A realistic question that comes to mind is, “Do audit committees have at least one financial expert?” An expert should be somebody who is capable of getting results that are superior to those obtained by the majority of the population. Therefore, such a person must be recognized for his or her extensive knowledge, skill and experience in finance to qualify to be the financial expert in the audit committee.
If we understand what the audit committee has to achieve by its oversight then it would be easy to understand why a financial expert is required. The audit committee has to understand many aspects listed below and will need a financial expert to provide a good insight of these matters.
1. The quality of the balance sheet based on the aggressive nature of accounting estimates & judgements used by management. For example; provisions for potential losses or impairment of assets may be too low, Revenue recognition may be too aggressive and early, Loans & advances in a bank or claims in an insurance company may not be based on reasonable historic assumptions or realistic discounting techniques.
2. The quality of earnings and impact of adjustments that distort the performance for the year. For example; profits can be created by adjusting estimates for depreciation, reversal of provisions, adjustment of deferred items, etc, which may not be clear for a non financial expert. Without a proper analysis, how would the audit committee be satisfied with the reliability of monthly or quarterly results?
3. The nature, extent and scope of external audit and some of the diplomatic explanations provided by external auditors, to make sense of the underlying issues in the company. Even provision for contingencies or impact of a disputed tax adjustment or under provision for idle/ obsolete assets can be manipulated by management and auditors can be convinced through documentation that it is approved by the board. Audit committee members should be able to challenge these because of their expertise and also having insight of board’s intentions.
4. A financial expert will understand the whole system of internal controls and be able to direct the internal auditors to supplement external audit findings. A person with appropriate expertise can understand the nuances of control weaknesses and visualize what could go wrong due to such weaknesses.
5. Enterprise governance or enterprise risk management systems require oversight by experts to the extent they impact financial reporting. If the people who are implementing are the experts and the committee that should provide oversight does not understand the process, they can be easily misdirected. These are the circumstances that caused the down fall of Barings Bank, Societe Genarale, the Swiss bank UBS, Lehmans, etc.
Therefore, it’s time regulators had a more stringent test for the qualifying criteria regarding a financial expert on the Audit committees. Nomination committees also should take this aspect a little more seriously prior to recommending friends of friends to audit committees or taking the easy way out of finding a retired accountant to be the financial expert!