10-POINT PLAN TO IMPROVE OVERSIGHT OF FINANCIAL REPORTING PROCESS
The New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), and the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees have released their report of 10 far-reaching recommendations intended to improve the quality of corporate financial reporting. The "blue ribbon" panel, drawing members from the business, financial, and accounting communities, was established in September 1998 by the NYSE and the NASD in response to concerns expressed by SEC Chair Arthur Levitt about the adequacy of oversight of the audit process by independent corporate directors. The panel was co-chaired by John C. Whitehead, former deputy secretary of state and retired co-chair and senior partner of Goldman, Sachs & Co., and Ira M. Millstein, senior partner of Weil Gotshal & Manges LLP and a noted corporate governance expert.
The committee was charged with studying the effectiveness of audit committees in discharging their oversight responsibilities and, within 90 days, making concrete recommendations for improvement. In compiling the 71-page report, the committee sought input through a public hearing and an open request for formal written comments on the topic.
The 10-Point Plan
The following recommendations are excerpted from the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees:
1. Revise the Definition of Independent Director. Both the NYSE and the NASD should adopt the following definition of independence for service on the
audit committee for a listed company with a market capitalization greater than $200 million (or a more appropriate definition as determined jointly by the NYSE and the NASD):
Members of the audit committee shall be considered independent if they have no relationship to the corporation that may interfere with the exercise of their independence from management and the corporation.
The report gives a number of examples of such relationships, such as a director employed by the corporation or any of its affiliates at any point during the past five years, or a director accepting compensation from the corporation or any of its affiliates other than compensation for board service or benefits under a tax-qualified retirement plan.
A director who does not meet the independence definition may only be appointed to the audit committee if the board, under exceptional and limited circumstances, determines that it is required by the best interests of the corporation and its shareholders, and the board discloses the nature of the relationship and the reasons for that determination in the next annual proxy statement.
2. Require an Independent Audit Committee. The NYSE and the NASD should require that listed companies meeting the size criteria have an audit committee comprised of solely independent directors.
3. Mandate Minimum Audit Committee Size and Increased Financial Literacy. The NYSE and the NASD should require that listed companies meeting the size criteria have an audit committee comprised of a minimum of three directors, each of whom is financially literate as defined in the report or becomes so within a reasonable period of time after appointment. Furthermore, at least one member of the audit committee should have accounting or related financial management expertise.
4. Mandate Written Charter Detailing Responsibilities and Duties. The NYSE and the NASD should require that the audit committee of each listed company 1) adopt a formal written charter, approved by the full board of directors, that specifies the scope of the committee's responsibilities and how it carries out those responsibilities, and 2) review and reassess the adequacy of the audit committee charter on an annual basis.
5. Mandate Annual Public Disclosure of Audit Committee Activities. The SEC should promulgate rules that require the audit committee for each reporting company to disclose in a proxy statement whether the audit committee has adopted a formal written charter and, if so, whether the audit committee satisfied its responsibilities under the charter. The SEC should also require periodic disclosure of the charter in the registrant's annual report to shareholders.
6. Clarify Oversight Responsibility for Outside Auditors. The listing rules for both the NYSE and the NASD should require that the audit committee charter for every listed company specify that the outside auditor is ultimately accountable to the board of directors and the audit committee as representatives of shareholders.
7. Mandate Discussion with Outside Auditor Regarding Independence. The listing rules for both the NYSE and the NASD should require that a registrant's audit committee charter specify that 1) the audit committee is responsible for ensuring the receipt from the outside auditor of a formal written statement delineating all relationships between the auditor and the company, consistent with Independence Standards Board Standard no. 1, and 2) the audit committee is also responsible for actively engaging in a dialogue with the auditor with respect to any disclosed relationships or services that may impact the objectivity and independence of the auditor and for taking, or recommending that the full board take, appropriate action to ensure it.
8. Require Outside Auditor to Discuss Quality of Financial Reporting. Generally Accepted Auditing Standards (GAAS) should require that a company's outside auditor discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the company's accounting principles as applied in its financial reporting. This requirement should be written in a way that encourages open, frank discussion and avoids boilerplate.
9. Require Audit Committee Annual Letter to Shareholders. The SEC should require that all reporting companies include in their annual report a letter from the audit committee to shareholders and Form 10-K, Annual Report, disclosing whether 1) management has reviewed the audited financial statements with the audit committee and discussed the quality of the accounting principles as applied and significant judgments affecting the company's financial statements; 2) the outside auditors have discussed with the audit committee their judgments of the quality of those principles; 3) the members of the audit committee have discussed among themselves, without management or the outside auditors present, the information disclosed to the audit committee; and 4) the audit committee, in reliance on the review and discussions conducted with management and the outside auditors, believes that the company's financial statements are fairly presented in conformity with Generally Accepted Accounting Principles (GAAP) in all material respects.
10. Mandate Interim Review of Quarterly Financial Reporting. The SEC should require that a reporting company's outside auditor conduct an SAS 71 Interim Financial Review prior to the company's filing of its Form 10-Q. Furthermore, SAS 71 should be amended to require that a reporting company's outside auditor discuss with the audit committee, or at least its chair, and a representative of financial management the matters described in AU Section 380, Communications with the Audit Committee, prior to the filing of the Form 10-Q (and preferably prior to any public announcement of financial results).
The blue ribbon panel completed its work in just about the 90 days that Levitt wanted. The next steps will take longer. Changes to listing requirements, auditing standards, and SEC rules have to follow due process procedures. Levitt indicated that the SEC would be watching the progress to ensure that the recommendations are implemented as quickly as possible.
Copies of the entire report can be obtained from the public affairs offices of the NYSE and the NASD, or online from www.nyse.com and www.nasd.com. *
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