Why Your Private Company Needs a Good Audit Committee

Why Your Private Company Needs a Good Audit Committee

by Matthew Perreault
March 20, 2019

Updated February 08, 2023

Many private company business leaders have the misconception that only public companies need an audit committee. Or they think that just having an audit committee, even one that simply goes through the motions, is enough. While it’s true that the Securities and Exchange Commission doesn’t require it of private companies, it is still in the best interest of your organization and its stakeholders to establish a strong and effective audit committee.

Below are the advantages of forming a good audit committee, plus best practices the committee should follow to ensure a credible and transparent process as they execute their duties throughout the year.

How an Audit Committee Benefits Your Private Business

An audit committee is generally made up of non-executive members of your board of directors and is responsible for overseeing financial reporting and disclosure, as well as selecting and overseeing the external auditor. Here are some key reasons your leadership team should consider forming an audit committee.

You’ll enhance your corporate governance

Even if you have a small business, it’s important to have strong governance — the audit committee’s role is to operate as a healthy power check to your leadership team. A good audit committee should hold management accountable for the financial information it produces, which is vital for the protection of your organization and its stakeholders. In addition, as your business grows, so will its complexity. The audit committee is the governance body that will be able to discover and mitigate the financial risks your organization will likely encounter as it evolves.

You’ll gain credibility with external stakeholders

An effective audit committee shows that your organization believes in strong corporate governance and relevant and reliable financial reporting. Key stakeholders outside of the board, including potential investors, strategic investors and lenders, will take notice and have more confidence in your business practices and in the performance of the company.

You’ll have the right framework in place to go public

It’s typical for executive teams to start discussing creation of an audit committee when they decide to go public, whether through IPO, reverse merger or other means. From a governance and financial reporting standpoint, you will be better prepared to go public if you have an audit committee in place before or when the company begins to evaluate strategic transactions. Ideally, the audit committee would be formed a few years before an exit event so that it has practice governing the company.

Best Practices for Audit Committees

The audit committee plays an important oversight role in the company’s financial reporting process, including the financial statement audit and the quality of the work performed by the independent auditor.

A common mistake audit committees make is to simply go through the motions, doing the bare minimum of work and not adding value through careful and periodic evaluation of the company’s financial reporting strengths and weaknesses. An audit committee should follow a charter, which dictates the scope of its responsibilities and best practices. Below we summarize a few best practices and offer insights into why they are important for the success of your committee.

The audit committee should:

Consist of members with specific qualifications

Audit committee members should collectively have a solid understanding of financial reporting, internal controls and the external audit process, as well as knowledge of your industry. Ideally, the members should bring skill sets not found in the current management team to help establish good governance. The committee chair should be an independent director with extensive knowledge of accounting and financial reporting, strong leadership and a good understanding of the committee’s duties.

Be the primary entity that interacts with the external auditor

As previously mentioned, the audit committee selects the auditor and handles the scope of the audit. The members should have the experience and knowledge to identify financial issues that the operations committee wouldn’t be able to. For example, the audit committee is more capable of assessing your company (without going to an auditor) to discover if you’re ready for an audit.

Practice healthy skepticism about business information

The point of the audit committee is not to nod in agreement with management but to act as a separate entity that asks valid questions about the status of the business. Its members should openly discuss concerns and work with good faith to maintain effective oversight of financial reporting, internal controls, regulatory compliance and internal/external audit.

Prepare for questions from the external auditor

It’s said that being prepared is half the battle. Some questions your audit committee should have answers for come audit time include:

  • Is there sufficient evidence to provide the external auditor for a successful audit? This is about knowing whether you have good records dating back to the beginning of the year that you feel confident would pass an audit.
  • Are there significant internal control observations, including potential material weaknesses or deficiencies that need to be addressed?
  • Are there external factors such as litigations, claims or assessments against the business that might need to be disclosed or estimated?
  • Is the business being purchased, is it going public, or will it remain a private company? The audit committee should know the company’s exit strategy.

Meet 2 to 4 times per year

The audit committee typically meets based on the frequency of the board meetings. If the board meets four times a year, there should be a sidebar scheduled for the audit committee. The audit committee meeting agenda can cover various topics, such as selection/review of the independent auditor and independence, pre-audit planning, results of the audit, review of the audit committee’s effectiveness, review of internal audit activities and reports, regulatory changes and others.

Report to the board on its activities

When preparing its report to the board of directors, the audit committee should consider key points that have come out of its task list for the year:

  • Auditor selection, auditor independence and fees – What were the key criteria used by the audit committee in evaluating and selecting the independent auditor? Are fees reasonable for the audit work that's required?
  • Management oversight – How is the audit committee interacting with management? What are the types of reports the committee reviews in carrying out its oversight responsibilities? What are the key performance indicators the committee is observing?
  • Concerns regarding internal controls and segregation of duties – Does management have the right tools in place to enable the company to operate well without the risk of having large internal control findings, whether or not there is an audit? Does the company have the right enterprise resource planning (ERP) and stock compensation management systems? Is there segregation of duties to prevent widespread management fraud?

Don't let the audit committee’s reporting to the board become a boring re-hash of every item the committee has worked on. Do update the board on key findings and issues that emerge. This will facilitate productive discussion on action items. Do a follow-up report at the next board meeting to inform the board on how the committee handled any items of concern.

The Bottom Line

While your private company is not required to have an audit committee, it is in your best interest to have an effective one so that you approach finance, accounting and audit processes with good professional conduct. And, should you decide to go public, you will have a mature governance structure in place.

By following best practices for forming and running an audit committee, you gain the financial literacy of its members, better insight into strengths and weaknesses in your business and credibility as an executive leadership team that prioritizes due diligence.

To learn more about the business benefits of an audit committee for your private company and how to establish one, contact our financial audit experts.

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