August 1999

The Blue Ribbon Committee serves up its recommendations.

The Evolving Role of Corporate Audit Committees: Implications of Recent SEC Actions

By Daniel P. Mahoney

In Brief

A Plan of Action

SEC Chair Arthur Levitt has been unambiguous in his resolve to bring greater meaning and transparency to corporate financial statements. At his behest, the Blue Ribbon Committee considered ways to improve financial reports by strengthening the role of the audit committee. Its recommendations and guiding principles have important implications not only for audit committees but also for corporate managements and internal and independent auditors.

The committee's recommendations, if formally adopted, would entail a number of significant changes in the financial reporting process. Even small public companies face changes, since only the first three of the 10 recommendations apply exclusively to large companies. The key ingredient in the recommendations is an audit committee made up of independent directors that have an understanding of financial reporting.

Everyone playing a part in corporate financial reporting will likely experience the impact of the SEC's resolve to enhance financial statement integrity. Corporate managers might view the potential changes with a sense of trepidation, while independent auditors may see opportunities for additional revenues. Investors should find comfort in the greater objectivity and transparency that the recommendations are intended to yield.

On September 28,1998, SEC Chair Arthur Levitt delivered a speech at New York University that identified various means by which companies often manage their reported earnings and the misleading financial statements that may result from these earnings management tactics. (A complete transcript of the speech was published in the December 1998 issue of The CPA Journal.) Levitt's concern over the deteriorating quality of corporate financial statements underscored a resolve to enhance the integrity of the financial reporting process. He proposed a "Blue Ribbon Committee" whose purpose would be to develop recommendations that would strengthen the role of audit committees in overseeing the financial reporting process.

The Blue Ribbon Committee was co-chaired by John Whitehead, former deputy secretary of state and retired senior partner of Goldman, Sachs & Company, and Ira Miller, senior partner, Weil, Gotshal & Manges LLP. The committee's nine other members included representatives from public accounting, the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), large corporations, and the Federal government. The recently released Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees offers 10 recommendations that would increase both the effectiveness and responsibilities of audit committees. The report is addressed to the presidents of NASD and NYSE. It will be up to their respective boards to approve in concept the recommendations and adopt implementing rules. Implementation of some of the recommendations will require action on the part of others including the SEC and the Auditing Standards Board. The report also includes five guiding principles for audit committee best practices.

The 10 Recommendations

The committee's report calls attention to the changing role of boards of directors, noting that membership today demands, more than ever, a commitment of time and energy. The committee also stresses a board's responsibility to ensure proper disclosure and transparency in financial reporting and preempt the "accounting games" that serve to erode the credibility of financial statements. It was from this starting point that the committee formulated its 10 recommendations regarding the appropriate structure and role of audit committees. The first two recommendations, not surprisingly, are intended to ensure an appropriate level of independence among the members of audit committees.

Audit Committee Independence. The two independence-related recommendations will not likely be viewed by corporate America as a dramatic departure from current structural guidelines for audit committees. Both NYSE and NASD currently have their own definitions of and requirements for audit committee independence. More specifically, NYSE requires its listed companies to have at least a two-member audit committee composed exclusively of independent directors. Similarly, NASD requires each of its issuing companies to maintain an audit committee consisting of a majority of independent directors.

Nevertheless, adoption of Recommendations 1 and 2 by NYSE and NASD would increase the rigor with which independence is assessed. For example, the current NYSE requirement for independence states that former officers of the company and its subsidiaries may qualify for audit committee membership if the board believes that such persons will nonetheless exercise independent judgment and provide material assistance to the functioning of the audit committee. In contrast, Recommendation 1 would, with rare exception, prohibit such membership if the former director in question had been employed by the corporation or any of its affiliates during the current year or any of the preceding five years.

Additionally, NASD's requirement for a majority of independent members would apparently be superseded by the requirement for an audit committee consisting solely of independent members. Adoption of the two recommendations would also require that stockholders be formally notified (via the annual proxy statement) of any exception to the independence standards.

Financial Literacy. Recommendation 3 stipulates the need for financial literacy on the part of audit committee members. Many in corporate America might be surprised such a requirement needs to be explicitly mentioned.

The stipulated need for at least three audit committee members, each of whom is "financially literate," calls attention to the apparent deficiencies of many existing audit committees. At least a minimal degree of financial competence might be reasonably presumed of any board member, particularly one on an audit committee. Nonetheless, the committee found deficiencies of such magnitude that a formal requirement was deemed necessary.

The committee's view of financial literacy is one that simply calls for the ability to read and understand each of a company's financial statements. Directors that have only limited familiarity with financial matters can achieve at least an adequate degree of competence via company-sponsored training programs. Even under this requirement, it would seem that the requisite level of financial literacy would be minimal.

As for the requirement of "expertise" on the part of at least one member of the audit committee, the report regards expertise as prior employment in finance or accounting, professional accounting certification, or other comparable experience providing a sophisticated knowledge of financial matters. Prior or current experience as a company chief executive officer is cited as an example of relevant employment. Here again, this stipulation may be disappointing to stockholders, creditors, and other financial statement users that might have assumed a high level of financial sophistication on the part of all members of corporate audit committees. However, in light of Chair Levitt's abundant stories of surprisingly deficient audit committee members, the recommendations may be quite justified.

Audit Committee Mission and Responsibility. Recommendations 4 and 5 address the committee's perceived need for formalized audit
committee charters. The committee believes that charters would steer audit committees toward more clearly defined missions and greater responsibility in carrying them out. A good charter is one that would impose upon the committee greater self-discipline. An appendix to the committee's report includes sample charters for reference.

The "safe harbor" referred to in Recommendation 5 reflects the committee's desire to avert increased exposure to liability on the part of audit committees that satisfy the formalized charter requirements. The committee's report expressly states that the business judgment rule (gross negligence) for determining liability under state law should continue to apply. Despite its recognition of safe harbor provisions in state law, the committee also believes that the SEC should formally adopt its own safe harbor rule as part of the Federal securities laws.

Recommendations 6 and 7 show the committee's concern over the close relationship that frequently develops between senior corporate managers and outside auditors, partly attributed to the expanding role of outside auditors in providing nonaudit services. Fearing that this relationship might, at least in some cases, serve to compromise the quality of audit work, the committee identifies the audit committee as the ultimate party to which outside auditors are accountable and the ultimate arbiter of their objectivity and independence.

Communication Between Committee and Auditor. Recommendation 8 would enhance the independent auditor's communication with the audit committee. The committee's report opines that current auditing standards require too little communication between the outside auditor and the audit committee. While generally accepted auditing standards (GAAS) require that the outside auditor communicate with the audit committee on such matters as difficulties experienced while conducting the audit, disagreements with management, consultations with other accountants, and illegal acts detected during the audit, they fall short of requiring communication on more subjective matters like the quality of the company's financial reporting.

Recommendation 8 is likely the direct result of Levitt's previously stated concern over the manner in which an increasing number of companies appear to be practicing earnings management. He has been highly critical of the "big-bath" charges and other accounting tactics used by management (and commonly accepted by outside auditors) in managing reported earnings and cited the growing level of public cynicism regarding the quality of corporate earnings.

The committee's call for greater communication on the topic of the quality of the company's accounting principles and the degree of aggressiveness or conservatism of these principles would seemingly make it more difficult to manage the financial reporting process. It would be incumbent upon the outside auditor to discuss questionable tactics with the audit committee; in turn, the audit committee may be reluctant to accept such tactics once their questionability has been brought directly to their attention. Additionally, the newly required level of financial literacy and expertise (as called for in Recommendation 3) would conceivably increase the rigor with which audit committee members address those matters that are brought to their attention.

Increased Visibility. Recommendation 9 would formalize to an even greater extent the audit committee's responsibility for overseeing the entire audit process. While Recommendation 8 would enhance the extent of communication between the outside auditor and the audit committee, Recommendation 9 would require formal disclosure of this communication and a statement as to whether the audit committee then views the financial statements as acceptable. Consequently, the audit committee would be the subject of a greater focus on the part of financial statement users.

The committee points out that increased public awareness of the audit committee's responsibilities and heightened sense of self-responsibility on the part of the audit committee members would likely result from formal implementation of its recommendations. By including the safe harbor provision and stating that the audit committee's effectiveness is predicated on the reliability of the information presented by other parties, the committee makes it clear that it does not intend to expose audit committees to greater legal liability.

Interim Reports. Recommendation 10 may be the recommendation of greatest potential interest to outside auditors. It is an outcome of Levitt's concern over pressure on companies to meet Wall Street's interim earnings projections. The expectation is that an SAS 71 interim financial review preceding a company's filing of its Form 10-Q would inhibit the practices that have led to an erosion of the quality of quarterly earnings.

While the committee's report aptly notes that companies may currently have their outside auditors delay their review of interim financial statements until the end of the year before the filing of the 10-K Annual Report, Recommendation 10 would result in a more stringent monitoring process. Adjustments of interim financial statement data that might otherwise await the filing of the 10-K or even be judged as immaterial when viewed at year end should serve to improve the quality of interim financial reporting.

The committee's report also notes that all of the Big Five accounting firms already require that their clients' interim statements be subject to an SAS 71 interim financial review as a condition to the audit engagement. This self-regulating practice was adopted recently at the informal urging of the SEC. Consequently, Recommendation 10 would not represent a change to Big Five client companies.

For the public companies that have not engaged the Big Five accounting firms and for the non­Big Five firms themselves, however, Recommendation 10 presents a potentially significant change. These companies would face more stringent rules as to the timing and perhaps depth of interim financial statement reviews. Auditors stand to gain from greater involvement in
the interim reviews and an increase in billable hours. For audit committees, the requirement would mean more frequent communication with the outside auditor and a greater overall level of involvement in the interim financial reporting process. For management, it would likely mean greater difficulty in managing quarterly earnings.

Finally, Recommendation 10 also has implications for investors--the intended beneficiaries of every recommendation--since it would offer the potential for greater confidence in interim financial statements.

The Guiding Principles

Along with providing the 10 recommendations on improving the effectiveness of corporate audit committees, the Blue Ribbon Committee's report offers five guiding principles for audit committee best practices. Because of the unique circumstances of each company, it is natural to expect the practices of audit committees to vary. Therefore, rather than identify specific practices that all audit committees should follow, the committee offers guiding principles for their development. The five guiding principles are summarized in the Exhibit.

Like the 10 recommendations, the guiding principles reflect a greater level of responsibility and power for audit committees. Audit committees are shown to be responsible for the delineation of roles and duties for each participant in the financial reporting process, for ensuring the proper discharge of those responsibilities, and for ensuring proper communication and flow of information among the participants.

A Watchful Eye

Implementation of the recommendations is in the hands of the boards of the two securities exchanges (NASD and NYSE), the SEC, and the Auditing Standards Board. Because of the short timetable given to the panel to discuss the recommendations, the SEC and Chair Levitt will be monitoring the progress the various implementing groups are making. *

Daniel P. Mahoney, PhD, CPA, is an associate professor of accounting at the Arthur J. Kania School of Management, University of Scranton.

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