Oversight of the Independent Auditor

As fiduciaries who represent the interests of shareholders and other stakeholders, corporate directors oversee a company’s financial health. To fulfill this role, many boards rely on independent auditors (also referred to as “external auditors”) to provide objective opinions on the integrity and quality of their company’s financial reporting—a key indicator of financial performance.

Effective board oversight of the independent auditor requires an understanding of the independence requirements of the board’s audit committee and the external auditor, their respective roles and standards, and the practical realities of working with an audit firm.

External audits, and the reports that independent auditors provide, offer “reasonable assurance that financial statements are free of material misstatement, whether due to error or fraud.” All public companies are required to engage independent auditors, and it is a recommended practice for private and nonprofit organizations.

Independence Requirements

Audit Committees

Public companies must have boards composed of a majority of independent directors. In addition, under rules passed in the wake of the Sarbanes-Oxley Act of 2002, all public companies with shares listed by a major exchange must have an audit committee composed of at least three members, with all members being independent (defined as receiving no compensation from the company other than director fees). The US Securities and Exchange Commission (SEC) rules require disclosure of whether the committee comprises at least one “audit committee financial expert” (defined as expertise in Generally Accepted Accounting Principles, or “GAAP,” financial statements, internal controls, and audit committee functions) and if not, to explain why.

The audit committee plays a key role in selecting, evaluating, and compensating the audit firm, especially in public companies, and the committee must meet certain independence requirements related to auditor oversight. Additionally, the audit committee oversees the company’s internal control system, which may include an audit function carried out by one or more employees, referred to as “internal auditors.”