The recent international growth of mandatory audit committee requirements

Abstract

This article explores the growth in the number of countries who now mandate that listed companies establish audit committees to improve their financial reporting process. By reviewing the current and historical company laws and major stock exchange listing requirements for each of the world's 40 largest capital markets, this article finds a significant increase in the number of countries who now, post-Sarbanes–Oxley, mandate that boards of directors establish a subcommittee to monitor their company's accounting and auditing processes. Specifically, it reveals that while only 10 of the world's 40 largest capital markets required audit committees when the United States enacted the Sarbanes–Oxley Act of 2002, this number has now grown to 31. This article offers insight to policy makers interested in amending company laws or stock exchange listing requirements to coincide with the corporate governance standards found in the world's major capital markets. It is also useful to corporate managers planning to enter new capital markets. Academic readers will benefit from the historical review of the growth of mandatory audit committees and the review of the academic literature studying the effectiveness of audit committees.

APPENDIX

Selected statutory language implementing mandatory audit committee requirements

United States

Public Company Accounting Reform and Investor Protection Act (Sarbanes and Oxley, 2002).

§ 301

[T]he Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the [audit committee] requirements [listed below] … .

Responsibilities relating to registered public accounting firms – The audit committee of each issuer, in its capacity as a committee of the board of directors, shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work, and each such registered public accounting firm shall report directly to the audit committee ….

Each member of the audit committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent … .

Each audit committee shall establish procedures for –

 (A) the receipt, retention, and treatment of complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters; and

 (B) the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.

§ 407

The Commission shall issue rules … to require each issuer … to disclose whether or not, and if not, the reasons therefore, the audit committee of that issuer is comprised of at least 1 member who is a financial expert, as such term is defined by the Commission.

European Union

Directive on Statutory Audits of Annual Accounts and Consolidated Accounts (European Parliament & Council of the European Union, 2006).

Article 41(1)–(5)

1. Each public-interest entity shall have an audit committee. The Member State shall determine whether audit committees are to be composed of non-executive members of the administrative body and/or members of the supervisory body of the audited entity and/or members appointed by the general meeting of shareholders of the audited entity. At least one member of the audit committee shall be independent and shall have competence in accounting and/or auditing.

In public-interest entities which meet the criteria of Article 2(1), point (f) of Directive 2003/71/EC (1), Member States may permit the functions assigned to the audit committee to be performed by the administrative or supervisory body as a whole, provided at least that when the chairman of such a body is an executive member, he or she is not the chairman of the audit committee.

2. Without prejudice to the responsibility of the members of the administrative, management or supervisory bodies, or of other members who are appointed by the general meeting of shareholders of the audited entity, the audit committee shall, inter alia:

 (a) monitor the financial reporting process;

 (b) monitor the effectiveness of the company's internal control, internal audit where applicable, and risk management systems;

 (c) monitor the statutory audit of the annual and consolidated accounts;

 (d) review and monitor the independence of the statutory auditor or audit firm, and in particular the provision of additional services to the audited entity.

3. In a public-interest entity, the proposal of the administrative or supervisory body for the appointment of a statutory auditor or audit firm shall be based on a recommendation made by the audit committee.

4. The statutory auditor or audit firm shall report to the audit committee on key matters arising from the statutory audit, and in particular on material weaknesses in internal control in relation to the financial reporting process.

5. Member States may allow or decide that the provisions laid down in paragraphs 1 to 4 shall not apply to any public interest entity that has a body performing equivalent functions to an audit committee, established and functioning according to provisions in place in the Member State in which the entity to be audited is registered. In such a case the entity shall disclose which body carries out these functions and how it is composed.

United Kingdom

Amendments to the Disclosure Rules and Transparency Rules Sourcebook (DTR) (Financial Services Authority, 2008).

1B.1.1

The purpose of the requirements in DTR 7.1 is to implement parts of the Audit Directive which require issuers that are required to appoint a statutory auditor to appoint an audit committee or have a body performing equivalent functions.

7.1.1

An issuer must have a body which is responsible for performing the functions set out in DTR 7.1.3R. At least one member of that body must be independent and at least one member must have competence in accounting and/or auditing.

7.1.2

The requirements for independence and competence in accounting and/or auditing may be satisfied by the same member or by different members of the relevant body.

7.1.3

An issuer must ensure that, as a minimum, the relevant body must:

(1) monitor the financial reporting process;

(2) monitor the effectiveness of the issuer's internal control, internal audit where applicable, and risk management systems;

(3) monitor the statutory audit of the annual and consolidated accounts;

(4) review and monitor the independence of the statutory auditor, and in particular the provision of additional services to the issuer.

7.1.4

An issuer must base any proposal to appoint a statutory auditor on a recommendation made by the relevant body.

Sweden

Swedish Corporate Governance Code (Swedish Corporate Governance Board, 2008).

§ 10(1)–(6)

1. The board is to establish an audit committee consisting of at least three directors. The majority of the audit committee members are to be independent of the company and its executive management. At least one member of the committee is to be independent of the company's major shareholders. No board member who holds an executive management position is to be a member of the audit committee. If the board of directors feels it is appropriate, the entire board may perform the audit committee's tasks, providing that no director who is a member of the executive management participates in this work.

2. The audit committee is to

 • be responsible for the preparation of the board's work to ensure the quality of the company's financial statements,

 • meet the company's auditor regularly to remain updated on the aims and scope of the audit, as well as to discuss co-ordination between external and internal audits and views on the company's risks,

 • establish guidelines on services other than auditing that the company may procure from the company's auditor,

 • evaluate the auditing work and inform the company's nomination committee of the results of this evaluation, and

 • assist the company's nomination committee in preparing nominations for the post of auditor and recommendations on fees for auditing services.

3. At least once a year, the board is to meet the company's auditor without the chief executive officer or any other member of the executive management present.

4. The board of directors is to ensure that the company's six- or nine-month report is reviewed by the auditor.

5. The board is to submit an annual report on the key aspects of the company's systems for internal controls and risk management regarding financial reports.

6. For companies that do not have a separate internal audit function, the board of directors is to evaluate the need for such a function annually and to justify its decision in its report on internal controls.