Audit committees are a strange invention. They are supposed to provide the independence that their master-the full board-does not provide, but their accountability is often unclear. So, how did this peculiar state of affairs come to be? And what are the chances of real change?

The search for independent oversight

Recent corporate scandals have highlighted the glaring lack of independent oversight at the board level, and as the search for an appropriate governance mechanism intensifies, the audit committee is taking centre stage. According to current wisdom, it is easier to make the audit committee independent than it is the board of directors.

When we speak of “independence” in the context of corporate governance, we usually mean “independent from management.” The theory is that such independence is necessary because the interests of management and owners are not always the same; left to its own devices, management could further its own interests at the expense of shareholders. “Agency theory,” which speaks to the gap between principal and agent, tells us that the bigger the gap between the owners of a company and its agents, the bigger the owners’ need for independent monitoring and the greater the attendant costs.

This article explores the appropriateness and effectiveness of the audit committee as a source of unbiased information. It is my belief that an independent audit committee is not a panacea for what is wrong with corporate governance. Audit committees, too, are ultimately compromised because they are part of a complex web of dysfunction. In fact, focusing on individual mechanisms of financial oversight, like the audit committee, misses the crucial point that it is the entire system of corporate governance that is in need of a major overhaul.

The increasing importance of the audit committee

Evidence that the audit committee is becoming a touchstone for good governance is all around us. In Canada, Ontario Securities Commission chairman David Brown has said that the establishment of rules for audit committees is his first priority for board reform; the province’s finance minister, Janet Ecker, has introduced a bill that will grant the OSC this power. According to a recent article in The Globe and Mail, Ontario is likely to introduce detailed new rules that will require audit committees to accept complete charge of the audit by taking full responsibility for hiring auditors, determining the scope of their work and supervising the process. In the United States, events are moving in a similar direction. Last year, the New York Stock Exchange proposed new listing rules requiring audit committees have greater authority and that both the audit committees and nomination and compensation committees be fully independent.

The seeming or desired independence of audit committees is not the only reason they are receiving so much attention. Audit committees also save the full board time and effort because the smaller groups can be constituted more easily. In addition, the audit committee brings a degree of financial expertise to the table that not all boards members may have. The Toronto Stock Exchange’s Corporate Governance Guidelines, for example, require that all audit committee members be “financially literate.” However, this requirement does not extend to the entire board.

Auditors and audit committees

Auditors are now more likely to be accountable to audit committees. The preamble of a 2001 SEC Final Rule says, “Among other things, an audit committee serves as the board’s principal interface with the company’s auditors…” And from The Globe and Mail last November: “The new Sarbanes-Oxley legislation in the United States requires disclosure of key issues to audit committees. For example, auditors must inform audit committees of any debates they have with management about alternative accounting methods that could be used. And auditors must give audit committees all correspondence with management. The United States has closed a critical information gap, and Canada must do the same.”

From a legal standpoint, auditors are appointed by the owners as a whole and are supposed to report to the owners as a whole. However, Robert A.G. Monks, a prolific author on the subject of corporate governance and the founder of Institutional Investment Services, is right to point out that in the context of typical annual general meetings, decision-making by owners amounts to no more than “coerced ratification.” Maybe this will change as a result of initiatives such as the Canadian Coalition for Good Governance, which is calling for shareholders to vote on every issue in a company’s proxy circular. For the moment, however, it seems that shareholders are putting their faith in the audit committee in order to keep auditors on the straight and narrow.

Boards and audit committees

Corporate governance is about institutionalizing and ensuring a system of accountability. The chain of accountability begins with the link between the owners and the board. Because boards are supposed to represent shareholders, they sit at the top of the system. And it is at the top where the whole system really starts to unravel.

The rise in importance of the audit committee is based on the fact that boards aren’t independent, and are often too large and financially “illiterate.” Given this reality, the presence and workings of the audit committee is a sort of consolation prize for shareholders because the body that they really should be able to entrust to oversee the company is inadequate. But can the integrity of a part ever compensate for a lack of integrity in the whole? What is the use of having an independent and expert subcommittee if the board which appoints it, and to which it is accountable, is too much in management’s pocket, too large to function effectively and financially “illiterate”? Is it possible to derive a legitimate committee from a board whose own legitimacy is open to doubt?

Is not the current focus on the audit committee dangerously compounding the full board’s failings? Is the audit committee becoming a reason to relax our expectations for proper board behaviour and, if so, will there not be an ultimate price to pay? After all, if the audit committee fails, the responsibility comes straight back to the full board anyway.

Leaving the full board alone to stand as an anachronism while promoting the audit committee to do the real job may make life easier for everyone involved in the system, but it does nothing to make the system work better. Instead of creating boards within boards, wouldn’t it be better if boards were independent in the first place? Couldn’t we identify what boards need to know to oversee their auditors effectively and then educate all board members sufficiently to do the job? If some boards are too big, why not simply make them smaller?

One of the main barriers to full board independence is, of course, the reality that in many closely held companies, managers are very significant owners as well; therefore, their presence on the board is almost inevitable. It is a brave, or strangely disinterested owner-manager who would willingly forgo a place on the board. But the important thing about a board’s composition is that it should not create any doubt or potential for conflict with its responsibility to uphold shareholders’ interests.

All the talk about independence misses the point that independence is not so much about not being management as it is about definitely being ownership. Managers with share options are not significantly sufficient owners to qualify; significant owners who happen also to be managers do qualify, as long as they can leave their managerial interests behind when they enter the boardroom.

Ultimately, it doesn’t matter who is on the board. What matters is that when managers are on the board of directors, it is their role to govern in the interests of shareholders-all of the shareholders. So, if boards are willing and able to do their jobs properly, we shouldn’t need audit committees and compensation committees for any other reason than time management.

In any case, nothing can take away from the fact that, ultimately, the entire board is responsible for ensuring that every legal and financial requirement is met. Boards do not exist to advise, to make business connections or to improve appearances. Boards exist to govern-to ensure a company’s success and safety on behalf of shareholders.

The chances of change

Recent accounting scandals may spur an overdue re-examination of the whole system of independent oversight and the role of boards. The New York Stock Exchange advocated, in the preamble to its report from the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, “Recommendations for the performance of audit committees must be founded in the practices and attitudes of the entire board of directors.” With the increasing focus on the audit committee, however, the board could become more sidelined than it already is. Unbelievably, after all that we’ve been through, we could end up with a system that is more dysfunctional than the one we have already.

I don’t believe we will ever achieve the independent oversight we so strongly desire until boards accept the fact that everything starts and finishes with them, not with their committees or their managers. They need to examine their own composition purely from the perspective of unconflicted allegiance to shareholders’ interests, and then correct any weaknesses. They also need to recognize that they are indeed accountable to the company’s owners for everything about their company, and that as a part-time group, they cannot fulfill such an immense responsibility with the tools they currently have.

In Corporate Boards That Create value, John Carver and I propose a new technology for governance based on an analysis of the purpose and nature of corporate board authority. This new technology, called Policy Governance®, has already been widely adopted by non-profit and public boards across North America and beyond. Using a special policy format, Policy Governance applies board controls to all possible owner concerns relating to the governance of company success and safety, but at the same time enables the fullest possible delegation to others. The policy format enables directors to use their wisdom and expertise to create policies that are brief but at the same time address all aspects of what they want the company to produce, and how they want the company to conduct itself. By using this system, boards become quite capable of carrying the full burden of their responsibility, including the monitoring of company performance and providing accountability to shareholders.

Still, there will be few takers for any new system of corporate governance without a wholesale change in directors’ understanding of their job as well as a commensurate shift in understanding among those who audit, regulate and consult with boards. There is little chance of either change occurring unless investors increase their expectations of boards and refuse to accept that a subcommittee, however perfectly composed, will safeguard their interests.

As John Carver and I noted in the December issue of Chartered Financial Analyst, the changes currently underway are primarily adjustments to existing mechanisms-improvements to be sure, but more minor repairs rather than a complete overhaul. The lack of a powerful, rationally framed design of the board’s job sets the stage for the repairs that we now need. Unless the integrity issue is adequately addressed, there are more failures ahead. For in the final analysis, we must be sufficiently bold and far-sighted to confront the nature of governance itself.