Financial Reporting and the responsibilities of the Board members and Audit Committee

A financial misstatement usually involves senior management of public companies, who are in a unique position to perpetrate financial misstatement by overriding controls. As a consequence, the role of the board of directors, audit committees, external and internal auditors is critical in properly addressing financial misstatements and override of controls. At times of negative economic environment, when targets are much harder to achieve, increased pressure is imposed at corporate level for better results and this creates incentives for financial misstatement and fraud.

But financial misstatement and fraud could also occur at lower levels of management when middle corporate managers may claim that they did not realise that they were committing a financial misstatement or fraud, but saw themselves as simply doing what was expected of them by senior management. Middle managers and other employees committing this type of fraud may not be doing it for a direct personal gain, but because senior management created the impression that the manipulation (or omission of adjustment/action) is needed, it is for the best interests of all, and after all this is what is expected of them by senior management.

When faced with a material financial misstatement or fraud, it is more likely that senior management either knew about it, should have known about it, or have caused it by putting pressure on lower-level employees. Such behaviour may be rationalised as: “We were sure that business was going to turn around in the near future and most probably next year, we were protecting company jobs in this way, we did not intend investors, etc.”

Senior management has the primary responsibility for the financial reporting process and for implementing controls to deter and detect financial misstatement and fraud. But at the same time in addition to senior management, the board of directors, the audit committees, the internal and external auditors have complementary and interconnected roles in delivering high-quality financial statement reports to the investing public and other interested counterparties. The Board of directors and audit committees are responsible for the oversight of a company’s business operations and control environment.

The audit committee in particular is responsible for overseeing not only the financial statement reporting process but also the company’s external auditors and the internal audit function.

In this respect, board and audit committee members of public companies are expected to be of high morale, well educated and experienced in their line of business, and have a sound understanding of the company’s business and its industry. At the same time, board members are expected to put less trust on a company’s senior management, perform their own due diligence on significant issues and challenge a company’s management actions and decisions. In other words, board members should be sceptical of senior management and ask questions about critical company matters.

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Audit committee members should not only possess the qualities described in the previous paragraph but also have a working understanding of International Financial Reporting Standards (IFRS) in order to be in a position to challenge senior management with questions on risks that could potentially create incentives for financial misstatement. Such probing questions should be addressed to senior management, external and internal auditors. Audit committee members are expected to have an active role, and not a passive one, when dealing with significant financial statement reporting issues.

The audit committee should be in a position to utilise both internal and external auditors in order to properly evaluate the effectiveness of management’s actions with regard to financial reporting matters. Even though the role of the audit committee is not to be directly involved in the management of the company, its role and responsibility is clearly to oversee the financial reporting activities and procedures of the company.

At the same time the audit committee should not only be in a position to understand the exposure to management override of controls but also to take remedial action and mitigate the possibility that an override could occur.

To conclude, the audit committee’s most important role is to set the tone at the top making it clear to other board members, senior company management, internal and external auditors that they should be doing the right thing at all costs by strictly following the financial reporting standards despite the consequences such an action could have on the company’s reported financial results.