Is It Time to Establish an Audit Committee in Your Company?

As I work with companies that are growing and facing new challenges, I am often asked if they should create an audit committee, and the answer is – it depends. I would like to present some recommendations that can help you decide if you should establish an audit committee in your company. Of course, these suggestions apply only to private companies, as SEC registrants are required to have independent audit committees.

Who Should Start an Audit Committee?

Is your company growing through acquisitions or mergers? Are you entering new markets or new ventures that require complex financing arrangements? Are you considering taking the company public? Any of these situations is a strong indication that you need to create an audit committee.

A private company’s leadership might establish an audit committee as they seek to increase capital from outside sources or as they enter complex financing agreements. Lenders and potential investors will examine the company from a variety of perspectives to determine its creditworthiness and credibility. A strong audit committee is a positive indication that a private company’s governance structure is appropriate and effective.

Of course, if you plan to take your company public, you will be required to create an audit committee as part of regulatory compliance. My advice is to start an audit committee as early as possible in the process of taking your company public. If you already have an audit committee in place, be sure that it meets the standards for public companies, including having independent directors and a financial expert. You must address a number of issues before the IPO, and you can do yourself a favor by establishing the audit committee as early as possible.

Why Should I Have an Audit Committee?

As companies grow, an audit committee can provide an extra layer of protection against business and fraud risk. An audit committee has oversight responsibilities for financial reporting, internal and external auditors, regulatory compliance, and responsibilities to monitor accounting policies.

Not every company, however, needs an audit committee. Many well-run, profitable businesses operate without one. Audit committees can be time consuming and costly, and companies should ensure they are committed to maximizing the benefits of a committee before creating one.

Companies should examine their operations for indications that an audit committee would strengthen the existing governance structure and bring value to the organization. And if a company does not need a committee currently, nothing prohibits leadership from changing course if future needs warrant it.

You might not need an audit committee if you are in any of the following situations:

• You don’t have a current need to raise capital from outside sources.
• You don’t see a future need to raise capital from outside sources.
• You have no plans for an IPO in the foreseeable future.
• Management is not fully committed to maximizing the benefits of an audit committee.

I think I need to spend a little time with the last example. I have seen companies set up audit committees only to fill them with members of the organization who are already involved in the day-to-day activities of the company. These committees are sometimes perfunctory, functioning only as window dressing, and, in my opinion, are often not worth having.

An audit committee can be more successful, on the other hand, when it has outside directors involved. Appropriately qualified independent directors often bring new ideas to the table and critically evaluate areas of risk to the company. They often are able to see risk because they have a fresh perspective, and management can benefit from their perspective and advice.

What is the Process for Starting an Audit Committee?

A company’s board of directors normally oversees the audit committee, which functions as a part of the board. The CEO, as a member of the board, often has a leading role in inviting committee members and often acts as the board liaison with the committee.

Basic steps for creating an audit committee include:

• Write the committee charter. The charter describes the structure, membership, meeting schedule, and primary functions of the committee.
• Determine internal representation on the committee and invite outside members to serve. Many committees include a director who serves as a financial expert; public companies are required to have one.
• Develop internal processes to ensure that the committee is provided the information it needs to effectively fulfill its governance obligations.

Initial tasks for a new audit committee include:

• Meet with key members of management to determine significant business and fraud risks.
• Review financial statements and challenge management, internal auditors and external auditors for accuracy and completeness.
• Become thoroughly familiar with the company’s code of ethics and how it impacts the ongoing operations of the company.
• Evaluate the company’s tone at the top.
• Brainstorm opportunities to tighten policies and procedures.
• Evaluate the transparency of the management structure and reporting processes.

One of the best pieces of advice I could give to a company setting up a new audit committee is that, to get the most from the committee, all key members of your organization must be completely committed to the committee’s work. An audit committee can be highly effective management tool, especially when everyone is committed to helping it operate at the highest level possible.

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