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12.3 Audit Committees

Rule 10A-3 under the Exchange Act directs the stock exchanges and NASDAQ to require listed companies to have an audit committee composed entirely of independent directors. Subsequent stock exchange and SEC amendments further strengthened this provision by requiring the following, among other things:

  • Each member of the audit committee is financially literate, as such qualification is interpreted by the board in its business judgment, or will become financially literate within a reasonable period of time after his or her appointment to the audit committee.
  • At least one member of the audit committee is a “financial expert,” defined as someone who has

    • an understanding of financial statements and generally accepted accounting principles;
    • an ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;
    • experience preparing, auditing, analyzing, or evaluating financial statements;
    • an understanding of internal controls and procedures for financial reporting;
    • an understanding of audit committee functions.
  • The audit committee has a charter that addresses the committee’s purpose and sets forth the duties and responsibilities of the committee.
  • The audit committee obtains and reviews an annual report by the independent auditor regarding the firm’s internal quality-control procedures, discusses the audited financial statements with the independent auditor and management, and reports regularly to the board of directors.
  • The audit committee is directly responsible for the appointment, compensation, retention, and oversight of the outside auditors. Additionally, the outside auditors must report directly to the audit committee.
  • The audit committee has the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties.
  • The audit committee approves, in advance, any audit or nonaudit services provided by the outside auditors.

The reasons behind these reforms are self-evident. Audit committees are in the best position within the company to identify and act in instances where top management may seek to misrepresent reported financial results. An audit committee composed entirely of outside independent directors can provide independent recommendations to the company’s board of directors. The responsibilities of the audit committee include review of the internal audit department, review of the annual audit plan, review of the annual reports and the results of the audit, selection and appointment of external auditors, and review of the internal accounting controls and safeguard of corporate assets.