The Audit Committee

This article aims to highlight the ever-increasing important role of the Audit Committee of public limited liability companies which we find listed on the Official List of the Malta Stock Exchange.

However, before doing so, it would be beneficial to understand how boards are structured and where the Audit Committee sits within these structures. There are two kinds of governance structures of companies – one-tier boards and two-tier boards. Malta’s Companies Act follows the Anglo-American approach, whereby companies apply the former structure, also known as the unitary model. This governance model consists of one board of directors that may include a mix of both executive and non-executive directors. This is the model applied by the UK and the US (thus the name Anglo-American). In Continental Europe, the tendency is to find the two-tier board system, where the Executive Board, as the name implies, is made up of the executive directors who generally are tasked with running the day-to-day operations of the company, while the Supervisory Board is made up of non-executive board members. The main objective of the Supervisory Board is that of monitoring and representing the interest of shareholders on the board.

With a one-tier board, this supervisory function is often undertaken by the Audit Committee and public limited liability companies that have their securities – whether equity or debt – listed on the Official List of the Malta Stock Exchange (more commonly referred to as issuers or listed companies) are required to have an Audit Committee which is compliant with the local Listing Rules issued by the Malta Financial Services Authority (MFSA).

While a board of directors of a listed company may include executive directors, listed companies are required to have a number of non-executive directors. The Listing Rules (amended in 2016 to implement new EU directives and regulation on the statutory audit of public interest entities (PIEs) which issuers classify as such) require that the Audit Committee of a listed company is composed solely of non-executive directors – at least three – and the majority of those directors have to be independent of the company. These requirements reflect the local transposition of Article 39 of Directive 2014/56/EU into our rules. Furthermore, the Listing Rules required that at least one member of the Audit Committee is competent in accounting and/or auditing and that the chairman of the Audit Committee is one of the independent directors. The rules talk also about the minimum number of times that the Audit Committee is set to meet during the year – at least four times.

What is the role of the Audit Committee and why is it important, particularly with listed entities? The primary objective of an Audit Committee is to protect the interest of the company’s shareholders (and stakeholders). If we were to look at entities that have their shares listed on the stock exchange, there exists a clear delineation between the ‘principal’ and the ‘agent’. The directors are considered agents who take decisions on behalf of the owners – the principals. The Audit Committee plays an important role in such cases in ensuring that they take objective stances on material matters, keeping in mind the interest they are bound to protect. If we had to look at issuers of bonds, most terms of reference of the audit committee seek to protect also the interest of bondholders as important stakeholders in the company – companies that issue bonds on the stock exchange include family-owned businesses and as such, to improve confidence in the transparency and good governance of the company with bondholders, the Audit Committee would seek to protect their interest in the company.

Another primary objective of the Audit Committee is to assist the board of directors in the company’s decision-making processes and ensure qualitative reporting, including financial, at all times. In satisfying the latter objective, the Audit Committee is expected to manage the relationship between the company and the statutory auditors, monitoring the audit process and the consolidation of the financial statements, review any reports drawn by the statutory auditors, ensuring the independence of the external auditors and discussing any recommendations made by the auditors to improve quality and effectiveness of the financial reporting, amongst others.

Quality and risk management controls are important considerations for the Audit Committee, as its members are tasked with monitoring the effectiveness of the company’s internal quality control and risk management systems, particularly with regards to the financial reporting of the company, so as to ensure that quality of reporting is not compromised. The Committee members are also expected to assess impact and requirements in terms of new reporting standards that may affect the company and its reporting regime.

Another important aspect of the Audit Committee is its oversight role on various matters concerning the company. As discussed earlier, the Audit Committee has to transmit transparency and confidence in the company and its business, and as such, one important oversight role that its members have is that of monitoring material transactions, including any related-party transactions that the company may be planning to enter into. The Listing Rules require the Audit Committee to scrutinise the transactions with related parties (which may include transactions with the shareholders, directors or other senior officers within the company) to ensure that these are conducted at arm’s length. This means that the transactions that are presented have to be set on normal commercial terms. This is a safeguard to prevent a related party from taking advantage of its position and also provides a level of comfort and confidence to external stakeholders.

In such instances, the Audit Committee is expected to assess and, if deemed fit, approve the transaction, taking into consideration the materiality of the transaction, ensuring the transaction is in the ordinary course of the business of the company and assessing whether the related party has been given any preferential treatment. When the transaction is approved by the Audit Committee and the Committee considers that the transaction is material in the context of the company’s business, then a company announcement should be made, describing the transaction, mentioning who the related party is and the nature and extent of interest of the related party in the transaction. Another instance when a company announcement is to be issued is when the Audit Committee does not recommend the transaction but the company would still intend to proceed with the transaction. In such instance, apart from the company announcement, the Audit Committee will request that a circular is also sent out to the shareholders to obtain their approval, or otherwise. At no time during the discussion of the transaction with the related party may the latter be allowed to vote on the transaction.

Companies which have securities offered to the public and listed on a stock exchange are considered to be public-interest entities (PIEs). This is a classification given to entities including listed companies, banks and insurance companies among others. Due to the nature of their business, their size and/or number of employees, they are considered to have a significant public relevance. It is therefore important to have a balanced board that is composed of people with integrity and who can and would pose questions to ensure that all stakeholders’ interests are protected.

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