The CEO and the audit committee - Governance

Chief Executive, The, April, 1993 by J. Michael Cook

An audit committee performs crucial oversight functions. But its effectiveness depends on the skills and priorities of its members and support from senior management.

As chairman and chief executive of Deloitte & Touche, I am the firm's senior client service partner. I spend a great deal of time with our clients in order to understand their needs and expectations, and to direct the resources of our firm to meet and exceed them. Participating in client service and ensuring that our services are top quality are among the most rewarding aspects of my job.

In this role, I work with a number of the most sophisticated, talented, and effective audit committees in the U.S. I believe these committees add considerable value to the quality and credibility of our financial reporting process, which is, in my opinion, justifiably recognized to be the finest in the world. Their oversight of auditing functions and of a company's internal control system helps to protect shareholder interests by keeping business on the straight and narrow.

HERE TO STAY

Audit committees have been a part of our system for over 50 years. Soon after its own formation to protect investors, the Securities and Exchange Commission urged public corporations "to establish a committee of non-officer directors to focus on the quality of financial reporting and, thereby, protect shareholders' interests." Since then, the concept has been explored, refined, expanded, codified, and mandated in various forms by bodies such as Congress, the New York Stock Exchange, and the AICPA. The audit committee movement received a boost from the disclosures of improper corporate conduct that precipitated the passage of the Foreign Corrupt Practices Act in 1977, and again from the incidence of fraudulent financial reporting that led to the formation of the Commission on Fraudulent Financial Reporting (the "Treadway Commission") in 1985. Although the Treadway Commission recommended that the SEC mandate audit committees for all public companies, such a comprehensive measure has never been enacted. Nevertheless, in almost all public companies, audit committees have become an essential part of the governance structure.

GUIDANCE FOR AUDIT COMMITTEES

Early writings on audit committees focused on their origin; development; membership composition; and "mechanics," such as size, frequency of meetings, and agenda setting.

The most comprehensive and instructive guidance on audit committee operations can be found in the October 1987 Report of the Treadway Commission. In it, the commission concludes that the audit committee is a necessary component of the financial reporting process and serves to deter fraudulent financial reporting.

The Treadway report includes specific "good practice guidelines" for audit committees. Many audit committees periodically review their own activities by comparing them to these guidelines, often with the assistance of their external and internal auditors. Such periodic "check-ups" are in and of themselves a good practice for diligent audit committees.

Only one of the Treadway Commission's recommendations for audit committees has not been widely adopted: the suggestion that the annual report to shareholders include a report from the chairman of the audit committee on its function and activities. Only a few such reports are provided today. The principal reason given for non-acceptance of the recommendation is the belief that such a report likely will become legalistic boilerplate and, therefore, will not be informative. Also, many companies fear that the report may confuse the responsibilities of the audit committee with those of senior management as expressed in management's report which usually accompanies the financial statements in the annual report. Although I strongly support the Treadway Commission's recommendations in general, I don't think a separate report from the audit committee to the shareholders is a necessary part of the financial reporting process.

WHAT MAKES AN AUDIT COMMITTEE EFFECTIVE?

In my experience, the mechanics of the audit committee (i.e., its size, how often it meets, etc.) are far less important to its effectiveness than the composition of the committee and the support it receives from and gives to management. There is no substitute for active committee members with an appropriate (but not excessive) degree of inquisitiveness and skepticism. An audit committee member need not be an expert in financial reporting, although such expertise in one or two of the members is useful. More to the point is the members' knowledge of the business of the company and the industry in which it operates, and a constructive, inquiring approach to challenging the financial reporting practices of the company. In a nutshell, members should demonstrate the willingness and the ability to ask the right, tough questions of financial management, external and internal auditors, and legal counsel.

SUPPORT FOR THE AUDITORS

Another function of the audit committee is to provide private access to the board of directors for the external and internal auditors if critical matters cannot be properly resolved through normal channels. Usually, this access is rarely needed or used, because management is committed to the integrity and effectiveness of the company's financial reporting, control, and audit functions. Like homeowners insurance, however, the value of the function is not measured by the frequency of its use but rather by its reassuring presence.