New accountability for corporate audit committees: regulators put the burden of improved external audits on corporate directors

Strategic Finance, May, 2002 by Andrew J. Felo, Daniel P. Mahoney, Steven A. Solieri

The responsibilities of corporate audit committees are increasing in both number and complexity. This trend was well under way prior to the Enron debacle and will likely continue because of it.

Today's audit committees must meet strict criteria and adhere to rigid rules established by the Securities & Exchange Commission (SEC), the New York Stock Exchange (NYSE), and the National Association of Securities Dealers (NASD).

The growing body of rules is largely the result of recommendations formulated by the SEC's "Blue Ribbon Committee on Improving the Effectiveness of Audit Committees" and the AICPA (American Institute of Certified Public Accountants) Public Oversight Board's "Panel on Audit Effectiveness."

Public companies and stock exchanges have, in large measure, formally acted on the recommendations, presenting audit committees with a host of new, important concerns. Now audit committee members are likely to find their role in financial reporting increasingly prominent. Most are, more than ever before, true "corporate watchdogs" of the financial reporting community.

Former SEC Chairman Arthur Levitt initiated these reforms with his groundbreaking 1998 speech "The Numbers Game" in which he criticized corporate financial statement preparers and the independent accountants who audit financial statements. Levitt outline a 10-point "action plan," which proved to be a significant harbinger of regulatory changes governing audit committee composition and responsibilities.

As a result, the SEC issued new and amended rules in its "Final Rule: Audit Committee Disclosure," which requires companies to make a series of disclosures in an audit committee report that must appear in the annual proxy statement of the corporate (see "A Summary of the Required Disclosures in an Audit Committee Report." p. 54).

AUDIT COMMITTEE INDEPENDENCE

The NYSE imposed the requirement that audit committee members of its listed firms "have no relationship with the Company that may interfere with the exercise of their independence from management and the Company." The NYSE Listed Company Manual elaborates on relationships that could be deemed to compromise the independence of audit committee members. It further notes that audit committees of listed firms are to be composed solely of independent members.

The NASD likewise imposed new independence rules, some of which are more stringent, such as disqualifying directors from serving on the audit committee because of conflict of interests. For example, an attorney director can't serve on the audit committee if more than 5% or $200,000 of his/her firm's revenue is generated from the company on whose board he/she serves.

Moreover, the NYSE now requires its listed companies to attest to the financial literacy of each member of the audit committee, with criteria for assessing such literacy to be determined "in the Board's business judgment." The NYSE also requires at least one member of the audit committee to possess financial expertise, where the assessment is at the discretion of the board members. In addition, audit committees must consist of a minimum of three members.

The NASD'S new rules in this area are similar to those of the NYSE. For example, they require that all members of the audit committee "be able to read and understand fundamental financial statements" and that at least one member have "past employment experience in finance or accounting, requisite professional certification in accounting, or other comparable experience or background." Like the NYSE, the NASD requires audit committees to consist of a minimum of three members.

While it seems intuitive that, given the scope of their financial oversight responsibilities, most audit committees already satisfy the basic financial literacy requirements of the NYSE and NASD, boards of directors must be careful not to assume the obvious. Making sure audit committee members have financial expertise is easy to do and crucially important.

INDEPENDENCE OF EXTERNAL AUDITORS

The Independence Standards Board (ISB) was created in 1997 through an agreement between the SEC and the AICPA and was disbanded in July 2001 after finishing its work, most of which was incorporated into the SEC's new auditor independence rules adopted in November 2000. The ISB issued Standard No. 1, "Independence Discussions with Audit Committees," which says that, at least annually, an auditor shall:

a. "Disclose to the audit committee of the company (or the board of directors if there is no audit committee), in writing, all relationships between the auditor and its related entities and the company and its related entities that in the auditor's professional judgment may reasonably be thought to bear on independence;

b. Confirm in the letter that, in its professional judgment, it is independent of the company within the meaning of the [Securities] Acts; and

c. Discuss the auditor's independence with the audit committee."

As you can see, the ISB Standard places responsibility with the independent auditors. But the SEC now requires audit committee members to address the issue of external auditor independence. The SEC's requirements pertaining to "Audit Committee Disclosure" specifically address the audit committee's responsibility in terms of the ISB Standard and require the audit committee to state (within its proxy statements) whether it has received from the auditors the independence disclosures required by ISB Standard No. 1 and discussed with the auditors the auditors' independence. Thus, it isn't sufficient for audit committees to merely acknowledge receipt of the auditors' independence disclosures; rather, the audit committee must speak to these disclosures in the proxy statement.