The Essential Issues on the Functions of the Audit Committee
The 2008–2009 financial crisis revealed that management at certain committee's with the knowledge and approval of their boards took decisions and actions that led to terrible outcomes for employees, customers, shareholders, and the wider economy. What should the Audit Committee's have done differently?
Well-implemented audit committee structures and processes are more important than ever, but whether and how well they have functioned is the critical question to be asked, after the financial and credit crisis.
Although the temptation to judge audit committee effectiveness by the extent of conformance to a set of perceived best practices can be overwhelming, it is also counter productive. Most studies of audit committee agree that it is end behaviors, much more than frameworks and structures that matter. "Box-ticking" neither improves audit committee nor accurately assesses it. Any arrangement can fail, but failures are more often caused by undesirable behavior and values than by bad structures and forms.
An examination of audit committee reveals a wide diversity of approaches, driven by differences in culture, law, institution-specific circumstances, the people involved, and precedent. This diversity is a good thing, since it means that the audit committee approaches are tailored to address the unique circumstances of each committee. Greater homogeneity would likely lead to poorer audit committee because the constraints that would have to be introduced to ensure homogeneity would reduce the committee's freedom to optimize.
This suggests that all parties with a stake in the design, operation, and evaluation of audit committee systems must focus on the essential question of responsibility and let the issue of form recede.
Behavior appears to be key, and a focus on right behaviors means a shift from the "hardware" of audit committee (structures and processes) to the "software" (people, leadership skills, and values). This means asking questions such as: How does the board both engage and challenge management? How does it support management in overcoming key difficulties? Are interactions open and transparent? Does management assist the board understand the real issues? What is the opinion of the CEO toward the board? Is the relationship between the CEO and the chair (where those roles are separate) a constructive one? Are issues presented to the board in a way that is responsive to the application of business judgment? What underlying organizational culture and values drive behaviors - and how can a desired culture best be supported and reinforced?
The art of audit committee is in making different forms function properly and adjusting the form to improve function. It takes responsible leadership, sound judgment, genuine teamwork, selfless values, and collaborative behaviors - all carefully shaped and nurtured over time.
Boards of directors play the pivotal role in the audit committee through their control of the three factors that ultimately determine the success of the committee: the choice of strategy; the assessment of risk taking; and the assurance that the necessary talent is in place, starting with the CEO, to implement the agreed strategy.
The 2008-2009 financial crisis revealed that management at certain committee's with the knowledge and approval of their boards, took decisions and actions that led to terrible outcomes for employees, customers, shareholders, and the wider economy. What should the boards have done differently? To answer that question, it is helpful to consider the mandate of boards.
Boards control the three key factors that ultimately determine the success of an Audit Committee's selection of business model (strategy), the risk profile, and the choice of CEO-and by extension the quality of the top-management team. Boards that permit their time and attention to be diverted disproportionately into compliance and advisory activities at the expense of strategy, risk, and talent issues are making a critical mistake. Above all else, boards must take every step possible to protect against potentially catastrophic risks.
The Board of directors every business must take a long-term view that encourages long-term value creation in the shareholders' interests, elevates prudence without diminishing the importance of innovation, reduces short-term self-interest as a motivator, brings into the foreground the company's dependence on its pool of talent, and demands the company's play a palpably positive role in society.
The importance of responsible, open leadership by a skillful board chair cannot be over emphasized. Effective chairs capitalize on the wisdom and advice of board members and management leaders and on the board's interactions with supervisors and shareholders, individually and collectively. Good chairs respect each of these vital constituents, preside, encourage debate, and do not manage toward a predetermined outcome.
To be continued in the next newsletter.
Inspiration/Source: Toward Effective Audit committee of financial Institutions, Lord Adair Turner, Chairman, FSA posted on blogs.law.harvard.edu/corpgov/2012