Board 1E/3N - Audit Committee 2N
Board 1E/3N - Audit Committee 3N
Board 1E/3N - Audit Committee All directors
Board 2E/2N - Audit Committee 2N
Board 2E/2N - Audit Committee All directors
Board 2E/3N - Audit Committee 2N
Board 2E/3N - Audit Committee All directors
Board 1E/6N - Audit Committee 2N
10.19
The problem for small companies was the size of
their boards which did not consist of enough non-executive directors with an
adequate experience range to properly staff an audit committee. Small companies
considered their best interests lay in appointing directors from their field of
business, not in satisfying a regulatory perception. The survey concluded that:
It was a strongly held view by small companies that this
committee was not appropriate for their size of company. The only function of
their audit committees was to act as a reviewer of financial statements. There
was no capacity to properly assess the scope or quality of the audit. There was
great reliance upon the auditor for complete advice in this field.[21]
Low levels of disclosure
10.20
An article authored by Ms Tracie Arkley-Smith, a
Lecturer at the School of Accounting, Charles Sturt University, was also
submitted for the PJSC’s consideration.[22]
The article reported a study by the same author of audit committee disclosures
in the annual reports of 310 listed companies for the 1996 financial year.
10.21
The functions of an audit committee most
frequently disclosed in the annual reports were an overview of the financial
reporting process (38%), monitoring the activities of the external auditor
(32%) and reviewing the effectiveness of the control environment (24%). The two
functions, which were least frequently disclosed, were the frequency of
meetings with the external auditor (1%) and recommendations on appointment and
remuneration of the external auditor (1%). The study found that larger listed
companies disclosed more information than smaller companies.[23] The conclusion reached in the
article was that the low level of disclosure of information on audit committees
might lead to a loss of confidence in audit committees as a monitoring
mechanism. The study did not recommend a statutory requirement for audit
committees but the legal enforcement of disclosure of information on audit
committees for large companies.
10.22
The results of the study are shown below:[24]
Audit Committee
disclosures
|
| Disclosure |
per cent of companies
disclosing
|
|
| Number of non-executive directors |
54.35 |
| Terms of reference of committee |
42.26 |
| Duties include overview of financial report process |
38.06 |
| Duties include monitoring the external auditor |
31.61 |
| Duties included reviewing the effectiveness of control |
|
| Environment |
23.87 |
| Duties include monitoring the internal auditor |
16.77 |
| Frequency of meeting with external auditor |
00.84 |
Duties include recommending appointment and
remuneration of external
auditor |
00.68 |
Conclusions
10.23
The PJSC was told that the size and complexity
of the listed company should determine whether a separately constituted audit
committee was required. A large number of listed companies at present have an
audit committee that has been delegated authority to review the audit process,
both internal and external. The terms of reference for the audit committee
encompass the review of half yearly and annual financial statements, the scope
of the internal and external audit, setting of audit fees, and review of
directors’ questionnaires to management. However, as witnesses told the PJSC,
for most small to medium sized companies the requirement would be costly,
impracticable and redundant. With only three or four directors acting as the
board smaller listed companies would not be able to meet the requirement for an
audit committee to have at least two non-executive directors and an independent
chair. In the view of the PJSC the imposition of a mandatory audit committee
for all listed companies is not justified.
10.24
The PJSC believes that it is essential that an
audit plan is adequate to the company’s circumstances and that the independence
of the auditor should be encouraged. Communication between the auditor, the
non-executive directors and the main board is also important. In the absence of
an audit committee, a board would need to have other mechanisms in place to
reassure shareholders and potential investors of the quality of the audit and
the adequacy of the company’s financial statements. The purpose of disclosing
information on audit committees, or where the board as a whole undertakes this
role, is to ensure that audit committees are, and are seen to be, operating
independently and effectively.
10.25
The requirement for listed companies to
establish an audit committee is addressed in the ASX Listing Rules. In the view
of the PJSC, ASX Listing Rules 4.10.2 and 4.10.3 and the Guidance Note deal
more than adequately with the functions and composition of an audit committee
and, in terms of best practice, provide the same level of monitoring and
accountability as sought under the proposed amendments. In fact the ASX
Guidance Note goes much further. It requests companies to state their policy
regarding the composition of the audit committee. However, the PJSC was not
persuaded that the Law should regulate the disclosure of information on audit
committees in annual reports. The diversity, size and circumstances of listed
companies makes this proposal impracticable. Any low level of disclosure in
annual reports is a matter that should be addressed in the first instance by
the ASX and its contracting parties.
Recommendation
10.26
The PJSC recommends that the Corporations Law
should not require listed companies to establish an audit committee.
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