Question

Every year, the board of directors of Northern Power, a distributor of electricity, commissions an effectiveness evaluation of its audit committee. An independent consultant with expertise in governance reviews the means by which the audit committee fulfills its responsibilities, as set out in its charter. Specifically, it evaluates how the members of the audit committee:

Oversee the quality and reliability of financial reporting and disclosures

Understand the key risks facing the organization and the processes management uses to identify, assess, and manage risks, considering internal audit findings, litigation, compensation schemes, regulation, and compliance

Evaluate organizational behavior, culture, and adherence to standards of conduct

Challenge management and the external auditor in determining materiality for financial reporting purposes

Assess reasonableness and appropriateness of critical accounting policies of the company

Confirm or reject the basis for management estimates and proposed accounting policy changes before approving

Evaluate, retain, or change external auditors

Review audit plans

Review management's assessment of internal control over external financial reporting The results of the evaluation are used to determine whether the roles and responsibilities of the committee have been met and could result in committee member changes or impact remuneration. In addition to the annual review, every three years the company conducts a benchmark review against leading practices and refines its charter, as appropriate.

I’ve done quite a bit of excerpting from COSO, and it says this:

2. Control Environment Principles relating to the Control Environment component

Principle 1. …

Principle 2. The board of directors demonstrates independence from management and exercises oversight for the development and performance of internal control.

Points of Focus

The following points of focus highlight important characteristics relating to this principle.

Establishes Oversight Responsibilities—The board of directors identifies and accepts its oversight responsibilities in relation to established requirements and expectations.

An example they use is:

Example: Reviewing and Documenting Key Activities of the Audit Committee

Every year, the board of directors of Northern Power, a distributor of electricity, commissions an effectiveness evaluation of its audit committee.

Required:

Look at the example that COSO uses for Northern Power, and respond to these questions.

1. Is the audit committee required to second-guess management, when management estimates something like the useful life of buildings for computing depreciation? Why?

2. Should the full board of directors second-guess the audit committee’s selection of which CPA firm should audit Northern Power? Why?

Answer 1

1) The audit committee is required to second guess management. The main reason why the internal audit is required is to oversight financial reporting of the company. I would explain you with an example. Sometimes if a company wants to get listed they will try to increase the profitability of the company. The management peoples perk and salary also depends on the financial report. So sometimes management people would try to manipulate the financial report in their favor. In such cases, the internal audit committee is required to second guess management.

In your case of depreciation, depreciation is calculated on two bases. One is a straight line and other is an accelerated method. So management can manipulate with methods so that profit of the company changes. So, it is the responsibility of the audit committee that company always follows the same accounting standard for calculating the depreciation of buildings.

2) Yes, the board of director should second-guess the internal audit work done by the audit committee. Because sometimes settlement happens between management and audit committee which goes against the interest of the company and would harm the reputation of the company if on later dates any faults are found out.