Accountancy: Stakes raised for internal auditors - Roger Trapp reports on what can be done to improve the make-up, function and performance of company audit committees

IN THE debate over auditing, prompted by the collapse of several 1980s success stories, great store is set by the audit committee. Although recommended in some quarters as long ago as the 1940s, the idea has steadily gained greater credence. It was among the recommendations of the 1992 report of the Committee on the Financial Aspects of Corporate Governance, chaired by Sir Adrian Cadbury, and has featured in similar exercises overseas.

But as with non-executive directors, just setting up a body responsible for overseeing internal controls and the audit process is no panacea. If they are not to fulfil a rubber-stamping function, both groups need detailed background information and training.

The links do not end there, of course. Audit committees are increasingly drawn from the ranks of non-executive directors. Indeed, a recent study of international best practice in this field has confirmed that independence is 'a key characteristic of an effective audit committee member'.

The study, Improving Audit Committee Performance: What Works Best, prepared by Price Waterhouse on behalf of the Institute of Internal Auditors Research Foundation, explained that this was because of the body's responsibility for overseeing the corporation's financial integrity.

'There may be occasions when the committee must question the actions or judgement of an executive officer,' it says. 'If members are not independent, the committee's inquiry may be ineffective.'

Obviously, it is one thing to state the need for independence, and quite another to establish an appropriate test. While the requirements differ slightly between institutions, it is widely accepted that members of management or indeed other employees do not fit the definition. But at a time when companies are forming stronger links with suppliers and customers, representatives of these are increasingly being considered unsuitable, too.

In the end, though, the authors shy away from an outright test and come up with the appealing, yet somewhat unscientific, view that 'a candidate's actual independence of mind and ability to approach committee matters objectively are what matter the most'.

More important perhaps, what positive attributes should a would-be audit committee member possess? In selecting non-executive directors in general, companies are increasingly abandoning the gifted amateur approach in favour of obtaining specific skills and experience - for example, by appointing business people who are nationals of countries into which they wish to expand or those with experience of sectors that they plan to enter.

According to the report, this thinking has carried over into audit committees. Best practice determines that at least one member should have a background in financial reporting, accounting or auditing in order to be able to guide the committee in dealing with difficult technical issues, asking the right questions and helping to put matters into the proper perspective. Furthermore, most committee members should have backgrounds in business 'and it would be helpful if at least one member was familiar with the company's industry'. Those that are not should be thoroughly briefed.

Nevertheless, the authors acknowledge the difficulty of finding potential directors who are familiar with the company's line of business but are not competitors, significant suppliers or customers.

Even if a company has achieved the ideal composition of its audit committee, it may still not obtain the maximum value. Much will depend on how the committee actually goes about its work.

Far from meeting just once a year to consider the appointment of the external auditors, audit committees are increasingly moving towards three or four meetings a year - in line, says Roger Marshall of Price Waterhouse's London office, with the trend towards quarterly reporting.

The meetings often have long and varied agendas and the members commonly call the chief executive and/or finance director for questioning about the financial results and other executives for information about such matters as tax or information technology, as well as the external auditor, or independent accountant.

While the audit committee may need to probe in order to do its job effectively, it is likely to be counter-productive to develop an antagonistic relationship. After all, as the survey states: 'Most duties and responsibilities of the audit committee require significant interaction with management to be accomplished effectively.'

Nor is it enough for managers merely to attend audit committee meetings when requested. They should participate fully by taking the lead in presenting reports on such matters as reviews of financial statements and operating results, and the adequacy of reserves.

The report calls for a 'healthy scepticism' on the part of committee members, with attempts to balance information received from the management by consulting the head of internal audit and the independent accountant.

With business becoming ever more complex, this is increasingly important. As a result of this, and the emphasis given it by the Cadbury Report, committees are paying extra attention to internal controls as well as to such functions as treasury operations, where companies can incur significant risks.

Similarly, the growth of contingent liabilities for environmental problems and additional regulation of certain industries provide extra areas of interest for the conscientious committee.

As the report says, committee chairmen are only too aware that they are operating in a changing corporate environment, which will necessarily lead to an expansion of their role. By putting more demands on committee members, this will make it more difficult to find appropriate recruits. 'But the stakes are too high for committees not to accept the challenge.'

(Photograph omitted)