Key Characteristics of Effective Audit Committees
Tom Ziemba, director of strategy & human capital, RSM McGladrey

Bank board audit committees have a significant challenge ahead of them. They have the responsibility for making sure the fundamental financial integrity of the financial institution is maintained, reviewed, and audited. In order to execute these accountabilities, the committee touches all aspects of the bank, including risk management and financial management issues. Furthermore, the committee must have a thorough understanding of how the bank operates and performs.

A number of the important characteristics of the committee define the extent and depth of its oversight role. These characteristics differentiate effective audit committees from less potent ones.The first characteristic is the development of a charter that outlines the roles and responsibilities for the committee. Second, the bank directors who are on the committee should be independent as defined by a relevant regulatory body. Third, there’s an ongoing education requirement for the committee—that’s very important. Because of the changing accounting regulations and rules, bank directors who sit on the committee have a real challenge keeping up with current issues in order to execute their roles effectively.

Internal Controls and Risk Management

What I’d like to do now is go over the three major accountabilities and roles for the audit committee and touch on each, one by one.The first accountability is assessing the adequacy of internal controls in the financial reporting system.Here the audit committee can expect management, and, in fact, should empower management to develop a charter or mission statement which describes the internal financial control systems for the bank. Second, the committee should require management to identify how it’s going to evaluate the effectiveness of those controls. Finally, the management team should report the results of that evaluation to the committee. The audit committee should review these results to make sure that the controls are adequate and commensurate with the complexity of the financial institution.

Closely related to the implementation of the financial and internal controls is the risk management profile adopted by the bank. The audit committee should reinforce the expectation that the management team should adopt a broad definition of risk management and that it will use this definition as a baseline to assess all aspects of bank risk.

There are three “agents” that will help the audit committee execute these accountabilities.One is the internal auditor who will participate in this process.The external auditor also will participate, and, of course, management has the ultimate responsibility for putting these programs and processes in place.

Financial Reporting Process

The second major accountability is oversight of the financial reporting process. Basically the audit committee has a responsibility for ensuring the integrity of the financial reports that are produced by the financial institution such as call reports, interim financial reports, and final financial reports.

In addition, the audit committee should pay particular attention to areas within the financial reports that can be directly influenced by management. It should review assumptions management makes about accounting rules which require certain information in the reports versus omitting them.An example might be if the bank moves along with a certain level of loan loss reserve, and then, all of a sudden, changes that in terms of the financial report.The audit committee would want to know why that change had occurred and whether it reflected a positive or negative change.

Overseeing the Audit Process

The third accountability is to oversee the audit process itself. There are two pieces to this.One is the internal audit process and another is managing the external audit. The internal auditor, if that person is resident in the bank,would report directly to the audit committee, sometimes with a dotted line to the CEO or the CFO.The external auditor would always report directly to the audit committee and would be accountable for managing the external audit process. Now, in both cases, there’s a charter and work plan put forth by the auditors,which will indicate exactly the scope of the audit, the kinds of issues it’s going to address, the people who will be involved in the audit, how the board will be involved, and the role of the management team.

In the internal audit process,what you are looking for is how well the internal controls have been established, the testing of those controls, and then any problematic issues that are identified by the internal auditor that management should attend to and the audit committee and board should be aware of. In terms of the external audit process, the board has a lot of accountability. It’s almost a performance management accountability, in that the board is managing a whole project and a group of people—the external auditors. So the first thing the audit committee must do is identify who the external auditor will be.

There are a number of criteria you should be looking at to make that determination. One would be the quality of the firm that’s conducting the audit and its experience in doing the kind of audits you’re looking for.Also, you’ll want an audit firm that’s commensurate in terms of skills and capabilities with the complexity of the financial institution. It’s important not to shoot over or under in terms of hiring an external audit firm. Next, from the audit firm, you’re going to want to know what the audit plan will be, which is the audit committee’s way of managing that audit process. The external auditors will obviously interface with management as well, and they’ll provide a lot of information to the audit committee, but their primary role is to give a pronouncement that the financial statements the bank is producing are accurate and fair representations. In addition, the auditor may comment not only on the financials, but also on whether or not there are incidents of fraud or any other wrongdoing, noncompliance with certain rules, laws, and regulations, as well as give an overview of the tone of how management views the audit process and the whole financial integrity management process.

This review provides the three key goals and responsibilities—or roles—for the audit committee. Therefore, because of the breadth of issues it has to deal with, including the financial issues that reflect how the bank is doing as a whole in terms of its business model, its strategies, and its day-to-day performance, the audit committee provides a very fundamental and important oversight role that is critical for the entire board and the ongoing integrity of the financial institution.

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