COMMITTEES : Far From Acceptable – When audit committees don’t stack up

An independent audit committee plays critical role in assuring stakeholders that the information they rely on for informed decision making is of sufficient quality. And while external independent auditors attest to the financial reports, these auditors have themselves come under fire following string of corporate scandals in the United States, Australia, Europe and Asia. No surprises, then, that corporate regulators have moved swiftly in the United States, United Kingdom and Australia to restore the confidence of the capital market.
Corporate governance regulations in these jurisdictions require that audit committees of listed companies comprise only independent directors, thus locking in independent oversight of financial reports prepared by management. Audit committees are also charged with overseeing the assurance process. These activities include ensuring the scope and quality of the audit is of adequate standard – and that the external auditor is independent – and acting as mediator during auditor and management discussions.
Such responsibilities are explicitly spelt out in the corporate governance regulations and guidelines in the United States, United Kingdom and Australia.
New Zealand, however, differs with respect to the composition and structure of the audit committee and its responsibilities in four key ways. First, in this country while the formation of audit committees is recommended practice, it is not legal requirement. Second, the composition and structure of the audit committee are not mandated. When our companies do establish an audit committee they have the discretion to structure it according to their needs and capabilities.
Third, guidelines on the activities and processes for which the audit committee is responsible are quite narrow. Finally, there is scarce mention of the nature and frequency of audit committee meetings.
The primary argument for not mandating or specifying minimum requirements is cost. Corporate management argues the dollars involved in implementing requirements similar to those in other jurisdictions do not justify the derived benefits in small market such as New Zealand. In addition, corporate management argues the magnitude of financial misstatements in New Zealand does not warrant implementing costly mechanisms. The benefits to be derived are difficult to quantify. further defence is that the pool of appropriately qualified independent directors is small in New Zealand.
Yet recent research from Auckland University of Technology’s Centre for Corporate Governance shows the current New Zealand position is far from desirable. Dr Vineeta Sharma, research student Chun Li Kuang and I have completed comprehensive study of corporate governance practices in this country based on analysis of New Zealand owned and NZX listed companies in 2004 and 2005.
We selected this time period because the NZX disclosures on corporate governance were effective since the 2004 financial year-end. Although there are more than 200 listed companies, we were able to review the annual reports for just 150 (72 for 2004 and 78 for 2005) due to the poor level of corporate governance disclosures relating to the board generally and to audit committees in particular.
Many companies failed to disclose whether they had an audit committee or reveal information regarding the directors’ status (executive, non-executive or independent). This flies in the face of strong recommendations from the SEC on disclosure of the charter and information on the composition and work of committees to assist stakeholders assess the effectiveness of board committees.
In many cases, it is impossible to tell whether an audit committee exists and to assess the composition of the board and its sub-committees. If an audit committee does not exist, companies ought to disclose the alternative mechanism that assumes the roles and responsibilities of the audit committee. Typically, this is the board of directors. Failure to disclose such information leaves the stakeholder in state of uncertainty and raises doubts about the companies’ corporate governance. It also questions the regulatory monitoring of listing rule requirements.
The audit committees we reviewed had anything from two to seven members – with an average of three. Eighty-five percent of the companies reviewed comply with the NZX listing rules regarding the requirement of having minumum of three members on the audit committee.
However, only 92 out of the 150 companies we reviewed provided data on the number of audit committee meetings they held. These companies each held an average of three meetings year. Almost 44 percent of audit committees met at least four times per annum. The reports do not disclose when these meetings took place. Typically, such meetings are to be held quarterly, with and without executive management, internal auditors and the external auditors. In the past, four meetings per annum was considered adequate but eight to 12 meetings year is now the norm in the United States, United Kingdom and, to some extent, in Australia.
When it cames to audit committee independence, the average percentage of non-executive directors on the audit committee was 96 percent (median 100 percent) and the average percentage of independent directors on the audit commitee was 71 percent (median 67 percent). All companies have majority non-executive directors on the audit committee. However, 73 percent of the companies have majority independent directors on the audit committee, suggesting 27 percent do not meet this governance recommendation issued by the NZX and the SEC.
Eighty-six percent of the audit committees comprise 100 percent non-executive directors but only 39 percent comprise 100 percent independent directors. These data suggest New Zealand audit committees do not have sufficient independence from management to effectively discharge their monitoring activities. In conjunction with companies with audit committees comprising fewer than three directors, this is concerning piece of evidence.
The gravity of the potential consequences is exacerbated when one considers the number of financial experts on the audit committee. On average, 35 percent (median 33 percent) of all directors, 33 percent (median 33 percent) of non-executive directors, and 26 percent (median 33 percent) of independent directors on the audit committee possess accounting and financial expertise. The governance recommendations require at least one financial expert on the audit committee. Since all audit committee members must be non-executive and majority independent, our evidence shows only 59 percent and 47 percent of the audit committees have at least one non-executive expert or one independent expert, respectively.
These figures suggest more than 41 percent of audit commitees do not meet the governance recommendations. If the audit committee does not have sufficient expertise to draw on, it will not be able to exercise due diligence and, moreover, it may not meet frequently to address issues in financial reporting. To effectively monitor the financial reporting process, audit committees must comprise at least one financial expert who is independent from management.
New Zealand regulations ought to specify that the expert be independent. Audit committees need directors who will challenge management when necessary and ask the right questions at the right time.
An important determinant of director’s desire to challenge management is the level of shareholding in the company. Leading researchers have consistently argued that directors holding more than five percent of the shares in company are unlikely to exercise independent judgement as their concern may be to maximise their own vested interests.
New Zealand is unique in this sense because many companies evolved from family-owned to listed corporations and ownership has tended to remain in the family. Twenty-seven percent of audit committees comprise directors