The Crucial Role of Audit Committee Effectiveness in Ensuring Reliable Financial Reporting: Insights from Recent Regulations in Germany and a Related Study

Recent changes in regulations in Germany about the Financial Market Integrity Strengthening Act (FISG) highlight the importance of audit committee effectiveness in ensuring the reliability and transparency of financial reporting. The FISG was enacted in response to high-profile accounting scandals and corporate failures, including the collapse of Wirecard, which shook the confidence of investors in the integrity of financial reporting and the effectiveness of corporate governance.

Overall, it imposes stricter requirements on audit committees, including the mandatory appointment of a qualified independent expert to advise the committee on financial reporting and audit-related matters. The regulations also require greater transparency in the audit process, including the publication of audit contracts and the disclosure of any non-audit services provided by the audit firm.

In this context, audit committee effectiveness is crucial in ensuring that companies comply with new regulations and maintain the trust of investors and other stakeholders. An effective audit committee should be able to identify and address potential risks to financial reporting, monitor the performance of auditors, and provide transparent communication with stakeholders about the audit process.

A recent study, published in The Accounting Review, explores whether the engagement of internal audit functions (IAFs) by audit committees (ACs) can improve the reliability of financial reporting. The study posits that the IAF, as a source of internal information, can provide the AC with inside expertise and objectivity, leading to better oversight over financial reporting. However, the study acknowledges that there may be limitations to the benefits of utilizing the IAF. For instance, internal auditors may feel uncomfortable conveying sensitive information to the AC or may be compromised by undue influence from management.

To understand the nature of AC-IAF relations and develop hypotheses, the study relies on insights from semistructured interviews with two chief audit executives and four audit committee chairs. Using AC charters, the study measures the extent to which ACs utilize the IAF as a resource. The findings suggest that the engagement of IAFs can improve the reliability of financial reporting, but this is contingent on factors such as the AC’s ex ante need for assistance and the AC’s promotion of IAF independence from management.

The study’s findings are particularly relevant to the internal audit profession as they provide insight into the factors that determine AC effectiveness in monitoring management. The study also sheds light on the benefits and limitations of AC utilization of the IAF, a practice that governance professionals consider one of the most vital AC activities. The study’s results can help regulators and markets understand the costs and benefits of maintaining an IAF and inform decisions on proposed mandates for IAFs to interface with ACs. Ultimately, the study contributes to the ongoing effort to improve financial disclosure quality in financial markets.

You can find the study here.